Investing in Bonds

Dear Subscriber,

Many people are uncomfortable with investing in shares at the moment, they feel that holding their money in cash is not the answer but they do not want the restrictions of a term deposit.

There is an investment category that is doing very well at the moment and that usually does well during hard and volatile times. That investment category is bonds.

Most people know little about bonds even though the worldwide bond market at $95 trillion is almost twice the size of the $55 trillion share market.

Nicola and I have written this newsletter in response to several recent requests for more information about bonds. Read on…

Yours truly,

Christoph Schnelle
Adv Dip.FS (FP) EPA Acc Level 2
SMSF Specialist Advisor

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Investing in bonds. A safer and steadier option than shares.

Generally, bonds are safer than shares and provide better returns than cash or term deposits.

What are bonds?

If you buy a bond, the issuer of the bond makes you two promises:

1. The issuer will pay you interest for the duration of the bond. That duration can be anything from one day to 50 years but is usually 2 – 10 years and,
2. at the end of the duration the issuer will pay you your money back in full.

What is the difference between bonds and term deposits?

Term deposits make you the same above two promises but are less flexible.

Bonds are traded on the open market which means that you can cash in a quality bond every business day.

Term deposits are expensive to cash in early.

At the moment the returns from bonds and term deposits are roughly equal with bonds doing a little better but historically, most of the time bonds had higher returns than term deposits.

What are the advantages and disadvantages of bonds?

The main advantage of bonds is their safety. Some bonds are more safe than others.

What makes bonds safer than most investments is that defaulting on a bond is usually an act of bankruptcy with many very negative consequences for the issuer. An issuer of a bond (a government or a large corporation) will go to great lengths to avoid such a default.

This is different to shares. If a share goes from $10 to 20 cents that is highly unpleasant for all involved but nobody needs to be in default.

The disadvantage of both bonds and term deposits is that in the long term (20 years) you usually get lower returns from bonds than from shares.

The interest income from bonds, cash and term deposits is taxable income.

Is it possible to make a loss with bonds?

If you invest in a $1,000 two-year bond that pays 5% interest and interest rates go up to 7%, then that bond suffers a capital loss. You will still get $1,100 back over two years (2 x $50 interest and the $1,000 back at the end) but anybody with cash could now get a bond that returns $1,140 over two years (2 x $70 in interest and $1,000 back at the end).

This means that if you want to sell your $1,000 bond prior to the maturity date, you would only get about $965 on the market and your bond will have made a $35 capital loss. A term deposit in the same circumstances will have also made the same capital loss, it is just not so obvious.

How do you invest in bonds?

The best way to invest in bonds is usually to invest in a bond fund. This is an investment fund that buys a number of different bonds.

There are bond funds that invest in Australian bonds, international bonds, very safe bonds, safe bonds, not-so-safe bonds, “junk” bonds and so on.

The bond funds I recommend only invest in very safe bonds or safe bonds. These particular bond funds also make a substantial effort to minimise capital losses from changes in interest rates. They never invested in mortgage bonds and were unaffected by the global financial crisis.

An example of one of my favourite bond funds is the Dimensional five-year fixed interest fund. It is one of the safest bond funds in the world which made it the best performing fund at the height of the global financial crisis. It has returned 7.82% a year on average over the last five years and 7.28% over the last ten years.

Please feel free to call me at any time to discuss investing in bonds, term deposits, shares and property on a no-obligation basis.

This message was sent by Christoph Schnelle of In Your Interest Financial Planning.
Click here to email Christoph or phone us on 1800 332 225.

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