Modern Portfolio Theory (MPT) emerged in the early 1950s via a seminal article published in the academic Journal of Finance and authored by Harry Markowitz. Without meaning to make light of Markowitz’ contribution (Markowitz is a Nobel laureate) MPT is just a fancy title for the old maxim that has been around since Adam was a boy: “don’t put all your eggs in one basket”.
Markowitz’ real contribution was to put some logic and process around the maxim, as it relates to investing. The simple concept is, in an ideal investment portfolio, two assets will be held: one that pays-out when the sun shines, and one that pays-out when it is raining.
Thus, the investment portfolio will always pay-out no matter the weather.
If this is applied to a portfolio of shares and risk-free government bonds, when investors are risk seeking and share prices are rising, bond prices will fall. But when investors become risk averse, share prices will fall and bond prices will rise.
Just think of only a few years ago when the world had a bi-polar fixation with the RORO trade – risk on, risk off.
Bearing in mind that Markowitz is an American economist, bonds serve another useful purpose in an investment portfolio, that otherwise only holds shares. Bonds pay regular coupons and thus generate an income.
Many shares in the US (especially in the past) do not pay dividends. Without bonds in an investment portfolio an investor would be forced to sell some shares each year just to generate an income, if an income was required.
In Australia, and elsewhere around the world, the need to hold bonds to generate an income is less of a priority. Nevertheless, combining bonds with shares serves the useful purpose of reducing the risk of an investment portfolio, while maintaining an appropriate rate of return.
This is why bonds should be held in an investment portfolio, but how many?
So far only risk-free government bonds have been considered. Risk free government bonds are bonds issued by the sovereign; in our case, the Commonwealth of Australia.
The bonds are considered to be risk free because the government cannot default on a debt obligation denominated in its own currency (this does not apply to state government bonds or any other bonds). Thus, to obtain the benefits of risk-free government bonds in an investment portfolio it is only necessary to hold one, in sufficient volume, and provided you don’t want to sell it before maturity.
But. And this is a big but, because this is where practicalities take us away from a neat theory.
Risk-free government bonds have some disadvantages not the least of which is; they don’t pay very much and this is because they are risk free. Higher returns come with greater risk – it’s always the way isn’t it?
At the present time, 10 year Commonwealth government bonds are yielding just 2.6% per annum. A three year bond yields less than 2%.
If you want to hold only risk-free assets in your self-managed superannuation fund, and you want to generate a retirement income of $100,000 a year without tying up your money for too long, you will need to have more than $5 million invested in three year government bonds.
The disadvantages of risk-free bonds are now starting to become obvious.
Another possible disadvantage is that the bonds typically pay a fixed coupon. The interest rate paid will be fixed at 5% per annum, or perhaps 10% or maybe
just 2% per annum.
It will all depend on level of interest rates in markets at the time the bond is issued.
But if you are holding a 5% bond and interest rates rise to 10% you are probably not going to be happy, especially if you can’t hold the bond until maturity and have to sell the bond. The price of the bond will be something less than face value and a capital loss will be incurred.
The reverse will be true if interest rates fall to 2%.
Investors wishing to mitigate the impact of interest rate changes on their risk-free bond holdings will employ what is known as a bond ladder. The idea is that you hold more than one bond and in fact you might hold ten, with one bond maturing each year over a ten year period.
This gives you a source of capital each year, if it is needed, or alternatively the proceeds from the maturing bond can be reinvested in a new bond at current interest rates.
Now that we are up to ten bonds in an investment portfolio, we can address the possibility that you don’t have $5 million in your SMSF to generate a risk-free $100,000 per annum. Generating $100,000 per annum may still be possible but it will require investing in riskier bonds.
Riskier bonds are bonds that can default, which as said earlier, are all other bonds. Introducing the risk of default introduces credit risk to an investment portfolio and in so doing, moves us further away from Markowitz’ ideal investment portfolio.
On a risk continuum, credit risk sits between risk-free and equity risk and the more credit risk introduced into a portfolio, the more bonds that need to be held to minimise the adverse impact of an event of default.
In this context, asking how many bonds do I need to hold, is a bit like asking how long is a piece of string? How much of your capital are you prepared to loose, if a bond issuer defaults?
This will be the subject of a follow-up article, “Investing 102: Credit risk”.
The author Philip Bayley is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.