Investment bonds have been around for a long time, but many people are not completely familiar with how they work. Here’s a quick summary on what they are, and their risks and benefits.
What is a Bond?
A ‘bond’ is essentially a loan. It’s where governments and large businesses borrow money, with interest and principal to be paid back in the future. The issuer makes interest payments to the investor (also known as a ‘coupon’ amount). When the bond matures, the investor receives the face value of the bond.
Bonds are issued by governments, semi-government organisations and corporations in Australia and overseas. They are used to raise money and finance for a variety of projects and activities.
Bond values and interest rates
Bond values and interest rates move in opposite directions. So, bond values can go up or down according to when the bond is sold.
For example, if you invested in a bond of $1,000 with a 5 per cent interest rate, you will receive an annual interest of $50 ($1,000 x 5% = $50), plus the return of your principal at maturity. But the market interest rate doesn’t always stay the same. Let’s say the interest rate goes up to 8 per cent. Any new bonds issued will now have a coupon rate of 8 per cent, meaning your bond with a 5 per cent coupon rate is not worth as much. Conversely, if interest rates fell after you purchased your bond, the value of your bond would rise because investors cannot buy a bond with an interest rate as high as yours.
A bonds credit rating is determined by the issuer’s ability to pay interest and therefore repay the principle upon maturity. If a person has a lower credit rating, their interest rate could be made higher for the issuer. This is due to the risk that the principle and interest wont be made on time.
What is a Bond fund?
A bond fund pools money from many investors. This money is then used to buy securities to meet the funds investment objectives. This allows you to invest in a variety of bonds and also enjoy greater diversity, especially if bonds are from a wide range of different countries.
This means if one fund fails to pay interest, the effect is less significant on the fund and its investors.
Types of funds
Not all funds are the same. You have a choice of investing in either an actively managed fund or an index managed fund.
An actively managed fund continuously buys and sells bonds which try to do better than the market interest. These are more short-term.
Index managed funds are more long-term based which provide returns in line with their market index. A index fund manager then uses the proceeds from maturing bonds and investor cash to maintain the fund’s risk/return profile.
Also relevant: Sharemarket 101: A guide to Exchange Traded Funds
Benefits of bonds
A few benefits of bonds are:
- Bonds are often seen as a defensive investment as certain bonds tend to perform well when other markets are struggling
- A combination of Australian and international bonds can expose you to different markets, which then smooths out returns and reduces your overall risk.
- Bonds can provide a regular income and have the potential to grow.
- The long-term total return by a bond fund can be expected to be higher than the income earned by a cash investment (although cash is at a lower risk than bonds).
Risks of bonds
All investments carry some potential risk. Even though bonds don’t fluctuate as much as shares, there is still the potential of bond prices to go up and down. Some of the types of risks associated with bonds are:
- Interest rate risk – the value of a bond fund can fluctuate depending on interest rates. Value of bonds increase when interest rates fall and then decrease when interest rates rise.
- Credit risk – Bond investors can lose money if a bond’s credit rating is reduced
- Currency risk (for international bonds) – fluctuates depending on the value of the Australian dollar. It can seriously affect returns from overseas investments.
- Political risks – for example, changes in economic policy, trade restrictions or the nationalism of industries can lead to market declines, therefore affecting the returns from overseas investments.
Bonds can provide a regular, stable source of income but like any investment, there are always risks associated. Ensure you know and understand what you’re investing in and do your research.
This is an edited version of an article that originally appeared on Align Financial and is republished here with permission. This article contains general information only. This should not be relied on as independent finance or tax advice. If you are after specific professional advice, speak to your registered tax agent/financial advisor or reach out to Darren at Align Financial.