Opinion
Bonds, corporate bonds: The reliable but unpopular investment
Dominic Powell
Money EditorReal Money, a free weekly newsletter giving expert tips on how to save, invest and make the most of your money, is sent every Sunday. You’re reading an excerpt − sign up to get the whole newsletter in your inbox.
In the grand scheme of all things finance, there are plenty of terms, definitions and products that are so complex that your average money fan would need significant study to properly grasp. Stuff like zero-coupon inflation swaps, modified internal rates of return or yacht insurance – all complete nonsense.
However, there’s one term you’ll probably hear (and that I’ve mentioned a few times in this newsletter, usually alongside Alvin and the Chipmunks) that is worth paying attention to: bonds.
Bonds are a reliable but unpopular form of investment.Credit: Fiona Bianchinotti
Bonds are much like shares or ETFs in that they’re investment options you can buy through your broker the same way you’d buy any other listed investment. However, the way they work is quite different to a “standard” investment, and can probably be likened more to something like a term deposit.
Say you’re a corporation or a government wanting to raise money. You issue $10 million worth of bonds with two-year maturity at a return of 5 per cent annually. An investor then purchases $100,000 of your bond: they will receive a guaranteed 5 per cent return ($5000) every year until the bond reaches maturity in two years, at which point they get back the capital they invested ($100,000).
For the company/government, they get money to fund whatever they need. For the investor, they get a reliable, unchanging source of fixed income for as long as they like. Keep in mind these bonds are – confusingly – different to insurance/investment bonds, which are a type of pooled investment.
What’s the problem?
The global bond market is roughly three times the size of the global equity market at a whopping $US300 trillion ($441 trillion). However, they remain generally unpopular with everyday investors.
The ASX’s investor study, completed last year, showed just 6 per cent of investors hold bonds, compared to 60 per cent for equities and even 15 per cent for cryptocurrency. It should be noted that most Australians are invested in bonds through their superannuation, where balanced portfolios often allocate 10-20 per cent to bonds.
What you can do about it
Who do bonds suit and what are some of the risks?
- Who do bonds suit? Like many fixed interest or cash-adjacent investments, bonds suit investors who are looking for certainty. James Williams, executive advisor at Viridian Advisory, says bonds are commonplace alongside equities for people looking to “smooth out” their returns, and can also be good options for retirees as they provide a regular stream of income without putting the initial capital at risk. Bonds are also a strong option when you have an expectation that interest rates will fall, Williams says, as bonds generally increase in value when interest rates decrease. “So if there is an expectation that interest rates are going to fall such as when economic conditions deteriorate then you may purchase bonds which may provide a positive return when rates are lowered to drive economic activity,” he says.
- Risks: Despite being considered one of the most stable and secure parts of financial markets, bonds come with risks just like any other investment. The main one is that with corporate bonds, companies could find themselves unable to repay what they owe you once the bond matures, meaning they default, and you are left in a bad situation. This is unlikely to happen with large, established companies but becomes more of a risk as you move towards smaller companies and those with poor credit ratings. High-risk corporate bonds are known as junk bonds and often have a higher chance of default (but offer a better annual return).
- Interest rates: Another main risk with bond investments is interest rates. As anyone with a mortgage will know, interest rates in Australia have risen sharply over the past few years, which would have been bad news for bond investors, as bonds with a 4 per cent yield are less attractive when you can receive 5 per cent or better from other fixed-rate investments. “This is demonstrated by the fact that the composite bond index has provided almost a flat return over the past five years due to the steep increase in interest rates,” Williams says. He notes that bond investors can buy and sell bonds before they hit maturity on the secondary market, so if you do get stuck with a below-rate bond, it is possible to sell it and buy a better one.
Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.