A bonding investment

When you invest in bonds, you are effectively lending money to a government or company at an agreed interest rate for a certain amount of time. In return, the borrower promises to pay you interest at regular intervals and repay your loan at the end of the term. Bonds should be considered as part of a diversified investment plan.

However, not all bonds are the same, ranging from very safe to very risky. Here are some things you should look out for before you invest. If you're still unsure, seek financial advice.

How bonds work

Bonds have a face value, which is the amount you will get back at maturity and a coupon amount, which is the interest paid each year. This payment may be divided into half-yearly or quarterly amounts.

This is simple if you buy a bond at the start of the term and hold it to maturity. Things are more complicated if you only hold a bond for part of the term.

Bonds that you can trade on a secondary market such as the Australian Securities Exchange (ASX) are known as 'listed' or 'exchange-traded' bonds. Listed or exchange-traded bonds give you the flexibility to sell the investment if your circumstances change. 

How interest rates are calculated

Bonds can pay interest at a fixed or floating rate. 

Fixed rate bonds

The interest on a fixed rate bond is set when the bonds are issued and is shown as a percentage of the face value of the bond. The interest rate stays the same for the life of the bond.

Floating rate bonds

The interest rate for floating rate bonds varies in line with movements in a benchmark interest rate. This means the coupon payment will vary each time, sometimes quite substantially. You could get higher returns if the benchmark interest goes up, but you could also get lower returns if the benchmark interest rate goes down.

Check the bond's prospectus for information on how and when the floating rate will be calculated for coupon payments.

Defensive investments 

In an investment portfolio, bonds may serve a different function to conservative investments such as savings and deposit accounts. The market value of bonds can go up and down depending on what's happening in the economy and with interest rates.

Certain bonds tend to perform well when other markets are struggling. For this reason, they are often seen as a defensive investment, as well as a source of regular income.

Over the last 25 years some high quality fixed rate bonds have provided comparable, and in some cases, better than average returns, compared to Australian and international shares and listed property. They have also been less volatile than shares, with fewer years of negative performance.

Case study: Jason diversifies his investments

""Jason has investments in shares and property. As he's nearing retirement, he decides to visit a financial adviser for advice about including less volatile, interest paying investments in his portfolio. After considering his adviser's recommendations and doing his own research, Jason decides to invest some of his money in bonds through a fixed income managed fund. The recommended fund invests in highly-rated government and corporate bonds, and has a strong track record. Jason understands that the past performance of the fund is no guarantee of future performance. However, because of his age and risk profile he decides that it is a good time to include more defensive assets and better diversify his investment mix.

How safe is a bond?

Bonds range from very safe (for example, Australian Government bonds) through to very risky (unlikely to repay your money). Its very important to know what you're investing in, as not all bonds or fixed interest investments are the same.

In general, bonds are less volatile than other investments such as shares. However, losses are still likely to happen in some years, as individual companies and even governments, sometimes default on their obligations to bond holders.

Most bonds have a credit rating, but most ratings agencies only make this information available to wholesale clients and advisers. It is really difficult for a retail investor to assess how risky a bond is.

Ask a licensed financial adviser to help you work out the quality of the bond you are considering

How bonds are valued

The capital value of a bond can rise or fall depending on the current interest rate and the amount of interest accrued since the last coupon payment.

For example, if a bond has a face value of $100 but you bought it 11 months after the last annual interest payment was made, you would have to pay the seller more than $100 to take into account the interest accrued.

A bond's capital value can increase or decrease before maturity based on current interest rates.

Let's say you bought a 10-year bond yesterday with an interest rate of 5% per year. If market interest rates halved overnight to 2.5% per year, then the income from your bond would be twice as valuable. This would increase the price of the bond.

If interest rates had doubled to 10%, the income from the bond would be only half as valuable. This would decrease the price of the bond.

How to invest in bonds

There are a number of ways you can invest in bonds and fixed interest.

Australian Government bonds

The Commonwealth of Australia issues bonds called Commonwealth Government Securities (CGS). For more information, see Australian Government bonds.

State governments and territories may also issue bonds. Information can be found on each state and territory's treasury website.

Corporate bonds

Most retail investors buy corporate bonds through a public offer, where a company issues a prospectus and investors apply to the company directly. You can also buy and sell some corporate bonds on the ASX.

See corporate bonds and ASIC's guide to investing in corporate bonds for more information.

Your super fund

Most super funds allow members to choose a mix of defensive (cash and fixed interest) and growth (property and shares) investments. To find out more see super investment options.

Managed funds

An investment professional can invest your money in a range of bonds through a managed fund or index fund. For more information see choosing a managed fund.

Hybrid securities and subordinated notes

These investments have higher risks than most types of corporate bonds. For more information see hybrid securities and notes.

Bonds can provide a regular, dependable source of income but be aware of their risks, know what you're investing in and do your research. If you are unsure, ask for professional financial advice before investing.

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Last updated: 18 Dec 2015