Category: Shares

The Risks of Investing in Bonds

In this post we cover the key risks of investing in bonds, including interest-rate risk, market risk and credit risk.

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:

Interest Rates

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 2020 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.

Inflation Risk

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.

Credit Risk

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.

Market Risk

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%.    

The information on this website is for general information purposes only. It is not intended as  financial or investment advice and should not be construed or relied on as such. Before making any commitment of a financial nature you should seek advice from a qualified financial or investment adviser. No material contained within this website should be construed or relied upon as providing recommendations in relation to any financial product. Balance Impact does not recommend or endorse products and does not receive remuneration based upon investment or other decisions by our email recipients, publications, newsletter or website users.

All About Bonds

This week we cover everything you never wanted to know about bonds, the unloved asset class 🙂 Learn when to include them in your investment portfolio, which type, and the returns you can expect.

Bonds are an important part of any investment portfolio, yet they are often overlooked due to lack of understanding.  The good news is they are fairly straight forward products.  

What are bonds?

Bonds are a tradeable debt instrument that pays a set amount of interest (e.g. 5% per annum) for a set period of time (e.g. 5 years).  At the end of the term of the bond, you get back your initial investment.  Bonds are commonly issued by companies and governments.

It’s easiest to understand what bonds are by looking at an example.  In the past, the Victorian Government issued $300 million of Green Bonds, the money from these bonds was used for “green” projects, e.g. LED traffic lights, low-carbon buildings and public transport.  The investors that bought the bonds were lending the Victorian Government the $300 million, for 5 years, at an interest rate of 1.75% (the RBA Cash Rate at the time of issuance).  This means that:

  • On Bond Purchase: Investors lend the Victorian Government $300 million

  • Years 1 to 5: Investors receive an interest payment of 1.75% p.a. for 5 years

  • End of Year 5: The Victorian Government repays the investors $300 million

Why Hold Bonds in your Portfolio?

The key reasons that people hold bonds in their investment portfolio are to:

Reduce Risk

The price of bonds moves around less than shares, making bonds a less volatile (i.e. less risky) investment.  Adding bonds to a portfolio will generally decrease the risk of that portfolio, provided the bonds are at least investment grade (more on that next post). 

The reason that the price of bonds moves around less than shares is due to their structure.  When you purchase a bond, you are receiving an agreed interest rate, for a set period of time, and you will receive your initial investment back at the end of that time period.  This provides an element of certainty around your investment returns. 

The key uncertainty that comes with bonds is whether the borrower (the bond issuer) will be able to make the payments they have agreed to.  As such, the credit quality of the issuer is very important.   In purchasing a bond from the Victorian Government, there is a high degree of certainty around the Government repaying your investment.  This high degree of certainty is reflected in the low interest payment of the bond.  Because of the low risk, your return is only 1.75% a year from the Victorian Government.

Income

Another reason people purchase bonds is for the income.  Whereas share dividends can move around from year to year, an interest payment from a bond is fixed, either absolutely, or as a spread above the cash rate.  Investing in bonds therefore provides more certainty for  income planning than shares.

Preserve Capital

A final reason for investing in bonds is to preserve capital.  When purchasing shares, it is possible for the share price to move around a lot, and potentially to fall to zero.  When purchasing bonds, there is a high degree of certainty that you will get your initial investment back, provided you invest in a high quality company / government. Also, even if a company runs into trouble, as a bond holder you will get repaid before shareholders receive any payments.  Getting paid ahead of shareholders helps decrease your chances of losing money if the company faces financial difficulties.

Quick Note:  Bond Pricing & Liquidity

Despite the relative safety of bonds, if you need to sell a bond prior to maturity you may not receive your initial investment back.  This is due to the inverse relationship between interest rates and bond prices.  If you bought a bond in a time of low interest rates, and have to sell in a time of high interest rates, the price of your bond will have fallen and you are likely to lose money. 

It is also worth noting that bonds are generally not as liquid as shares, which is often reflected in wider bid / offer spread  i.e. you pay more to buy a bond than you receive when you sell one.

