Australian bonds: your secret weapon for a resilient portfolio? (Part II)

Maybe you have an investment property, maybe you don’t. Either way, generating a consistent and predictable cash flow into your bank account is invaluable for any investor.

Building a passive income-generating portfolio is a significant accomplishment—often viewed as a key to financial success or early retirement. After all, cash flow is king when it comes to achieving financial independence.

Equities vs Bonds: Which Offers Predictable Income?

Equities are renowned for their potential to deliver substantial returns. However, can they provide a predictable income stream? Equities can indeed provide income through dividends, but this is merely a possible cash flow stream, not a guaranteed one.

If a company underperforms, dividends may be reduced or eliminated altogether. Moreover, high-dividend stocks often struggle to keep pace with the capital growth of stocks that do not pay dividends, further complicating the goal of reliable income generation.

So … what’s the solution?

A possible solution for investors is bonds.

Bonds provide an attractive alternative for investors seeking a consistent and predictable income stream. They can also help investors create a financial cushion, offering the potential to retire earlier by generating income without relying on employment.

While no investment comes with a guarantee, bonds typically offer a less complex route to stable income than sifting through stock market opportunities and assessing companies’ dividend yields.

In this second instalment of Saxo’s three-part series, we’ll explore how to structure your portfolio to generate income, reduce volatility, and possibly benefit from the growth in the underlying value of fixed income assets over time.

With the cost of housing and living essentials still rising in Australia, many are finding that the dream of building an income stream from property rentals is becoming increasingly unattainable. Bonds, however, can offer a solution, enabling investors to generate cash flow without the challenges that come with real estate ownership.

Interest rates – what really makes the world go round

You’ve probably heard the term “yield curve” thrown around in financial news, but not everyone understands how it affects their investments.

The yield curve measures the spread between current interest rates and expectations of future rates, and it plays a critical role in determining bond prices.

• Normal yield curve: In a healthy economy, a ‘normal yield curve’ suggests that future interest rate hikes are expected as part of sustainable growth. 
• Widening yield curve: When prices rise too quickly and inflation accelerates, the yield curve widens. In response, central banks typically raise interest rates to curb spending and stabilise price increases. This was evident post-COVID-19, as global economies boomed and inflation ensued. 
• Inverted yield curve: Conversely, an inverted yield curve occurs when rates are expected to drop, typically during periods of economic slowdown and high unemployment. In this scenario, central banks often lower rates to stimulate growth by reducing the cost of borrowing.

Source: RBA

How do we work out if the timing is right for bonds?

Recently, the US Federal Reserve reduced the US cash rate by 50 basis points, bringing it down to 5%.

What does this mean for investors?

In short, US bonds may become less appealing for new fixed income investors. This is because bond prices and yields are inversely correlated: when yields rise, bond prices fall, and when yields fall, bond prices rise. As rates have started to decline in the US, bond prices in secondary markets are rising, meaning investors now pay more for a lower yield.

So, how can we use this info in our portfolio?

When the yield curve widens and rates are expected to continue rising, it may be wise to wait until rates peak before locking in a long-term bond yield. Once you invest, your bond’s coupon payments will typically remain fixed, providing consistent income.

On the other hand, when the yield curve is about to “invert,” or rates have peaked and are expected to fall, locking in a higher yield could be a sound strategy. This would enable investors to earn income while also benefiting from the potential increase in bond prices as rates decline.

While many central banks worldwide have started cutting interest rates, Australia has not yet followed suit. With the first Australian rate cuts expected in Q1 2025, according to comparison website Finder’s September RBA Cash Rate Survey, now might be a good time for investors to consider purchasing bonds while prices are still low and before rates begin to drop.

Bonds or Property: Weighing Your Options

For some, investment property investing is currently out of reach - not a “never,” but a “not now.” Fortunately, generating steady, recurring income is still achievable with bonds. They offer a cost-efficient way to start investing in income-generating assets, without the significant capital required for real estate.

This article is designed to help you take a moment to reflect on your financial goals and how bonds might provide a pathway to long-term, recurring income, without the complexities of property ownership. Bonds present an opportunity to grow your wealth without the need for a mortgage or ongoing real estate management.

In our next article, we’ll explore how Australian bonds perform under tough market conditions, and how you can combine bonds and stocks with Saxo to achieve a balanced portfolio aimed at both growth and income.