Forget the search for El Dorado; investors these days are looking for something more tangible. They want the certainty of cash in the hand at better rates than those on offer at the bank, but after the turmoil of recent years they also value security.
With the cash rate at a record low around 3 per cent and term deposit rates below 4 per cent, investors must look elsewhere for a decent yield from the fixed-interest portion of their portfolio, and that is where bonds fit in.
Put simply, a bond is a loan provided by you, the investor, to the issuer who may be a government, a company or other body. The bond issuer promises to make interest payments, called the coupon, and repay the principal at specified dates.
People buy bonds for income and the security of knowing they will get their money back in full if they hold onto their investment until maturity. Of course the higher the quality of the bond (eg. AAA rating), the lower the yield and the lower the chance of default. Unlike a term deposit, bonds can be bought and sold on the secondary market. This provides bondholders with the opportunity to make capital gains to boost the total return from their investment.
There is an inverse relationship between the value of a bond and interest rates. If interest rates fall, the value of your bond will increase because it pays a fixed rate of interest based on its face value. If interest rates rise, the market value of your bond will fall but you still recoup your initial investment if you hold to maturity.
There are many kinds of bonds but government bonds are the standard against which most fixed-interest investments measure themselves in terms of both risk and return.
Commonwealth bonds are issued and guaranteed by the federal government while semi-government bonds are issued by state governments, to finance infrastructure and other spending programs. You can also buy bonds issued by local government authorities and government-guaranteed authorities like Telstra.
Most government bonds pay a fixed coupon rate but you can also buy inflation-linked bonds where returns are adjusted for inflation over the life of the bond.
Top ranking government bonds are AAA-rated and the coupon reflects that. Although it must be stressed we are talking here about bonds issued by the likes of Australia or the US, not Greece or Spain. The higher the credit rating, the safer the investment and the lower the interest rate needed to attract investors.
In recent times Australian Government 10-year bonds have paid interest of about 3.5 per cent. That is not much of an incentive to invest for 10 years, but foreign investors have been lapping them up because Australia is regarded as a safe haven, albeit with a high Australian dollar. Not only that, but 10-year US Treasury bonds pay interest of just 2 per cent and shorter-term US bonds pay close to zero.
If you want to earn a better return on your fixed-interest investments, you need to turn to the corporate sector.
Corporate bonds are issued by companies at fixed or floating rates of interest where the coupon rate varies in line with some market indicator. They are higher risk than top-rated government bonds so quality is the key. This is because the promise to pay regular income and repay your capital depends on the creditworthiness of the company and the quality of its assets.
In other words, there are no capital or income guarantees with corporate bonds. Even so, they are less risky than shares. If a company fails, bondholders will get their money back before shareholders.
As experienced investors know, there are rewards for accepting some level of risk. The challenge is to make sure that you understand the risks and that you are being adequately rewarded.
For example, when BHP Billiton launched a $1 billion bond issue last year it was snapped up by investors, despite offering a coupon of just 3.75 per cent1. The reason for this was the perceived safety of the investment by the market. But you can also find bonds issued by smaller listed companies, which are well known and well run, offering coupons of up to 7 per cent.
A balancing act
Used wisely, bonds are designed as an income diversifier, providing some protection for your investment portfolio from market downturns. While they may be boring, they can also be complex so you may need professional advice to select the right investment mix.
Bonds do their job best when you hold different types of securities with different risk and return profiles to minimise any losses. It also means selecting bonds with different maturities to protect against adverse interest rate movements.
Most people will find it easier to achieve the necessary diversification with a bond fund where professional managers buy and sell bonds for capital gains as well as income. Then you can sit back and enjoy a regular income without sacrificing safety.
1 Jonathan Shapiro, ‘Big Australian boosts local bond