Bonds are a popular investment options that offer lower risk compared to shares. When you invest in a bond you are essentially lending an entity such as the government or a corporation. The government or corporation will make regular payments, called coupons to you throughout the term of the bond.
In Australia, several types of bonds are available, including bonds issued by the government (government bonds) and bonds issued by corporates (corporate bonds). The yields on bonds vary based on factors such as the issuer’s creditworthiness, the bond’s term length, and market conditions.
What are Bond Yields?
Bond yield measures the return an investor realises on a bond. The yield varies with the bond’s price and represents the annual return that the bond will generate for the investor (from when they buy it until maturity). The yield values indicated on this blog are sourced from reliable financial institutions and are current as of 20th July 2023.
Understanding the Importance of Bond Yields
Bond yields play a crucial role in assessing a bond’s potential returns and risks. Higher yields often indicate higher risk, while lower yields may suggest lower risk. Understanding yields helps investors decide which bonds to invest in based on risk tolerance and investment goals.
Types of Bond Yields
Yield to Maturity (YTM) is the total return anticipated on a bond if it is held until it matures, expressed as a per annum rate. It considers the(coupons you receive and depending on the price at which you bought the bond, any capital gain or loss that you will realise when the bond matures.
The Relationship between Bond Prices and Yields
How Bond Prices Affect Yields
There is an inverse relationship between bond prices and yields. When bond prices increase, yields decrease and vice versa. This occurs because the fixed interest payments of a bond become more attractive relative to other investments when prices drop, increasing demand and pushing up prices until yields adjust downwards.
How Yields Affect Bond Prices
Similarly, an increase in yields makes a bond less attractive, causing its price to fall. Conversely, a decrease in yield makes a bond more attractive, increasing its price.
How Interest Rates Affect Bond Yields
The Impact of Interest Rate Hikes
Interest rates have a significant impact on bond yields. When central banks raise interest rates, bond yields tend to increase. New bonds issued after the rate hike carry higher coupons, making existing bonds less attractive unless their prices drop and their yields rise.
Timing Your Bond Sales and Purchases
Understanding the relationship between interest rates and bond yields can help investors decide when to buy or sell bond. If you believe interest rates will drop in the future, you may want to buy bonds today to lock in the higher rates.
Comparing Bonds and Equities
The Role of Dividends in Equities
Dividends play a crucial role in equity investments. They provide an additional income stream to shareholders and can significantly enhance the overall return of an equity investment. However, unlike bond coupons, dividends are not guaranteed and can be cut or eliminated by a company if the company decides not to pay a return to its shareholders (for whatever reason).
The Role of Income in High-Yield Bonds
High-yield bonds offer higher yields than government or high-grade corporate bonds. This is because they carry a higher risk of default. The increased income from high-yield bonds compensates for the greater risk being taken on by investors, but these bonds are also generally more volatile and can suffer significant price drops during periods of economic stress.
Assessing Bond Risks
One of the main risks associated with bonds is interest rate risk. Bond prices tend to fall when interest rates rise, leading to potential capital losses for bondholders. Conversely, bond prices usually rise when interest rates decline, resulting in capital gains. Investors should consider this risk when making investment decisions.
If a bond fall in value due to rising interest rates, investors can simply hold the bond to maturity, and will receive, (as long as the issuer is solvent) the previously agreed coupons periodically as well as their principal investment back at maturity.
Strategies for Investing in Bonds
When to Hold Bonds Until Maturity
One strategy is to hold bonds until maturity, especially if you are seeking a stable income stream and are not concerned about potential price fluctuations. This way, you will receive the bonds full value at maturity, regardless of any interim price changes. However, this only applies if the issuer remains solvent.
When to Sell Bonds
Another strategy is to sell bonds before maturity if you can benefit from price appreciation or believe that interest rates will rise, causing bond prices to fall. This allows you to capture capital gains and potentially reinvest in higher-yielding bonds.
Diversifying Your Portfolio with Bonds
Investing in bonds can help diversify your investment portfolio, reducing overall risk. Bonds typically do not correlate with shares, meaning the two investments are likely to perform differently during market fluctuations. Including bonds in your portfolio can help provide stability and income regardless of stock market conditions.
Understanding bond yields is essential for investors looking to maximise returns and manage portfolio risks. By comprehending the relationship between bond prices, yields, and interest rates, investors can make informed decisions about buying, selling, and holding bonds. Remember to consider your risk tolerance, investment goals, and the current economic environment when investing in bonds. With this knowledge, you’ll be better equipped to navigate the world of fixed-income investments.
Disclaimer: Australian Bond Exchange Pty Ltd ACN 605 038 935 AFSL 484453 (ABE). This article is intended to provide general information of an educational nature only. It does not constitute the provision of personal advice and does not take into account your personal objectives, financial situation or needs. Before investing with ABE, you should consider the appropriateness of the investment to your particular financial and taxation situation and consider obtaining independent advice before making an investment. Examples in this article are for illustration purposes only and are not a recommendation to buy, sell or hold a particular investment. ABE makes no representation or guarantee as to the availability of a bond with the characteristics described in this article or that an investment made by you will generate the returns in the illustration. Past performance is not an indication of future performance. Investing with ABE is subject to our Client Services and Custody Agreement Terms and Conditions and Financial Services Guide.