Bonds — Are They Worth It?
If you’re interested in investments, you’re probably seeing a lot of hype around the classic asset class of "fixed interest".
Fixed interest, loosely referred to as bonds, is an asset class many Australians don't know much about.
Whether bonds are a good investment for you depends on your financial goals, risk tolerance, and overall investment strategy. Bonds can be a valuable addition to an investment portfolio for several reasons, but their suitability varies from person to person.
Bonds and term deposits: what’s the difference?
Most people get this asset type confused with term deposits. A term deposit is locking up money for a term (usually months or years) with a bank, in return for a guaranteed interest rate. Fixed interest (or bonds) is one of four main investment asset classes. Going from low risk to high, they are: cash, fixed interest, property, and shares.
Bonds in action.
Bonds are financial instruments that represent a loan made by an investor to a borrower. They are a form of debt security, and when you invest in bonds, you are essentially lending your money to the issuer in exchange for periodic interest payments and the return of the principal amount at the bond's maturity date.
Bonds can be cheaper than borrowing from a bank and come without the restrictions banks love to put on loans.
Coupons.
Banks issue bonds for a certain period (such as five, seven or 10 years), make regular cash payments (looks like interest, but is referred to as “coupons”), and then repay the debt at the end of the term.
While the coupon paid on the bond might be 4%, the value of the bond might have fallen 6%, giving a -2% return for the year. The same in reverse — the value of the bond could rise by 6%, making a total return for the year of 10%. But, bonds aren't as volatile as shares or property, which can move more dramatically in shorter periods.
Cash.
Cash is when you give your money to the bank, and the bank decides who to lend it to. Bonds are riskier than cash because they’re often issued at $100, usually in $500,000 lots. But, the value of the bond will move up and down, depending on the health of the company/government issuer, interest rates and inflation, and overall economic health. As a result, they can have negative returns.
Bonds at the moment.
Through an investment cycle, income streams from bonds (coupons) usually sit below the income streams from shares (dividends). Recently, this has inverted. The future expected dividends from shares have fallen well below the more certain coupon payments from fixed interest.
This is partly because of the fall in bond prices. Since the bottom of the interest rate cycle at the end of 2020, the overall average value of Australian bonds has fallen as much as 20%, while international bonds as an asset class have fallen about 30%.
Rising interest rates have been the main reason — when interest rates rise, the capital value of bonds tends to fall.
So, the hype around bonds —with their guaranteed income streams and falls in capital value — has some merit where, comparatively, they believe they are a "no-brainer" over a few years.
Making a return on your investment when you own bonds.
- Interest income: As a bondholder, you receive periodic interest payments from the issuer based on the coupon rate. This interest income is typically paid semi-annually or annually, depending on the bond's terms. You can make a return by collecting these interest payments.
- Capital gains: If you buy a bond at a price below its face value (at a discount) and hold it until maturity, you will receive the full face value when the bond matures. The difference between the purchase price and the face value is your capital gain.
- Selling in the secondary market: You can also make a return by selling your bond before it matures in the secondary bond market. If the bond's market price has increased since you purchased it, you can sell it at a higher price than you paid, resulting in a capital gain. Conversely, if the market price has fallen, you may incur a capital loss.
- Yield to maturity (YTM): YTM is a measure that considers both the interest payments and any potential capital gains or losses if you hold the bond until maturity. It represents the annualised return you can expect from the bond if all payments are received as scheduled.
Understanding the risks.
Like any investment, bond investments come with risks, including interest rate risk, credit risk (the risk of issuer defaulting on payments), and market risk (price fluctuations). Understanding these risks and conducting thorough research is essential before investing in bonds— we can help.
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