Explained: Bonds and why they’re back in business

When some people think of bonds, they might conjure images of old men working in finance and dressed in pinstriped suits. Or perhaps they remember reading the best-selling Liar’s Poker by Michael Lewis. 

Until recently, it was difficult for everyday investors to access bonds due to high minimum investment amounts, lack of diversification and costs. However, with the rise of exchange traded funds (ETFs), investors now have a solution to easily access bonds and make them an essential part of their portfolios. 

First, what is a bond?

A bond (also known as a fixed income security) is a loan made by investors to a company or government. Bond holders lend money to the bond issuer for an agreed period (until maturity) and in return for that, they are paid a regular income (hence the fixed income) in the form of interest (also known as a coupon payment). 

At the end of the agreed period of maturity, investors also receive their principal back.  

As bond prices are inversely impacted by interest rates (that is, bond prices fall when interest rates go up) they become less popular when rates are low. That is because they pay low levels of income and may be subject to rising rates.  

In recent years, bonds have fallen out of favour with investors. That is largely due to the historically low interest rate environment we have been experiencing. 

The growth of bond ETFs

Bonds are becoming popular with retail investors for two main reasons. The first has to do with interest rates. As rates rise, bond yields (that is, what the bond returns to the investor) also rise, making it an attractive, low-risk option for investors to earn income. 

Second, whereas buying bonds in the past was difficult, expensive and only open to government/corporate clients, now anyone can buy bonds for as little as $500. Retail investors can gain exposure to bonds through the ASX, just like buying and selling shares. 

As a result of these two changes, bond ETFs have started to enjoy strong growth over the past five years, growing at a rate of 43 per cent per year, to more than $15.6 billion, and now make up 12 per cent of the overall ETF market. 

Common types of Australian bond ETFs

The three most common type of bond ETFs that Australian retail investors can purchase are Australian government bond ETFs, corporate bond ETFs and international bond ETFs. 

Australian government Bond ETFs invest in bonds issued by the government, Treasury and semi-government entities. These can be Australian government or NSW government bonds. A popular government bond ETF is the iShares Core Composite Bond ETF (ASX: IAF).  

Corporate Bond ETFs invest in investment grade bonds issued by corporations such as the big banks or other reputable corporations. The Vanguard Australian Corporate Fixed Interest Index ETF (ASX: VACF) is a popular corporate bond ETF. 

International Bond ETFs invest in bonds issued by governments around the world, including the UK and US governments. The Vanguard International Fixed Interest Index (Hedged) ETF (ASX: VIF) is favoured among Australian investors. 

Returns

As mentioned, bonds are back in favour with investors due to their yields. At present, they are as competitive as bank deposit rates. 

Current yields are:  

• Government bonds: IAF – 3.7% 

• Corporate bonds: VACF – 4.6% 

• International bonds: VIF – 3.3% 

Why invest in a bond?

The main reasons to invest in bonds is the fixed and steady returns they provide and the diversification that they offer. Bonds can provide a cushion to falling shares and property prices. 

Any portfolio should be diversified to weather market downturns and volatility (such as we are currently experiencing). To diversify, investors should own shares, commodities (such as gold) and bonds. This is because bonds have historically had periods of negative correlation to shares. That is, when shares go down, historically, bonds have usually performed well and either held their value or gone up in value. 

How to invest in bonds

Gone are the days of bonds being the exclusive remit of stuffy bankers in high-priced suits. 

These days, buying and selling bonds can be done simply and efficiently through your broker or favourite share trading platform via the ASX.   

You can buy and sell your bonds the same way you buy other shares. 

Marc Jokum is investment strategy and research manager at Stockspot. 

Have you dabbled in bonds? Do you have any tips? Why not share them in the comments section below?

Also read: Higher interest rates drive big annuity take-up