Bonds have a reputation for being one of the more boring asset classes, only slightly more exciting than cash. However they are important financial instruments, and if you have superannuation, chances are some of your money is invested in them. Bonds may also suit some personal investors – so how do they work?
What is a bond?
When you buy a bond you are making a loan to the issuer, usually a government or a corporation. While there are different types, the key characteristics of a typical bond are:
- Face value – the amount the buyer receives on its maturity date. Usually this is $100 per bond.
- Coupon rate and coupon dates – the interest payment expressed as a percentage of the face value. Most bonds pay interest once or twice per year on the coupon dates.
- Maturity date – the date the investor receives the face value of the bond, along with the final coupon payment.
- The issue price – this is usually the same as the face value.
How are bonds bought and sold?
While bonds can be bought directly from the issuer (the primary market), most are traded on a secondary market. In Australia, government bonds are traded in large volumes between institutional investors. However, Australian retail investors can receive all the benefits of investing in bonds by buying CHESS Depository Interests, which are listed on the Australian Stock Exchange (ASX). Various corporate bonds are also traded on the ASX.
Many Australian investors participate indirectly in the bond market via managed fixed interest funds.
How risky are they?
Like any loan, the security of a bond depends upon the ability of the borrower to pay the interest and face value when due. Bonds issued by financially stable governments, (Australia being one), are considered very low risk. Buy such a bond, hold it to maturity, and you know with a high level of certainty exactly how much money you will receive and when.
Corporate bonds and those issued by financially ‘weak’ governments are higher risk, and usually offer a higher interest rate to reflect this. So-called ‘junk’ bonds are extremely high risk, and more of a gamble than an investment.
What drives bond prices?
While the relative risk of quality bonds can be low if bought and held to maturity, it’s a different story if you need to sell before the maturity date.
If interest rates rise, bond prices fall so it is possible to make a loss, even with quality issuers. This somewhat extreme example explains how this works.
Imagine you buy two hundred 10-year bonds with face value of $100 (total value $20,000) and a coupon of 3%. You’ll receive $600 interest each year for ten years and then get your $20,000 back. Overnight, interest rates jump to 4% and a sudden emergency means you need to sell your new investment. A potential buyer now has a choice between earning $8,000 over ten years from the new bond versus $6,000 from yours. Clearly, something has to give, and that something is the price of your asset. In this example, and assuming annual coupon payments, your bond is now only worth $18,377.82.
On the other hand, if interest rates fall, investors can realise a gain as bond prices rise.
It isn’t just actual changes in interest rates that affect bond prices. Expectations of what interest rates may do in the future also play a big part.
Another influence on prices is time to maturity. All other things being equal, longer-term bonds usually pay a higher interest rate than short-term bonds. This reflects the higher risks of locking your money away for longer.
Investors in managed fixed interest funds need to be aware that, even if the manager takes a buy and hold approach, the daily unit price will change in line with the market value of the bonds held.
There are many reasons why you might want to include direct bonds in a portfolio, but it needs to be an informed and considered decision. Please contact our office if you have any questions.