There’s been a lot of noise recently in the market about fixed income and bonds, as advanced economies battle with high, sticky inflation, a lack of housing supply, and rising interest rates.
The key thing to remember is that wherever you decide to invest your money, there is always risk involved. You just need to make sure you get paid for the risk with your returns.
Generally, equities (shares/stocks) are high risk, high return, term deposits are low risk low return, and fixed income investments like bonds sit somewhere in between.
As a defensive asset class, bonds and fixed income investments are lower risk in comparison to other investments (like equities). They’re also typically lower yield, but bond yields are rising in response to the recent RBA rate hikes.
No matter which type of investment you choose, it’s essential to read the Information Memorandum (IM) document or product disclosure statement (PDS), and seek professional financial advice, before signing on the dotted line.
Ready to dive into the world of fixed income and bonds?
Table of Contents
- Terminology
- What are bonds, and how do they work?
- Can you sell a bond before the maturity date?
- Types of Bonds & Debt Securities in Australia
- Types of interest on bonds
- How to buy bonds in Australia
- What affects the price of bonds?
- How to make money from bonds
- Three advantages of bonds
- The disadvantages of bonds
- Are bonds a good investment?
- Thinking of investing?
Terminology
Glossary
AGBs
Australian Government (Treasury) Bonds
ASX
Australian Securities Exchange (Stock Exchange). A marketplace for the trading of stocks/shares/equities (ownership) of listed companies.
Coupon rate/ Interest rate
A percentage of the face value of a bond or fixed income product, paid from the date of issue until maturity.
eAGBs
Exchange-traded Australian Government Bonds
Face value
The principal value on which coupon interest payments are calculated.
Issuer
The seller/borrower/debtor (typically a company or government).
Investor
The buyer/lender/creditor/bond holder/ security holder
Maturity date
The date on which the bond or fixed income product is due to be repaid.
RBA
The Reserve Bank of Australia (RBA) is the central bank of Australia, and controls monetary policy including the Cash Rate Target.
Yield
The annual rate of return on a bond or fixed income product.
What are bonds?
When the government, or a company, needs capital, it can issue debt securities (like bonds) to raise the necessary funds.
When you buy a bond, fixed income products or hybrid securities, you’re lending the issuer (a business or a government) money. They then agree to pay you interest in return for the loan, until the maturity date.
Bonds typically offer fixed rates of interest, with semi-annual or quarterly payments, and are seen as “defensive” assets due to the lower risk attached.
Learn more about the bond basics here.
How do bonds work?
Bonds work in a similar fashion to a loan, in that the higher the risk (the more doubt there is that the issuer can repay the debt), the more the company/government must pay in interest (the coupon rate) to bond holders/ security holders.
Can you sell a bond before the maturity date?
Selling a fixed income product or bond before it reaches the maturity date (matures) means you’ll get market value, instead of face value.
Market value can be lower or higher than face value and is influenced by:
- Credit risk of the issuer
- Level of liquidity
- Interest rate movements
- Maturity Date
Types of Bonds & Debt Securities in Australia
There are only two types of bonds you can buy in Australia, but many different types of debt securities that also offer stable returns.
What are the different types of bonds and fixed income investments?
A government or treasury bond refers specifically to a bond (that acts as a loan) issued by governments. As a highly secure investment product, second only to cash at the bottom of the risk spectrum, they have very low-risk attached and low but predictable yields.
A corporate bond is a bond issued by a corporation or private company (that acts as a loan). These bonds are riskier than government bonds, which means they generally pay a higher rate of interest.
There are many other fixed income products (securities) that act in a similar fashion to bonds, in that they provide predictable coupon payments and a set maturity date.
Market-linked securities, hybrid securities and bond-linked securities are just a few examples of other fixed income instruments.
How do corporate bonds work?
Corporate bonds are issued by private organisations who are looking for capital or funding.
These fixed income products can be bought either on the primary market or the secondary market.
Typically, bonds are issued when companies need more money than banks are able to lend. They do this through a process called ‘bond issuance’.
