Are bonds a smart investment?

You have heard of shares, property, term deposits and savings accounts but are you on top of bonds as an investment vehicle?

Bonds are often used as a safe beginner investment or as a diversifier to an established portfolio. Bonds can be among the safer forms of investment and they’re usually used for long–term investing plans as you should ideally keep hold of them until maturity.

How they work

With bonds, you’re essentially lending money to either a company or to the government at a fixed interest rate for a fixed amount of time. The borrower promises to pay you interest at pre–set intervals and then repay the money at the end of the term, or maturity.

Some bonds are safer than others, however, so before you buy any, you need to know what you’re getting into. Government bonds are considered the safest, as they’re guaranteed, with some company bonds being more speculative.

Of course, you should speak to a financial adviser to make sure you’re on the right track.

Your bonds will have a face value—the amount you’ll get back when they mature—and a coupon amount, which is the interest you’ll receive each year. Generally, the interest is paid every quarter or half–year.

If you buy a bond at the start of its term and hold it until it matures then everything’s pretty simple. You can also hold bonds for a part of their term by buying or selling them on a secondary market like the Australian Securities Exchange. These bonds are exchange–traded or listed bonds and they offer you some flexibility if you want to release money or sell them if their face or coupon values go up.

About the interest rates

Bonds pay you interest at either a fixed or a variable rate.

Fixed rate bonds

As you probably expect, a fixed rate bonds’ interest rate is set at issue (as a percentage of the face value) and stays constant throughout the term.

Variable rate bonds

Variable, or floating, rate bonds have an interest rate that varies alongside a benchmark rate. Your coupon payment will be different each time as a result—sometimes quite dramatically. To find out more about the bond’s rate you should read its prospectus, which will tell you when the floating rate is calculated.

So, are bonds a smart idea?

Bonds may be suitable for investors looking for a low-risk investment to back up their savings and term deposit accounts. As the market value of bonds can rise and fall, they can offer more flexibility than term deposits, and you can sell them when they’re worth more. If you cash out a term deposit account early, you’ll face penalties, sometimes as much as the entire amount of interest earned, which doesn’t happen with bonds.

In addition to this, government bonds tend to do well when other markets are more turbulent. This makes them a good defensive investment and also a good source of regular income if they’re fixed.

Bonds can be less volatile than shares

You can choose from very safe bonds all the way through to riskier ones which may pay lots of interest or may not pay you anything at all. In general, however, investing in bonds is safer than investing in shares because you should at least get the face value returned to you at maturity.

You might be able to look at the credit ratings of your preferred bonds, but some are only available to advisers and wholesale investors. If you can’t find the rating of a company bond, you should ask a licensed adviser for their assessment.

How your bonds are valued

The capital value of your bonds rises and falls with the prevailing market interest rate and also the interest that is accrued since its last coupon payment. If you buy a bond with a $1,000 face value that pays interest annually, you’ll pay more if you buy it several months after the last coupon payment because you’ll also be buying the interest. It’s best to buy listed bonds shortly after they’ve paid out their interest if you can.

Interest rates also affect your bond’s value

If you were to buy a five–year bond with a fixed interest rate of six per cent per year and then the market interest rates fell to three per cent suddenly, your coupon income would effectively double, making the bond more valuable.

On the other hand, if market interest rates rocket up to 12 per cent (you never know), the income from the bond halves and the value of the bond falls.

Investing in bonds

There are lots of ways in which you can invest in bonds, so take some time to find out more about it all before making any decisions. The first step is to choose a good advisor or broker.

Australian Government bonds

The government issues Commonwealth Government Securities (CGS) and these make very safe investment vehicles for more conservative investors and for people planning to hold their bonds for a long time.

You can also buy bonds from territory and state governments, so head to your area’s treasury website for more information.

Corporate bonds

Companies issue corporate bonds through public offers; they publish a prospectus for the bonds and you can apply to the company yourself. Some corporate bonds are listed on the ASX, so you can sell them if you need or want to.

You can use them in your super fund

Most super funds let you use a mix of the more conservative (or defensive) vehicles like cash and bonds with some slightly racier (growth) investments like shares and property.

An investment manager can take care of your bonds

If you choose a managed fund, your investment professional can decide which bonds to buy into and then take care of them until they mature or you decide to sell them.

Bonds can give you a dependable and regular income stream

How much income, of course, depends on which bonds and on how they perform, which is why you need to do your homework first. No matter how much each payment is, though, you can usually rely on it if you choose the right bonds.

You can research and compare investment brokers and margin loans and InfoChoice.

The information contained on this web site is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser. If you or someone you know is in financial stress, contact the National Debt Helpline on 1800 007 007.

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