Common misconceptions about bonds

1. Bonds are risky like shares

No. As the old saying goes, a picture is worth a thousand words. The buyer of a bond is a lender to the company (or government) that issues the bond. Thus, a bond is simply a tradeable version of a loan. Investors who buy shares are usually looking for capital appreciation, as well the possibility of taking advantage of certain tax rebates in certain cases.

In this sense a bond investor is the banker, and simply expects a series of interest payment (known as coupons) at regular periods through the bond’s life and the return of the full-face value of their investment when the bond matures (also known as the redemption date).

If a company were to go into liquidation, the diagram below shows how the remaining assets will be distributed in a wind-up. The equity investor who owns shares will take the first line of losses, and in certain cases may loss much or all their capital. Next line of defence are hybrids.

Thus, for a bond investor to lose any capital, the equity investor will have lost all their capital.

2. When I buy a 5-year bond, I must hold it to maturity

No. As touched on above, a bond is simply a tradeable loan. Bonds largely trade in an open, liquid “over the counter” market. They are issued at a price of $100, and mature at $100, and will trade at market determined prices through their life. Thus, a bond investor can “sell out” of their investment before the bond matures. This price could be higher or lower than $100 depending on many economic factors that affect the interest rate settings of central banks and the expectations of what may happen in the future.

3. When interest rates (yields) fall, the price of fixed rate bonds falls

No. The price of a fixed rate bond moves in the opposite direction to its interest rate or yield. Fixed-coupon bonds comprise the bulk of issuance in the Australian debt market. “Fixed rate” refers to the total annual income that the bond investor receives, usually in two semi-annual payments.

In 2022, Challenger issued the bond illustrated below which has a fixed coupon of 7.186% and this is identical to the yield to maturity on issue date. Since then, the bond has traded at market-determined prices that are determined (like any other security) by market forces. The most important of these is the creditworthiness of the issuer, and expectations as to interest rates in the broader bond market, and the time until the bond matures.

If investors are happy to accept a lower yield to maturity for Challenger bonds than the 7.186% offered on issue date, then the fixed trading price of this bond will rise above $100 because the value of the fixed annual payments will be worth more than $100 at the new, accepted, lower yield.

4. The only way to get exposure to corporate bonds is to buy a “Bond Fund” or “Balanced funds”

No. Balanced funds are pooled investment vehicles which will have a mixture of bonds and fixed income – and these often have high management/exit fees. While these funds can be expected to have more capital stability than more volatile equity-only investments, you will have to trust a well-paid investment manager to make the decisions. These balanced funds do not have any “maturity date” upon which you can expect to receive all your capital back and often lack transparency.

” Bond Funds” will mostly have greater levels of lcapital stability than the above balanced fund due to the lack of equity investments. However, these vehicles still have the drawback of entry and exit fees, management fees and the absence of a date upon which the investor is owed the return of their capital. They are not capital guaranteed but have the advantage of some levels of diversification over single bond purchases due to the different securities in the fund.

5. Bonds are just like term deposits

No; however, like term-deposits, corporate bonds are interest-bearing investments. Term deposits, unlike corporate bonds, can benefit from a government guarantee subject to certain caps. They are typically shorter-term investments, mostly months in duration, compared to corporate bonds which usually have terms of two- to five or more years to maturity.

As can be seen from the below indicative table, investment-grade corporate bonds will give investors stronger yields than term deposits by quite a margin. Another advantage is that they are tradeable securities and thus may be bought and sold quite easily, subject to the liquidity available in the over-the-counter market. There is however no guarantee that these bonds will be able to be sold for as much or more than the investor has paid but, unlike term deposits, they are not subject to the forfeiture of interest if they are terminated (sold) early.

The yield gain for corporate bonds is around 2-4% compared to term deposits.

Below is a table of the current indicative rate of return for classes of fixed income investments:

*Rates indicative at the time of writing