For example, a company issues $100 million in bonds, each with a coupon rate of 6% and a face value of $10,000. These bonds are offered to investors to raise the $100 million that the company needs to fund their venture, split across multiple investors (creditors).
Corporate bonds vary in terms and creditworthiness, so you must understand the issuer’s creditworthiness and read their information memorandum, prospectus and/or annual report.
The interest payment on a corporate bond (known as a coupon rate) is usually higher than on government bonds because of the higher default risk.
How do government bonds work?
There are two main types of Australian Government Bonds (Treasury Bonds) listed on the Australian Securities Exchange (ASX). Each offer three or ten year “loan terms” (a.k.a. the maturity dates are three to ten years from the issue date).
Although not always the case, longer-dated bonds usually offer better interest rates because interest rates are more likely to change before maturity, making the risk slightly higher.
Treasury Bonds (TBs): Fixed Interest Rate
These are medium to long-term fixed-rate debt securities. Interest is paid as a percentage of the original face value, paid at a fixed rate every six months, and the face value is repaid on the maturity date.
Treasury Indexed Bonds (TIB) Interest Rate Linked to Inflation
These medium to long-term indexed bonds are linked to the Consumer Price Index (CPI), which measures inflation. Interest is calculated on the adjusted face value and is paid quarterly at a fixed rate. On maturity, investors receive the capital value of the bond.
Types of Interest on Bonds
The type of bond issued impacts the amount of interest paid to creditors (bond holders, security holders or investors).
There are three main types of bonds, each slightly different due to their relationship with the Reserve Bank of Australia (RBA) Cash Rate rates and inflation.
These fixed income products have a set interest rate (coupon rate) from when the bond is issued to the maturity date. On issuing the bond, companies will review current inflation and cash rates to determine the coupon rate.
The interest paid on these fixed income products will fluctuate until Maturity Date, generally in response to changes in the RBA Cash Rate.
The coupon rate is calculated by adding a certain margin or percentage to the underlying cash rate, based on risk and other calculations.
The coupon rates of these bonds are directly linked to the current Consumer Price Index (CPI), which measures inflation. As inflation increases, so do the interest payments on these bonds.
Bond Prices: How To Buy Bonds In Australia
There are several options for investing in bonds in Australia:
Most bonds are not publicly traded, which means they’re not available to retail investors with less than say, $500,000 to invest.
Instead, these bonds are sold ‘over the counter’ in the secondary market (also known as the OTC market) to wholesale investors.
Bonds sold in the primary market (wholesale market) not only have a significant minimum investment amount (think $500,000 and up), every day Australians do not have access.
If you are not a broker, you will need a broker to execute your trades for you.
Retail investors can only purchase exchange-traded Australian Government Bonds (eAGBs) through licensed ASX brokers. These government bonds trade on the ASX and operate much like passive ETFs. .
Corporate bonds and other fixed income securities however, can be traded with the Australian Bond Exchange (ABE) from as little as $10,000 investment.
ABE is a leading marketplace for investing in fixed income securities, so if you’re a retail investor interested in accessing the secondary fixed income securities market, get in touch.
What Affects Bond Prices?
Two major factors cause bonds prices to fluctuate, interest rates and risk.
Bond prices (not to be confused with bond yields) have an inverse relationship with both interest rates and risk. That means, as one goes up the other goes down.
If the issuer’s credit rating is high or improves, it is more likely that the issuer will be able to make the required interest payments on the bond. As such, the credit risk of issuers can have a substantila impact on how bonds are priced.
If an issuer has a low credit risk, and is more likely to repay the debt in full, this decreases the risk and increases the price (and value) of the bond. If the issuing company’s credit rating declines, the increased risk can cause the price (and value) drop.
The higher the underlying central bank cash rate (e..g the RBA Cash Rate), and therefore interest rates on lending, the lower the price of the bond.
When bond prices are low, coupon rates (amount of interest payable) are higher. This is because the investment is seen as riskier (issuers need to pay higher interest for debt) and therefore the “loan/debt” (security/bond) is seen as less valuable.
If the interest rate on newly-issued bonds is lower than the interest rate paid on existing bonds, the value of the existing bonds will increase. This is to ensure the market is not unfairly balanced toward the purchasing of newly-issued bonds.
