A bonding investment

When you invest in bonds, you are effectively lending money to a government or company at an agreed interest rate for a set period of time. In return, the borrower promises to pay you interest at regular intervals and repay your loan at the end of the term. Bonds should be considered as part of a diversified investment plan.

However, not all bonds are the same, ranging from very safe to very risky. Here are some things to look out for before you invest. If you’re still unsure, seek financial advice.

How bonds work

Bonds have a face value, which is the amount you will get back at maturity and a coupon amount, which is the interest paid each year. This payment may be divided into half-yearly or quarterly amounts.

This is simple if you buy a bond at the start of the term and hold it to maturity. Things are more complicated if you only hold a bond for part of the term.

Bonds that you can trade on a secondary market such as the Australian Securities Exchange (ASX) are known as ‘listed’ or ‘exchange-traded’ bonds. Listed or exchange-traded bonds give you the flexibility to sell the investment if your circumstances change.

How interest rates are calculated

Bonds can pay interest at a fixed or floating rate.

Fixed rate bonds

The interest on a fixed rate bond is set when the bonds are issued and is shown as a percentage of the face value of the bond. The interest rate stays the same for the life of the bond.

Floating rate bonds

The interest rate for floating rate bonds varies in line with movements in a benchmark interest rate. This means the coupon payment will vary each time, sometimes quite substantially. You could get higher returns if the benchmark interest goes up, but you could also get lower returns if the benchmark interest rate goes down.

Check the bond’s prospectus for information on how and when the floating rate will be calculated for coupon payments.

Defensive investments

In an investment portfolio, bonds may serve a different function to conservative investments such as savings and deposit accounts. The market value of bonds can go up and down depending on what’s happening in the economy and with interest rates.

Certain bonds tend to perform well when other markets are struggling. For this reason, they are often seen as a defensive investment, as well as a source of regular income.

Over the last 25 years some high quality fixed rate bonds have provided comparable, and in some cases, better than average returns, compared to Australian and international shares and listed property. They have also been less volatile than shares, with fewer years of negative performance.