A Bonding Investment
When you invest in bonds, you are effectively lending money to a government or company at an agreed interest rate for a set period of time. In return, the borrower promises to pay you interest at regular intervals and repay your loan at the end of the term. Bonds should be considered as part of a diversified investment plan. However, not all bonds are the same, ranging from very safe to very risky. Here are some things to look out for before you invest. If you’re still unsure, seek financial advice.
How Bonds Work
Bonds have a face value, which is the amount you will get back at maturity and a coupon amount, which is the interest paid each year. This payment may be divided into half-yearly or quarterly amounts. This is simple if you buy a bond at the start of the term and hold it to maturity. Things are more complicated if you only hold a bond for part of the term.
Bonds that you can trade on a secondary market such as the Australian Securities Exchange (ASX) are known as ‘listed’ or ‘exchange-traded’ bonds. Listed or exchange-traded bonds give you the flexibility to sell the investment if your circumstances change.
How Interest Rates are Calculated
Bonds can pay interest at a fixed or floating rate.
Fixed Rate Bonds
The interest on a fixed rate bond is set when the bonds are issued and is shown as a percentage of the face value of the bond. The interest rate stays the same for the life of the bond.
Floating Rate Bonds
The interest rate for floating rate bonds varies in line with movements in a benchmark interest rate. This means the coupon payment will vary each time, sometimes quite substantially. You could get higher returns if the benchmark interest goes up, but you could also get lower returns if the benchmark interest rate goes down. Check the bond’s prospectus for information on how and when the floating rate will be calculated for coupon payments.
In an investment portfolio, bonds may serve a different function to conservative investments such as savings and deposit accounts. The market value of bonds can go up and down depending on what’s happening in the economy and with interest rates. Certain bonds tend to perform well when other markets are struggling. For this reason, they are often seen as a defensive investment, as well as a source of regular income.
Over the last 25 years some high-quality fixed rate bonds have provided comparable, and in some cases, better than average returns, compared to Australian and International shares and listed property. They have also been less volatile than shares, with fewer years of negative performance.
How Safe is a Bond?
Bonds range from very safe (for example, Australian Government bonds) through to very risky (unlikely to repay your money). It’s very important to know what you’re investing in, as not all bonds or fixed interest investments are the same. In general, bonds are less volatile than other investments, such as shares. However, losses are possible if interest rates change or bond issuers default on their obligations to bondholders.
Most bonds have a credit rating, but ratings agencies may only make this information available to wholesale clients and advisers. This can make it difficult for a retail investor to assess how risky a bond is.
How Bonds are Valued
The capital value of a bond can rise or fall depending on the current interest rate and the amount of interest accrued since the last coupon payment. For example, if a bond has a face value of $100 but you bought it 11 months after the last annual interest payment was made, you would have to pay the seller more than $100 to take into account the interest accrued. Interest rates can also affect a bond’s value.
Let’s say you bought a 10-year bond yesterday with an interest rate of 5% per year. If market interest rates halved overnight to 2.5% per year, then the income from your bond would be twice as valuable. This would increase the price of the bond. If interest rates had doubled to 10%, the income from the bond would be only half as valuable. This would decrease the price of the bond.
Please contact your financial adviser if you wish to find out more about bonds and how to invest into bonds.
Source: Australian Securities & Investments Commission, Money Smart, December 2018.