It’s important to fully understand the impact on bond prices of both a lower interest rate and a higher interest rate. If you’d like to know more about how bond prices work, contact an ABE investment adviser today.
The higher the risk of a bond, the lower the bond price (on the OTC or wholesale market), but the higher the coupon rate (amount of interest payable to the creditor/investor). This is because the risk of losing the initial investment is higher, and therefore the bonds themselves are worth less.
As the risk decreases, the bond becomes more valuable and the bond price increases. This is because the market ‘prices in’ the fact that as risk decreases, and the bond is worth more as the company is more likely to pay back the face value at the maturity date.
Bond Yield: How To Make Money From Bonds
There are various ways in which you can gain solid yields (return on investment) from bonds and other fixed income products:
- You can keep the bonds until maturity and collect the coupon payments (interest payments), and the principal at maturity if no credit events have occurred.
- You can buy bonds while they are low in price, and sell before the maturity date if prices rise, to make a return on the difference.
- You can buy the bonds or fixed income products at face value, and sell these when bond prices are high to make a profit of the difference.
- You can buy multiple bonds or fixed income securities with varying maturity dates and coupon rates to spreak the risk throughout your portfolio
Three Advantages of Investing in Bonds
There are three key advantages to investing in bonds and fixed income securities:
These types of financial products are generally stable, passive and predictable.
The interest rate is often fixed, which allows investors to plan cashflow, and for seniors can provide income flows throughout retirement.
Fixed income securities, like bonds, help to diversify your portfolio, as “defensive assets” that spread risk across your investment assets.
This means that if your equity (shares) investments are having a “bad run” then the stable, lower-yield investments should still generate passive income.
Bonds and fixed income products are generally lower risk investments than shares, as values are generally tied to financial and economic markets, with a greater risk of capital loss when major economic events cause share prices to drop.
Generally speaking, bonds and other fixed income securities do provide a lower return on capital, however they do not carry the volatility risks. With shares, your investment could double – or halve – in one day.
Before investing in shares, bonds or other securities, make sure to seek the advice of a financial adviser, as insolvency law is complex and dependent upon different factors that can impact the outcome in a credit default or insolvency event.
The Disadvantages of Investing in Bonds
Let’s look at the downside of investing in bonds.
Long “loan terms” (maturity dates far in the future) increase the risk of rising interest rates, which in turn could impact the issuers credit risk as the interest rates on other debts increase.
The potential yields on bonds and other fixed incoem securities is less than shares and other riskier financial assets.
Are Bonds a Good Investment?
Investing is risky, so when you are reviewing the best type of investment for you, make sure to contact a financial adviser to get advice based on your personal and financial situation.
If you’re considering buying bonds or other fixed income securities, here’s a few scenarios where bonds could be a good investment for you.
You’re looking to diversify your portfolio
If you already have a significant property or shares investment portfolio, bonds can help to diversify and spread risk. By introducing debt securities and other fixed income products into your portfolio, you can feel confident in the face of market volatility.
You don’t want too much risk
If you don’t want a high-risk investment, bonds might be a suitable investment for you.
Bond prices tend to be reasonably stable and are typically less risky than shares, and the downside is that your potential return is significantly lower with bonds than with shares.
You’re retiring or are retired
If you are retired or entering retirement, you may find a stable but conservative revenue stream is more attractive than a riskier and higher-yield investment.
Based on an average life expectancy of 81-85 years old, retiring at 60 in Australia could cost you almost $1,000,000. And that doesn’t account for inflation.
Thinking about investing?
We hope this guide has shed some light on everything you need to know about bonds and fixed income.
If you’d like to learn more, request a callback here or give us a call on 1800 319 769.
Disclaimer: This guide contains general advice only. You need to consult with your independent financial, tax and/or legal adviser, and consider your investment objectives, financial situation, and your particular needs prior to making an investment decision. Australian Bond Exchange Pty. Ltd. and its authorised representatives does not accept any liability for any errors or omissions of information supplied in this document except for liability under statute, which cannot be excluded.