Bonds 101. A BigFuture Guide

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Ashlee Warner
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1 Bonds 101 A BigFuture Guide

2 Why are bonds important? Bonds are often the second largest asset class after shares in a long-term investor s portfolio. Bonds are often present in a portfolio as a defensive asset class that lowers overall portfolio volatility. It s a good idea to know what they are and how they work. What is a bond? When you invest in a bond, you are lending money to a government, financial institution or a company. The borrower will agree to pay you interest and a principal amount when the bond comes due for repayment. Investors can invest in bonds directly, but most people will invest in bonds as part of their diversified superannuation fund or in a managed fund. Bonds can be bought and sold through a broker such as a bank. Unlike shares, there are no exchanges like the Australian Stock Exchange for bonds. This makes bonds less easily traded (liquid) than shares. Generally, bonds are less risky than property or shares but they also have lower returns. Not all bonds are the same; some bonds pay a higher interest rate but have a higher risk of defaulting, meaning an investor may not get their money back. Bonds are a defensive asset class. This means bonds are a relatively good investment in bad financial markets or times of economic uncertainty. Many high quality and government bonds will maintain their value, even when share markets turn negative.

3 Understanding the jargon While less volatile than shares, bonds are certainly no less complicated to understand and value. Here are some of the basic building blocks you need to know to understand how bonds work. Face Value: this is the amount the borrower (issuer of the bond) agrees to pay when the bond comes due. Maturity Date: This is the date the Face Value of the bond comes due for repayment. Interest Rate/Coupon: The interest rate is the percentage income an investor is paid. For example, if the interest rate is 5% on a $100 bond, the investor would receive $5 interest each year. This term is often called the coupon rate of a bond. Bonds often make two interest payments each year (in our example, two payments of $2.50) Credit rating: Companies (primarily Standard & Poor s, Moody s, and Fitch Group) provide credit ratings of bond issuers as well as specific bond issues. Bonds with less financial risk have a higher credit rating and pay lower interest than bonds with higher financial risk. Price: The price of a bond is often not the same as the face value. The price might have been the same as the face value when the bond was first issued in the market, but many things may have occurred since then. Some obvious influences on the price of a bond are; the time to maturity, changes in the issuer s credit risk, and changes in interest rates. Yield To Maturity (YTM): The YTM is the effective interest rate for a bond, taking into consideration its interest rate and its current price. The YTM allows an investor to compare the value of bonds with the same maturity that have different prices. Main subgroups: The main subgroups of bonds are Government, Semi Government (including bonds issued by the states), Financials, Corporates and Hybrids. Bonds can be split between investment grade (with credit rating better than BBB-) and sub-investment grade (lower than BBB-, also called junk bonds).

4 Key value drivers: Generally, the longer the maturity date, the higher the interest rate. This is because the longer the time to maturity, the longer the time in which something could go wrong, causing the bond issuer trouble in repaying the borrowed amount. When interest rates go up, a bond s price declines and when interest rates go down the price of a bond goes up. This is all about the opportunity cost of owning a bond. If you have a bond paying interest at 5% and general interest rates fall to 4%, the value of your bond rises because your bond pays interest at a rate which is higher than that available to new investors. The lower the credit rating the higher the interest rate. If an issuer has a lower credit rating, an investor requires a higher interest rate to compensate for the risk that the borrower may not be able to repay the amount owed. Government bonds are often call risk free bonds. Risk free means that they are free of credit risk. This is because the Government can always print money to repay a loan. Risk free does not mean to say that the price won t change or decline, just that the bondholder knows they will be repaid. A risk free bond is a term that should only be applied to government bonds where that government can print money. For example, it does not apply to Greek Euro bonds because the Greek Government does not have the right to print Euros. Conclusion Bonds remain an important part of many investors portfolios. Bonds are a defensive asset class, as they often hold their value when broader financial markets decline. But all bonds are not the same. Some pay higher interest but are of higher risk, while others pay lower interest and may be materially less risky.

5 Further Reading Everything You Need to Know About Bonds, PIMCO Bond Prices and Interest Rates, Khan Academy The Australian Bond Market, Reserve Bank of Australia Want More? BigFuture.com.au

6 GENERAL ADVICE WARNING Any advice on this website is of a general nature only and has been prepared without taking into account your objectives, financial situation or needs. Before you act on any advice on this website, please consider whether the advice is appropriate for you having regard to your objectives, financial situation and needs. It may be prudent for you to seek appropriate licensed financial advice before making any decision. The content is provided by BigFuture Pty Ltd.

Questions 1. What is a bond? What determines the price of this financial asset?

Questions 1. What is a bond? What determines the price of this financial asset? BOND VALUATION Bonds are debt instruments issued by corporations, as well as state, local, and foreign governments to raise funds for growth and financing of public projects. Since bonds are long-term