Last week we introduced the basics of bonds, this week we’ll explain some of the features and risks in more detail.
What are the key risks of investing in bonds?
Bonds are less risky than shares, but they do still contain risk. Below we outline some of the key ones:
The price of bonds can move around depending on the level of interest rates. For example, say that you bought the Victorian Government Green bond in 2016 which pays an interest rate of 1.75% p.a. The cash rate at the time the bonds were issued was 1.75%, meaning you were getting paid the cash rate at the time of purchase.
Fast forward to 2019 and the cash rate is 3.50%, now you own a bond that is paying you 1.75% less than the cash rate. Investors would rather buy a bond that is paying them the 3.5% current cash rate than one paying them 1.75%. Because of this, the price of your 1.75% bond has gone down. At the end of the 5 years, you will still get your $1,000 back, but in the intervening years the price of your bond will move around and you will have missed out on the additional 1.75% return that other investors were able to earn during that period.
Because bonds are generally lower risk, they also offer lower returns. This introduces the possibility that your return may not keep up with inflation. For example, the interest payment on the Victorian Government Bond of 1.75% is below the average inflation rate of 2.50%, which means that at the end of the 5 year term the purchasing power of your investment will have fallen, introducing the risk that during the term of your investment you may have lost money in real (i.e. inflation-adjusted) terms.
In buying a bond, you are essentially lending money, leaving you exposed to the credit risk of the borrower. A bond is a legally binding obligation to repay the debt, however a company (or Government) in bankruptcy may not have the money to repay. As such, you should be happy with the risk of the company you are buying a bond from.
One of the key ways that people measure credit risk is via a credit rating, you can read more about them here. The ratings go from AAA (lowest risk of default) to C (highest risk of default). The higher the risk of default, the higher the interest rate that the bond should pay. To minimise risk, it is generally best not to invest below a BBB- rating.
The Victorian Government is rated AAA, meaning that there is a low risk of default, which is why the interest rate is so low at 1.75%. It is worth noting that credit ratings can change, which may impact the price of your bond. If you invest in a AAA rated bond, which is subsequently downgraded (e.g. to AA), then the price of the bond is likely to fall.
Bonds are part of the financial markets and are subject to falls in prices when the bond market declines. For example, when interest rates begin increasing, the bond market as a whole usually falls due to the inverse relationship between bonds and interest rates.
Bonds are also impacted by the share market. A study found that in periods of market volatility, the correlation between the bond and share market can get up to 0.50. This means that if the share market drops by 1%, the bond market could drop by 0.50%.
What types of bonds are there?
There are a wide variety of different types of bonds that you can invest in, below we have listed some of the most common:
Fixed Rate Bonds: The Victorian Government Green Bond is an example of a fixed rate bond, because the interest rate it pays (1.75%) is fixed at the date of issue and will not move. Fixed rate bonds expose you to the risk that interest rates will rise.
Floating Rate Bonds: Floating rate bonds are bonds where the interest rate moves, usually in line with the cash rate. For example, the Victorian Government could have issued their green bond as paying a floating rate of the cash rate. This means that the interest rate will increase any time the cash rate increases, and vice versa. Floating rate notes are a good investment if you think that interest rates will be increasing soon.
Inflation Linked: It is also possible to purchase inflation linked bonds. These bonds pay an interest rate that is based on inflation, for example they may pay the Consumer Price Index+0.25%. The Consumer Price Index is the most common way that inflation is measured. Inflation-linked bonds are helpful for people on a fixed income, for example in retirement, who need to ensure that their interest payments are at least keeping pace with inflation.
Investment Grade: Investment grade bonds are those with a credit rating of BBB- or above. Investment grade bonds are lower risk than non-investment grade bonds.
Junk Bonds: Non-investment grade bonds (i.e. bonds rated less than BBB-) are also known as junk bonds. They are higher risk than investment grade bonds. If you decide to purchase junk bonds, make sure that you are being compensated for the higher risk by being paid a higher return, and that you are happy with the credit quality of the bond issuer.
That’s it for this week, next week we are going to move on from bonds and discuss the role of shares in your portfolio.
The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.