Bonds for beginners
It’s well worth being familiar with bonds. Some say if more people had invested in bonds five years ago when interest rates were low, instead of finance companies, a lot of pain and financial ruin could have been avoided.
Apart from providing a regular income stream, bonds are less risky than shares. They act as “shock absorbers” in a balanced investment portfolio and help give the investor a smoother ride.
A bond is really an I.O.U. usually issued by governments, local authorities and companies. It is a promise to repay a sum of money at a certain interest rate – over a certain period of time. A council might need to fund a new water treatment plant or public buildings, or a company might need funds to grow its business.
A company can borrow money from a bank, they could raise money by selling a share in the company or they can raise money from the public by issuing bonds. It generally gives companies greater flexibility with their funding needs.
When investing in bonds you need to understand some terms, and what they mean.
Face value – can also be called the par value. When a bond is issued they are usually for a minimum of $5,000 or $10,000 – which is the “face value” of the bond and the amount the bondholder receives when the bond matures.
Coupon rate – A bond is issued with a fixed rate of interest, this is called the “coupon” rate.
When the Fonterra bonds were issued recently they had a “coupon rate” of 7.75%. So a $100,000 investment would pay interest of $7,750 a year until the bond matures in 2015. Interest payments are generally six-monthly.
Maturity date – Is the date when the bond matures, so in the case of Fonterra bonds they will mature in March 2015, and the bondholder gets to bank the “face value” of the bond. Most of the recent bond issues have been issued for 5-6 years.
Yield – Is also called the yield to maturity. Once bonds have been issued they can be bought and sold just like shares. If interest rates rise, the purchaser will receive a higher yield (effective interest rate) on their money. While the recent Fonterra bonds were issued with an interest rate of 7.75%, they could be purchased several weeks later with a yield of 8.2%.
Remember bonds are the opposite of property & shares - you want to buy when interest rates are high. When interest rates fall the bond becomes more valuable.
The NZDX is New Zealand’s market for trading debt securities, which include a range of government and corporate bonds and other fixed income securities. Currently the NZDX has approximately $13.5 billion of bonds listed on the exchange.
In comparison to a simple term deposit, bonds can offer greater diversification, more flexibility and more stable long-term interest rates. Rather than $100,000 invested in a 2-year term deposit, an investor could spread the same amount of money over five different bonds with different maturity dates. Some bonds might be for 2-3 years, others could be for 5 years, and if interest rates were high like last year, the investor might want some 8-10 years bonds in their portfolio.
A year ago it was possible to purchase a variety of high quality bonds that matured between 2012 and 2016, where the average yield was over 8.5%. Buying the same investments today they would yield closer to 6%. Compare that with the 2-year term deposit of 7.5% a couple of years ago, and the 4% - 4.5% that is currently on offer for 2-year money.
The beauty about bonds is the flexibility they offer. If your circumstances change and you need some or all of the funds, you can usually sell a bond within three working days. Try doing that with a term deposit and see how much the bank will charge you for “breaking the contract”.
While there are a range of ‘risks’ that affect fixed interest investments, the most obvious and most material in respect of the returns are ‘credit’, ‘liquidity’ and ‘interest rate’ risk.
Credit risk
This would be better described as ‘default’ risk. Will the bonds pay their “coupons” (regular interest payments) and will you get your money back at maturity? Credit default is, pretty much the major reason you won’t get your money back!
Liquidity risk
Having decided to sell your investment you are faced with liquidity risk. Having made an investment in good times, an investor needs to know there is a “market” for their investment when they come to sell. You may be able to sell the investment, but because of market conditions it is sold at a large discount to its value.
Interest rate or ‘duration’ risk
All interest rate investments with a future maturity date have a ‘duration’ risk. This is simply a measure of the price of your bond to changes in interest rates. With investments in property and shares, an investor should buy when prices are low and sell when prices are high. With bonds it’s the opposite.
Not all bonds are equal. Those with a higher credit rating usually have lower interest rates, and those with low or no credit rating, generally have to pay higher interest rates to attract investors.
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Financial Update is a regular publication published by Spicers Portfolio Management. It discusses topical investment and financial planning issues. A free copy of Spicers disclosure statement can be obtained by calling 0800 102 100 or visit www.spicers.co.nz.
Spicers is widely recognised as one of New Zealand's leading financial planning firms with a strong reputation for quality advice, integrity and delivering results. Established in 1987, the company has a network of 50 advisers throughout New Zealand and successfully provides advice on more than NZ$1.2 billion on behalf of its clients.
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