The 4 Key Questions for First-Time Buyers
Bonds might seem confusing but they’re actually very simple. If you’re unfamiliar with how bonds work or which bonds are right for your investment goals, here are a few questions that can help.
A bond is essentially a way for an organization to issue debt without having to borrow from a bank. A government or a corporation accepts money from you and then promises to pay that money back with interest over a certain period. Bonds are a great investment for self-managed super funds as they provide a steady stream of predictable income (typically at much better rates than term deposits) over regular intervals.
One of the great benefits of bonds is that they are much less risky and volatile than shares. In addition, the regular cash flows and the repayment of the capital is very predictable which is particularly important in the retirement planning as you can’t afford capital losses.
Breaking the myth about outperforming stocks and bonds.
In the graph below you can see the performance of both stocks and bonds over a long-term period to counter the myth that stocks outperform bonds. In addition, the correct weighting of bonds in your overall portfolio has huge benefits such as reduce volatility and give you certainty of income.
1. What Are the Common Types of Bonds?
Understanding the different types of bonds will give you a big advantage, opening your options and opportunities. As you might imagine, the safest bonds will yield the lowest returns.
- Federal Government: Backed by tax payers and the ability to print money, bonds issued by governments are as close to risk-free investments as you can get.
- Semi-Government: These are bonds issued by state and territory governments which allows them to fund their budget and can support among other things the building of infrastructure.
- Investment-grade corporate: Corporations will issue bonds to investors at various interest rates and repayment timelines. An investment-grade corporation refers to a company that has an excellent financial reputation such as BHP and Telstra. The rates of return on these bonds are generally closer to the government bonds and as such not very interesting.
- Non rated, high-yield corporate: High-yield bonds are sold by corporations and offer excellent interest rates, but you have to accept an increased level of risk. They may be new companies using the bond market to build their businesses or more established ones which have discovered that the bond market offers them cheaper and more stable funding than bank debt.
2. What is my return on investment?
Almost every investment product offered to investors comes with some stated target rate of. However, many of these investments will also have a fine print somewhere that states that the return is based on past performance and doesn’t represent future performance. In other words, your returns can vary up or down which creates some form of uncertainty.
Bonds however are very different. With a direct bond portfolio you make your money when you buy, unlike stocks or property where you make (or lose) your money when you sell. The reason for this is that you know in advance already exactly how much interest you get paid and when and how much you will get back.
With bonds you can accurately calculate your overall return on investment in advance when you purchase the bond – we call this Yield to Maturity (YTM). YTM is the total anticipated return on a bond if the bond is held until it matures. The YTM calculation takes into consideration the price you paid for the bond, the total coupon payments over the term of the bond and the payout you receive at maturity and is expressed as an annual rate and that’s the return on your investment.
3. Will the borrower pay me back?
Learning the types of bonds will give you an idea of your risk level, and the YTM will tell you the returns, but only independent research can determine the relative likelihood of the borrower paying you back.
For government-issued bonds, whether local or federal, you’ll need to consider the financial history, political stability and general economic conditions of its jurisdiction. For corporate bonds, the ratings agencies are usually the first place to check to gauge the quality. The better the rating, the lower the interest rates and the more likely you’ll be paid back.
If you’re looking for low-risk bond investments, then AAA down to BBB bonds will be your best choice. However, with that low risk comes low returns and you are perhaps better off staying in Government guaranteed Bank Term Deposits. The above graph helps to demonstrate this.
If you’re looking for higher returns, you might want to investigate the high-yield space. We prefer bonds issued by publicly listed companies as they are required to publish on a regular basis their accounts which makes it easier to evaluate the credit risk. In addition, the company can raise capital through share issues and cut back or cancel their dividends to make sure we bond holders get paid our interest and capital.
4. Will bonds help me balance my SMSF?
Bonds are a great way to balance your SMSF portfolio because they’re a known risk mitigator. If a corporation hits financial difficulties, bonds will be paid out before shareholders. In addition, Bonds give you the steady income you need to finance their lifestyle or grow their wealth. Of course you still want other assets listed in your portfolio, but the correct weighting of bonds provides an undeniable element of stability and safety.
Bonds show that you have the stamina and patience to think about your long-term financial future rather than chasing down an unlikely windfall. Instead of trying to time the market perfectly (a near impossible feat), you’re doing your due diligence to find organizations and institutions that will best complement your investment strategies and protect yourself against upsets and changes in the market.
Want to know more about how bonds can help you?
A large part of the work we do here at the Australian Bond Exchange for our clients is to examine and evaluate the entire bond market (over 3,000 bonds just in Australia) and find the best choices for our clients. We’re happy to discuss with you your outcomes and we can find the bonds that offer the return and stability you want for the lowest risk.
No matter what types of bonds you choose contact us today to take your first steps toward a stronger portfolio.