While many investors are familiar with how the stock market works, the bond market seems a world away.
Retail investors see bonds as the province of governments and big corporations — a world where they don’t think they belong.
We regularly hear about the bond markets in financial commentary. But if you wanted to buy bonds, how would you know where to buy them? And how would you know which ones to buy?
Because bonds are unfamiliar, retail investors tend to stick with something they know…like shares and the property market. Plus, many investors might be unsure how the bond markets work.
When you buy a share, you know that you’re buying a part of a company. You and all the other shareholders own the company.
But buying bonds is different. When you buy a bond, you’re don’t become a shareholder. Instead you’re acting as a lender. Just as the bank lends you money to buy a house, a bond buyer is lending money to the bond issuer.
The bond has clearly defined terms. Not only the size of the bond, but how often interest is paid, and the interest rate.
Governments and corporations issue bonds to raise money. For a government, it might be to finance their spending commitments. For a corporation, it might be to fund expansion. For some companies, it might be cheaper to issue a bond than borrow money from a bank.
And as long as the company continues to make the designated payments on the bond, there’s little interaction between them and the bond holder. By comparison, a bank might be more inclined to put stricter covenants in place.
The mechanics of a bond
Just as your credit score helps determine how much you can borrow — and the interest rate you’ll pay — the same applies to those issuing bonds. A country like Australia, with a triple-A credit rating, will pay less interest than a country whose rating is poor.
In simple terms, a bond’s interest rate reflects the risk of the borrower.
All bonds have something called a face value. This is the dollar value of the bond, and is the amount the issuer needs to pay back when the bond matures.
Let’s say a company issues a $10 million bond, with a 5% interest rate, which matures in 10 years. The buyer will receive $500,000 in interest payments each year. Along with the final interest payment, the issuer needs to hand back the $10 million when it matures after 10 years.
But just because an investor buys a bond, it doesn’t mean they have to keep it until it matures.
A set of cash flows
Investors buy bonds because they want to receive regular income over a long period. By buying a bond, they’re locking in these cash flows until it matures.
But what would happen if you bought a bond with an interest rate at 5%, and interest rates rose? Let’s say the same company from the above example is issuing bonds at 6%. Well, you’d be missing out on $100,000 a year in income (on the $10 million bond).
And this is where bonds can become confusing for retail investors. When interest rates rise, a bond with a fixed interest rate drops in value. Just because the bond has a face value of $10 million, it doesn’t mean that’s what its value will always be.
The value of the bond reflects current interest rates. If you were to buy a bond, you’d be prepared to pay more for a bond that pays 6% than one that pays 5%. And that’s how the bond market works.
Bond traders look to trade in and out of bonds based on their view on interest rates. They’ll top up their bond holdings at current rates if they think interest rates will fall. And they’ll look to offload these holdings if they think interest rates will rise.
How to invest in bonds
Unless you have a big chunk of money to invest, it’s unlikely that you’ll be bidding at Treasury to buy a government bond. But that doesn’t mean you have to miss out on the action.
Just as a range of ETFs have come to market to target specific sectors, so too have they for bonds. For example, Vanguard offers an Australian Government Bond Index [ASX:VGB], which invests in both federal and state government bonds.
And iShares (issued by BlackRock) offers a similar product as well — the Core Composite Bond ETF [ASX:IAF], although it also includes high-grade corporate bonds as well. If you look around, you’ll see a variety of providers that offer bond ETFs.
The handy thing for income investors is that some pay their distributions quarterly. And you only need to invest a size that suits you. A $1,000 investment can gain access to millions of dollars from a broad range of bonds.
Bond ETFs typically have low volatility, as their share prices don’t fluctuate too much. That’s one of the attractions of putting them in a portfolio. You can generate income without having to watch the share prices like a hawk.
For Markets & Money