How to invest

When deciding to invest in bonds, you have a number of options:

Direct Investment: There are some bonds listed on the Australian Stock Exchange, the most common of which are the exchange-traded government bonds, including indexed bonds (which pay a rate that is tied to inflation).  It is also possible to buy corporate bonds directly, known as XTBs (exchange-traded bonds). 

If you do decide to buy directly, it is important to create a diversified portfolio to make sure that you do not overly concentrate either your:

  • Credit risk: the risk of not getting your money back, which is highest if you have lent to just one borrower; and

  • Interest rate risk: the risk that interest rates rise, making the interest rate you agreed to receive today look unattractive, and the price of your bond falls.

It is quite difficult to build a diversified portfolio by directly investing in bonds.

Passive Funds: Another option open to you is to invest in a passive fund, for example a bond exchange-traded fund (ETF).  This will give you access to a diversified portfolio of bonds.  One point to note here, not all bond ETFs are the same.  A Government Bond ETF will have less risk, and consequently less return, than a Corporate Bond ETF.  If you are purchasing a Corporate Bond ETF make sure to check what the average credit rating of the portfolio is, an average rating of less than BBB- is very risky, and if this risk is not reflected in a higher return, then you may be better off avoiding such an investment.  We look more at ratings next week.

Active Funds:  It is also possible to pay a fund manager to construct a diversified bond portfolio.  The fund manager will manage both the interest rate risk, and the credit risk of the bond fund.  There are some good fund managers out there, however they may be hard to find as the SPIVA report shows that only 12% of bond fund managers outperform passive funds over a 10 year time period.

Risk of Too Many Bonds?

Bonds are an important part of a portfolio, but should not be 100% of your portfolio.  Bonds, like cash, are a defensive asset.  This means they are helpful in reducing the risk of your portfolio, but this reduced risk comes with reduced return.  According to Russell data over the last 20 years Australian bonds returned 6.8% compared to 8.7% for Australian shares. 

Investing in a portfolio of high quality government bonds, like the Victorian Government Green Bonds, could expose your portfolio to inflation risk.  Over the last 20 years inflation has averaged 2.5%, if you were receiving only 1.75% on your bond portfolio, then the real value of your portfolio is slowly being eroded over time.

There are also other risks of investing in bonds, which we have touched on here (like credit risk and interest rate risk).   Next week we explain in more detail some of the risks of investing in bonds, and how best to manage these risks within your portfolio.

The information on this website is for general information purposes only. It is not intended as  financial or investment advice and should not be construed or relied on as such. Before making any commitment of a financial nature you should seek advice from a qualified financial or investment adviser. No material contained within this website should be construed or relied upon as providing recommendations in relation to any financial product. Balance Impact does not recommend or endorse products and does not receive remuneration based upon investment or other decisions by our email recipients, publications, newsletter or website users.

Asset Classes

What is an asset class and which one should you invest in?
We set out the characteristics of the three main asset classes (cash, bonds, shares) and the pros and cons of investing in each.

What is an asset class and which one should you invest in?

Asset Class Selection

There are three main asset classes; cash, bonds and shares.  The characteristics of each are set-out below:

Asset Class Purpose Risk Time Frame Investment Options
Cash Have money available for short term cash needs Low Short term High interest savings accounts, term deposit, cash exchange traded funds
Bonds Earn income and protect capital Low – High Short to medium term Directly through purchasing Government bonds (low risk) to junk bonds (high risk).

Indirectly through bond exchange traded funds, actively traded bond funds

Property Earn income via rent and increase the value of your investment over time through property price increases Medium – High Medium to long term Directly through purchasing a property.

Indirectly through a property exchange traded fund, a property managed fund, or through shares in property companies

Australian Shares Earn income via dividends and increase the value of your investment over time through share price increases High Medium to long term Directly through shares purchase.

Indirectly through equity exchange traded funds, equity actively managed funds.

International Shares Increase the value of your investment over time and spread your risk globally, rather than being concentrated in the Australian market only High Medium to long term Directly by purchasing shares on foreign stock exchange.

Indirectly through equity exchange traded funds, equity actively managed funds.

In our masterclass series we delve into each asset class (see links above) to explain exactly how you can invest in it, and why you may want it to form part of 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 and before acting on the advice.

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