Given bonds come in so many different varieties, and are heavily influenced by macroeconomic and other forces - none the least being central bank policy - it is hardly surprising that bonds are the asset class Australian investors struggle with the most.
For example, according to Deloitte Access Economics, private Australian investors hold less than 1% of all corporate bonds on issue in Australia, compared to almost 20% in the United States.
As a defensive asset that provides a stable source of income, while protecting the money you invest, bonds can be a worthwhile way to diversify any portfolio. While no Australian government has ever defaulted on bondholder debt, many investors steer clear of bonds, simply because they don’t understand them and hence lack the confidence to buy them.
To make matters worse, the advice sector has not been as effective as it should be at championing bonds, and the role they can play alongside other asset classes.
With all of the above in mind, Azzet will run a series of highly focused articles on bonds within an Australian context.
While these articles are not designed to provide a definitive chapter and verse, they will bootstrap your knowledge base of all things bond-related. Each article will simply and unambiguously address a handful of key fundamentals one must grasp before dipping into the bond market.
What exactly are bonds?
A bond is a debt instrument, and like other debt instruments sitting under the fixed income asset class umbrella (like term deposits), bonds are a form of lending. But when it comes to bonds, you typically lend money to fund government or corporate activity. As the bond issuer, a government or corporate entity undertakes to pay you (as the creditor) regular interest plus its face value in exchange for your loan.
But while governments that borrow money in their own currency are considered risk free – meaning they’ll never really default – private-sector borrowers are riskier to lend money to, and this explains why they pay a higher interest rate.
So if the five-year bond rate is, say, 2.5%, you’d need a corporate rate considerably higher over the same term to make it worth taking on the added risk. When it comes to government bonds, the rates on offer are typically a function of what the market expects the average future central bank cash rate setting to be, among other factors.
The inflation impact
While many fundamental and technical factors play into determining the bond rate, one useful example is the inflation outlook.
As a case point, if inflation is likely to exceed a central bank’s expectations in future years, the market will factor in rising interest rates on the expectation the central bank will lift interest rates to bring inflation back within its comfort level.
With bonds, you also get to decide how long you lend your money for – and the terms (loan duration) can vary from one to 10 years-plus – and how your interest is paid.
Three types of interest
There are three types of interest you can be paid, depending on which option you choose. For example, a fixed-rate bond once issued stays the same assuming you hold it until the maturity date. In bond-speak, these interest rate payments are called fixed coupon rates and represent the yield the bond offered on its issue date.
There are also variable interest rates, which can move up or down over the bond term. With floating rates, coupon payments are based on an underlying interest rate, plus a specified percentage or margin. It’s not rocket science. Your coupon payments (on a floating rate) will rise if interest rates move up and fall if they come down.
Once the predetermined length (aka the duration) of the loan ends, the bond issuer will repay you the original amount they borrowed from you. Then there are indexed bonds where the coupon payments (and the face value) increase in line with CPI changes, thus providing protection against inflation. (It can be argued that most floating rates provide equal protection against inflation. Fixed coupons do not).
What happens when you sell?
If you sell your bond on the secondary market before maturity, there’s no guarantee you’ll receive what you paid for it. If you sell a bond before maturity you’ll have to settle for market value, which depending on market interest rates and supply and demand, could be more or less than what you paid for it (the face value).
The demand for a bond on the secondary market will be determined by a number of factors, including the bond's maturity date, yield, and the coupon payments left to be paid out.
If you have no specific maturity date in mind when investing in bonds, the market will typically indicate what duration will deliver the most beneficial outcome. For example, during an economic downturn, long-term bonds tend to complement declining interest rates, and vice versa.
To a large extent the fortunes of bonds are impacted by the prevailing interest rate environment. To properly understand bonds, you need to remember that bond yields move opposite bond prices. If interest rates move up, the bond will trade at a discount. This is because newly issued bonds pay investors higher coupon rates than old ones, and the opposite also applies.
So the longer the duration, the more exposed the bond will be to interest rate changes.
Four things you must understand about bonds
As a fixed-income instrument, they represent a loan by an investor to a borrower, typically a company or a government.
They have an end date, when the loan principal is due to be paid to the bondholder.
They’re easily tradeable, but often only in large amounts (though this is changing).
Bond investors must legally repay their capital by maturity, which is why they’re considered lower risk than shares or real property.
