Smart Investor, September 2011

Almost every tax-paying Australian has exposure to bonds. If you have a super fund, then it’s almost a certainty that it will be putting at least some of your money into this asset class. Bonds are considered a safe haven, an anchor to a portfolio (not always correctly, as we’ll discuss). But how exactly do they work?

Bonds are part of a category that most of the world calls fixed income, but which Australians more commonly call fixed interest. (In both cases it’s a misnomer, since the asset class tends to include some products where the interest rate isn’t fixed at all, but can move around.) You can think of bonds as a variation of cash, in that the same broader principle applies: you lend your money, as you do to a bank when you have a cash account, and get some interest back in return.

Bonds are issued by governments, banks, companies, and supranationals like the World Bank and Asian Development Bank, as a way to fund themselves. A bond is, in essence, an IOU: the issuer borrows a certain amount of money from the market with a promise to pay it back over an agreed period of time with an agreed rate of interest to the lender.

Every bond has several key characteristics. It will have a face value, which is the amount you get back at maturity. It will have a coupon, which is the amount of interest it will pay each year; this is usually paid on a quarterly or twice-yearly basis. And it will have a tenor, which is the bond’s duration – the time after which it must be repaid. In the spectrum of fixed income this can range from overnight or a few months in the money markets, to the three to five year duration common in corporate bonds, and on to 10, 20 or 30 years in government bonds; there have been some bonds issued with a duration of 100 years.

Bonds can become more or less valuable depending on what is happening elsewhere in the markets. If you have a bond that pays a fixed rate of interest, then if broader market interest rates decline, your bond’s rate of interest becomes more valuable; if market interest rates rise, your bond is relatively less valuable. See the box for more on this.

While bonds are often seen as a safe haven asset class, the truth is they cover a multitude of risk profiles. For example, an Australian government bond, issued by the Reserve Bank of Australia or a state government is very safe, one of the safest assets in the world; a corporate bond from a blue chip name is pretty reliable; but structured bonds, or high yield bonds from lower-rated issuers, may carry higher risks. Rating agencies like Moody’s and Standard & Poor’s help investors by giving ratings to different bonds and issuers; the rule is that anything below the BBB- level at S&P is called high yield, or to use a less complimentary term, junk.

Very few investors will put money directly into individual bonds other than Commonwealth Treasuries, although an increasing number of listed bonds on the ASX may change this. Instead, most investors go to a fund manager for their fixed income allocation, paying a professional to decide which are the best bonds to hold, and when to get in and out of them.

There is a whole gamut of investment styles in the fixed income universe. Some funds focus only on Australian fixed income, others on international; some will only buy higher rated credits, others focus on lower ones; some look at structured bonds like convertibles (which start out behaving like a bond but may convert into shares in certain circumstances), and others do not. There was a time when Australian investors were being put into highly complicated fixed income products like collateralized debt obligations (CDOs), but these have fallen badly out of favour with the global financial crisis. These days, simplicity is in favour.

BOX: How a bond’s value can change

A bond’s coupon tells you what rate of interest you will get from it. But that’s not the same as the yield the bond will provide.

Let’s say you buy a $1,000 bond that pays a 10% coupon, paying out $100. At the outset, it has a yield of 10%. That’s easy. But if the bond’s price rises or falls, then the yield changes. Perhaps confusingly, when the price goes up, the yield goes down; when the price goes down, the yield goes up.

Why? Well, if the bond’s value dropped from $1000 to $900, but it’s still paying out the guaranteed $100 (your 10% coupon), then the yield is higher (100/900 = 11.1%) because your return is greater relative to the value of the bond that is paying it out. Fund managers will look further than this to another measurement called yield to maturity, which calculates the total return you will receive if you hold a bond to maturity. There’s no need for most individual investors to hammer this one out as they’ll generally be trusting decisions to a fund manager.

Generally, investors want to buy bonds with high yields, provided they have comfort those yields are sustainable; but if they already own a bond, then they instead want the price of the bond to go up (and hence the yield to fall), giving them a better return on their investment. It’s all about perspective.