Bonds: Back to basics

PORTFOLIO POINT: There are many different types of bonds available to investors in the Australian market, with varying degrees of risk.

What is a bond?

A bond is a debt security where the issuer (the borrower) promises to pay the bond holder (the lender) a specific interest rate (known as the coupon) during the term of the bond and to repay the “par value” (principal) at the maturity date.

Types of bonds

Within the Australian market, many different types of bond investments are available and the following is a list of the most common:

Government bonds – Bonds issued by the Commonwealth government are considered to be among the lowest risk investments in the Australian capital market. As they are not directly linked to the performance of the economy, they can provide considerable portfolio diversification and, to some degree, a hedge against the effects of an economic downturn on a portfolio.

Semi government bonds – Bonds issued by the state governments through their central borrowing authorities, such as the NSW Treasury Corporation, or where a direct or implied guarantee from the Commonwealth government exists.

Corporate bonds – Bonds issued by a corporation will usually have a higher coupon than a Commonwealth government or semi government bond of a comparable term, as there is a higher risk of the company defaulting.

Fixed rate bonds – This is a very common type of bond where the coupon is a fixed percentage of the bond's par value.

Floating rate notes (FRNs) – FRNs have a variable coupon that is quoted as fixed margin above or below a widely published reference rate, such as the bank bill swap rate (BBSW). For example: if BBSW was 5% and the FRN fixed margin was 1.5%, the FRN coupon would be 6.5%.

Zero-coupon bonds – A zero coupon bond does not make coupon payments and is issued at a substantial discount to par value. The difference between the issue price and the par value will compensate at maturity for the lack of coupon payments.

Subordinated bonds – If a bond issuer becomes bankrupt, the repayment of creditors will be determined in accordance with a “hierarchy”. Subordinated bonds rank for repayment after the liquidator, the Australian Taxation Office and “senior bonds”, and are clearly a more risky investment.

Perpetual bonds – These bonds are often called perpetuities, or “perps”, as they do not have a maturity date. In fact, there are international perpetual bonds still being traded that were issued back in the late 1800s, with the most well-known being “UK Consols (a form of UK government bond).

Inflation linked bonds – Inflation linked bonds have coupon payments that are indexed to inflation and, typically, a lower coupon than comparable non–inflation linked bonds.

Yield calculation

Current yield – The current yield calculates the yield based on the current market price of the bond, which may be different from the par value. For example: A bond has a par value of $100,000 and makes an annual coupon payment of $6,000 or 6%. If the market value of this bond declined to $80,000, the current yield would be 7.5% (being $6,000 / $80,000 *100).

Yield to maturity – Yield to maturity calculates the total yield if you hold a bond to maturity and comprises three elements:

• The coupon paid on the bond
• An assumption that the coupon payment received is reinvested
• The capital gain or loss that will be realised at maturity.

If the bond has been purchased at a discount, then a capital gain will be realised when the bond matures, as the par value is repaid to the bond holder. Conversely, at maturity, a loss will be realised by the bond holder if they purchased the bond for a price higher than par value.

Redemption features

While the maturity date indicates how long a bond will be outstanding, many bonds are structured in such a way so that an issuer or investor can substantially change that maturity date.

Call provision – Callable bonds allow, and sometimes require, the bond issuer to redeem the bonds at a specific price before maturity and usually have a higher yield than non-callable bonds of a comparable term.

Put provision – A put provision gives an investor the option to sell the bond to the bond issuer at a specified price prior to maturity. As there is protection provided to the investor, the bond usually has a lower yield than comparable bonds without put options.

Conversion – Convertible bonds contain an option for the bond holder to convert the bond at maturity into shares in the bond issuer at a price fixed when the bonds were issued. They offer a lower yield due to the potential for capital gain on the shares received.

The link between price and yield

From the date of issue until the maturity day, a bond’s market price will fluctuate depending on the particular terms of the bond, prevailing interest rates, the bond’s credit rating and other factors.

In general, when interest rates fall, the market price of bonds with higher rates will rise. Conversely, when interest rates rise, the price of bonds with lower rates falls to bring their yield into line with higher-interest bearing new issues. In other words, a bond’s price and its yield are inversely related.

Final thoughts

Bonds are often referred to as “fixed income” investments, but that certainly does not mean that they are without risk. While they are usually considered much safer than shares, bonds can still lose value due to a wide range of factors.

Mark Bennetts is a senior advisor at Lachlan Partners Wealth Management in Sydney. This article first appeared in The Investing Times.