by
Elizabeth Moran | Nov 26, 2013
Key points:
1. Australian Commonwealth Government bonds are very low risk and one of the few sovereigns to retain the very highest AAA credit rating.
2. There are risks with Commonwealth government bonds as most of the bonds are fixed rate. No matter what price you buy the bonds, as long as you hold to maturity your return will always be positive.
3. Generally I would recommend an allocation for SMSFs to Commonwealth government bonds but state government and territory bonds are marginally higher risk, so pay marginally higher returns and given the very low interest rate environment these would be my preference.
Last week the Australian Commonwealth government had a new bond issue of $5.9 billion. The bond was fixed rate and set at 4.5% per cent with a 20 year term until maturity. Total Commonwealth debt is expected to climb in the coming years but the question remains is investment in Commonwealth government bonds a good strategy for SMSFs?
Commonwealth government bonds are very low risk in that the Commonwealth can raise taxes and print money and is one of the handful of sovereigns that still retains the very highest AAA credit rating. In fact, they are considered “zero risk”. Because the bonds are the lowest risk investments in Australia, they will suit very conservative investors or those with known longer-term commitments.
However, there are risks with Commonwealth government bonds as most of the bonds are fixed rate (the Commonwealth also issues inflation linked bonds). The problem being that, as interest rates have moved lower in recent years, bond prices have increased. So, many of the fixed rate Commonwealth government bonds already on issue are trading over their issue value to $100. That’s fine for investors who purchased the bonds at first issue, as they have made an additional gain, but new investors buying the bonds will pay more than the $100 that they will receive if they hold them to maturity. That is fine as well because in effect you’re buying a higher fixed income stream until maturity, so are willing to pay more for that certainty.
If you buy a Commonwealth government bond that is priced over $100, as long as you hold to maturity your return will always be positive. The problem arises if the bond prices drop quickly and you are a forced seller. In that instance you may incur an overall loss.
For example, let’s consider an Australian Commonwealth government bond (ACGB) with a maturity of July 2022, issued at $100 face value with an interest rate (coupon) of 5.75 per cent. Investors have been attracted to the relatively high interest rate of 5.75 per cent, which is the rate the Commonwealth must pay over the life of the bond. Investors earn $2.875 each six months per $100 bond for the life of the issue.
Understandably, investors will pay more for the bond to access the high income, in fact at the moment they will pay around $112.95 per bond. The higher up-front payment means that income reduces slightly to be 5.09 per cent, while the return or yield to maturity incorporates a loss in value of the bond of $12.95, as the Commonwealth will only ever repay that original $100 face value. So the yield to maturity is lower at 3.96 per cent.
Investors assessing whether these bonds make good additions to their portfolios need to assess whether 3.96 per cent is adequate compensation for the risk involved. The other decision with ACGBs is whether to hold to maturity or buy the bonds with the intention of banking the higher income and selling if interest rates move higher and bond prices start to fall.
Generally I would recommend an allocation for SMSFs to government bonds. They are extremely liquid instruments with virtually no credit risk. However, state government and territory bonds are marginally higher risk, so pay marginally higher returns and given the very low interest rate environment these would be my preference.
A selection of Commonwealth government bonds is available through the ASX, although to access the complete list you’ll need to find a fixed income broker. Some state and territory bonds can be bought direct, or via a broker.