Pros and cons in endowment bonds

Retail zero-coupon endowment bonds have just been launched.

Summary: A zero-coupon endowment bonds product has been launched. Designed as a long-term investment product, the bonds accrue value at a rate of 4.29% per annum but pay no return until maturity. However, the accrued value of the endowment bond is taxable and investors must declare the increased value of the bond as a part of their assessable income each year.
Key take-out: Endowment bonds bought by a SMSF in accrual phase pay tax at 15%, but once in pension phase the accrued income is currently tax-free. They can also be used as deferred annuities to create a retirement income stream.
Key beneficiaries: General investors. Category: Fixed interest.

With all the focus on building a retail bond market in Australia, and with Commonwealth bonds commencing trading on the ASX last week, the emergence of a new retail bond product this month has largely gone under the radar.

Endowment Bond Exchange Limited (EBX) commenced operations earlier this month, offering retail investors the opportunity to buy short to very long-dated zero-coupon bonds called endowment bonds.

A zero-coupon bond does what the name implies; it does not pay a coupon (that is, an ongoing interest payment). In fact, it does not generate any income until the bond matures. So the bonds are issued at a discount to face value, and will increase in value over time as the coupons that would have otherwise been paid accrue to the face value of the bond.

For example, at the time of writing, EBX was offering a bond for which you would pay $2,825.75 and collect $10,000.00 upon maturity.  Does this sound too good to be true?

Well, yes and no.

The particular bond concerned is a 30-year bond accruing value at the rate of 4.29% per annum. So the rate of return is not spectacular, and you have to wait a long time to collect.

But for an investor who wants or needs a known level of income at a specific time in the future, and who wants minimal credit risk attached to the investment, an endowment bond is a unique product in the Australian market for retail investors.

The closest comparable fixed-interest products that may also have a place in a long-term investment portfolio are annuity bonds offered by life insurers (variable returns), Commonwealth government bonds and inflation-linked bonds (fixed returns and now tradable on the ASX).

Another similar product offered by life insurers and friendly societies is insurance bonds. Insurance bonds can be fixed interest or equity based, or a combination of the two.

Like endowment bonds no returns are received until maturity, in this case after at least 10 years. However, unlike zero-coupon bonds the returns are tax-free at maturity.  

In the case of the example given above, the endowment bond is matched by an identical bond issued by Treasury Corporation Victoria (TCV) under a wholesale arrangement with EBX. TCV does not issue endowment bonds directly to retail investors.

At the present time, EBX can also offer endowment bonds backed by NSW Treasury Corporation and Rabobank Australia. The range of entities backing endowment bonds is expected to expand to include other state government funding corporations and major banking groups.

With endowment bonds available for any term to maturity, ranging from one year to 40 years (at a later date), it is essential that the entities providing the matching wholesale bonds be of the highest credit quality. Endowment bonds are not a high-yield investment opportunity.

They are just the opposite – low yielding, but with very low credit risk. Endowment bonds are about buying certainty for the future and not having to worry about sharemarkets crashing or interest rates falling ever lower, while you are trying the save for your retirement or another specific purpose.

Endowment bonds are not intended for short-term saving or for putting money away for rainy day. While it may be possible to redeem an investment early, there is no secondary market for the bonds.

While endowment bonds are ideal for inclusion in the investment portfolio of a self-managed superannuation fund (SMSF), they can be used for any other purpose where there is a long-term savings goal. Endowment bonds can be used to save for school fees, philanthropy or even succession planning, such as in the case of professionals hoping to buy into a partnership one day.  

However endowment bonds probably work best in a superannuation portfolio, particularly one that is either in the pension phase or will move into the pension phase before too long. The reason for this is that the accrued value of the endowment bond is taxable.

The investor must declare the increased value of the bond as a part of their assessable income each year, even though no cash flow has been received from the investment. Cash must be found from elsewhere to pay the tax liability.

This is the reason that zero-coupon bonds have not been popular in Australia in the past.

However in a SMSF that is in the accrual phase, tax will only be payable at 15% and there should be sufficient income from other investments to cover any liability. In fact, with any reasonable holding of equities paying fully franked dividends, the franking credits will likely offset any tax liability on an endowment bond.

And in a SMSF that is in the pension phase and the beneficiary is aged over 60, there will be no tax liability, under current legislation.

Another advantage of endowment bonds in a SMSF portfolio is that they can be used as deferred annuities to create a retirement income stream well into the future.

For further information go to www.ebx.com.au. A prospectus to buy endowment bonds can be downloaded online.


Philip Bayley is a former director of Standard & Poor’s and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.

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