Why bonds should be in your investment portfolio

Investing in bonds – government or company debt – is considered a defensive investment asset, particularly in an unstable economic climate. However, many investors are unsure about bonds. This could be because they tend to produce lower yields than shares (particularly in low interest rate environments), or simply because many investors don’t know enough about this asset class.

While stocks, managed funds and property are all solid investment options, bonds shouldn’t be left on the shelf. Investors tend to favour bonds in times of economic instability due to the certainty of their capital value at the maturity of the bond and promised income stream.

Here are a few reasons adding bonds to your portfolio may be beneficial.

As bonds are issued with either a fixed coupon payment (or fixed margin), this provides a level of certainty to investors who are seeking a stable source of income to meet expense requirements.  

Bonds typically experience low volatility as the income stream is known and the capital value at maturity is known. The key factor that influences the value of a bond on any given day is the current market outlook on interest rates. However, as the capital value at maturity is already known, any day-to-day fluctuations in the market value shouldn’t be too concerning for investors intending to hold their bonds until maturity.

Bonds can be issued with either a fixed rate, or a margin above the Bank Bill Swap Rate (known as the BBSW). Bonds with a fixed rate can experience greater volatility than a floating rate as there is a greater chance their yield will deviate significantly from newer bonds issued at current interest rates. As the yield on floating rate notes adjust with the interest rate changes in the market, it’s more likely that new fixed rate bonds are offering a similar yield.

In a rising rate environment, consider looking for floating bonds that will follow the interest rate curve upwards. Conversely, adding to fixed bonds when rates are peaking at attractive levels will add not only a stable income stream, but you may also experience some capital growth on the bond should rates decline.

The basics about bonds you need to know

When the government (or a corporation) needs to raise funds, they borrow money from investors by issuing bonds to them. Essentially, bonds are a way for governments and companies to borrow money.

When an investor buys bonds, they’re essentially lending money to the Australian (or other) government, or large corporations, for a fixed period. In return they receive regular interest payments called coupon payments.

The bond terms are set at the time of issue and the investor can transfer or trade the security at any time for an agreed market price. The issuer of the bond, such as the government or corporate company, must pay interest and principal back upon maturity, or it is in default.

The value of a bond – the yield to maturity – is the average annual return of a bond from the time bought at market value until maturity.

Government bonds – when governments sell bonds to investors to finance their deficits – are considered one of the safest investments because the government sets the rules. Corporate bonds are issued by private companies and pay investors a higher interest rate since they are more likely to default than the government.

It’s important to consider the credit risk of corporate bonds and watch out for scam high-yield bond investments as it’s rare for corporate bonds to be issued to retail investors. Credit ratings are supplied by the likes of S&P and Moody’s as a measure of their financial backing and the possibility that the issuer could default or go insolvent. Bonds that have a credit rating of BBB- or above are regarded as investment grade and are highly unlikely to default. Below that level, ‘high yield’ or ‘junk’ bonds and are more speculative, although they pay a higher rate.

It’s also possible to invest in the broader bond market through ETFs rather than through individual government bonds to diversify even more.

If you’re interested in having a conversation about how bonds could work for your investment portfolio, contact me here.

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