To no one’s surprise, there has been renewed interest in government bonds in recent months, considered safe havens during troubled times.
While no investment is completely risk-free, in comparison to other investment options likes shares and property, government bonds are regarded as one of the safer investment types in the market, second only to cash at the less-risky end of the risk spectrum.
How bonds work
Bonds operate in a similar way to taking out a home loan — the difference is you’re the lender rather than the borrower.
When buying bonds, such as those issued by the Australian or US government you’re essentially lending them money for a fixed period of time at a set value. In return, these governments pay you regular interest, and at the end of your bond term, they’ll also refund your original investment.
If you decide to sell your bond before its term has ended however, you’ll receive the market value of your bond — what someone is prepared to pay for it — which could be less than your original investment.
Key benefits of investing in bonds
Reduced risk
Bonds are classed as a defensive asset class. They can provide a stable source of income while reducing your portfolio’s vulnerability to volatility in the share or property markets.
There are different levels of risk when it comes to bonds though.
With any bond, you are relying on the strength of the underlying borrower. The good news is that Australia is an excellent borrower. It’s one of just 10 countries in the world to have a AAA rating from the three major credit ratings agencies1. So lending money to our government is probably safer than to some other countries. Argentina, for example, has defaulted on its government debt nine times.
You can also buy bonds issued by large companies like Apple or Australia’s big banks. This is sometimes called credit investing. With corporate bonds, while you have the potential to earn higher returns, you face a higher risk. Unlike even the biggest companies, national governments can tax their citizens to help them pay their debts!
So, there is a chance you won’t get your initial investment back. Once again, you need to assess the underlying borrower – and remember that the higher the risk, the higher the coupon rate – and the other way around.
Diversification
Having defensive asset classes like bonds in your portfolio can provide stability during volatile markets.
For instance, when interest rates drop, the value of bonds increase which is typically the opposite effect to shares. So, having a mixture of different types of investments can help to even out the impact of external market volatility on your portfolio.
Regular income stream
Like shares that pay dividends, bonds pay regular interest (also referred to as coupon payments) which can serve as a stable income stream and protect your investment from inflation.
How much you earn off this interest depends on how it’s paid. There are three options:
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Fixed rate: when the bond is issued, the interest rate is established and remains the same throughout the term of your bond
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Floating rate: as with a variable rate home loan, it can go up and down over the term of the bond. This means if interest rates increase, your payments will also increase
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Indexed: your interest payments will change to reflect the Consumer Price Index
How to invest in bonds
Corporate bonds
One option is to buy corporate bonds directly from a company when they issue a public offer. A prospectus is then provided containing all the information about the bond such as the minimum amount required to invest, bond price, the bond term etc.
You can also buy corporate bonds directly from a stock exchange like the Australian Securities Exchange (ASX) or through a broker or managed fund but there are fees associated with this approach.
It’s also important to be aware that you’re essentially buying them second-hand via a stock market, so they are valued at market price rather than their set value when first issued.
Government bonds
You can invest in government bonds via the ASX, through a broker or a managed fund. You’ll also need to pay brokerage fees.
Bottom line: Bonds are not a short-term investment but they are regarded as one of the safer types of investment in the market. Talk to us on 03 6165 2666 if you think they could fit in with your investment strategy.
Source : MLC Insights September 2020
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