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How does investing in bonds work

How does investing in bonds work

Most risk-averse investors prefer government and corporate bonds as a defensive investment, but how exactly does this security work? Here’s a quick guide on how bonds give investors predictable income over a fixed period.

Risk-averse investors who want to limit their losses usually invest in bonds as a defensive investment strategy, due to its nature as a form of debt.

This is because government institutions or companies that issue bonds promise to pay interest as long as the investor holds onto the bond.

There are four basic things a person must know about bonds to understand how it works. These are:

  1. Bonds are a form of debt
    When institutions need money to finance their projects and operations, they can choose to issue shares or bonds. Unlike shares that come with part-ownership of a company, however, bondholders function as lenders.

  2. Bonds provide fixed returns from interest incurred over an agreed duration
    Bondholders don’t just lend money to companies, they lock it in for a fixed term.

    In return, the bond issuer commits to paying the bondholder interest for the whole term. The interest is calculated based on the bond’s face value and paid out quarterly, semi-annually or annually, depending on the terms of the bond.

  3. Bondholders are paid back in full plus interest and face value upon maturity
    Bond issuers are expected to pay back the face value and the last interest payment when the bond reaches maturity—the end of the bond’s term.

  4. The biggest risk in bonds are inflation and interest rates
    When interest rates move, the bond’s price and actual returns also move, but they move in opposite directions. This means:
  • When interest rate rise, the bond’s price will fall even as its returns increase;
  • Falling interest rates mean lower yield and higher bond prices.

Add rising inflation rates in the mix and a bondholder’s purchasing power by the end of the term could be lower than expected.

How can one invest in bonds?

Bonds can be purchased or sold in secondary markets like the Australian Securities Exchange (ASX), but unlike shares traded by shareholders, bonds are usually sold by stockbrokers from their own asset range.

Step 1: Shop for bonds from brokers or bondholders
Brokers may only be able to offer a percentage of what is available in the secondary market. Investors are advised to look over the list of all bonds offered in the market and check different stock brokers to see what they can offer.

The other option is to see if another bondholder is selling their bond in the middle of its term.

If a bondholder offers to sell their bond, it is advised that potential buyers check its terms first to determine the prevailing face value and interest rate when the bonds were first offered, and if there are newly issued bonds from the same institution. Buying a bond within its term automatically decreases the lock-in period of an investor’s capital, but they may end up earning less if the interest rate is lower compared to newly issued bonds.

The investor may also spot an initial public offering in the primary market through newspapers and company announcements, but in most cases, the secondary market is the best place to search.

Step 2: Understand the risks of a chosen bond
It is true that bonds are less risky when compared to shares, but there are also some high-risk bonds available in the market.

An investor should check a company’s track record when it comes to paying its debts, especially when it offers high interest rates (coupon).

This is because high-risk companies usually offer high returns, but they are also the ones that, experts believe, have a higher chance of defaulting.

As a general rule, government bonds are low-risk bonds while the risks in corporate bonds vary. Investors would benefit from checking a company’s bond rating, which are usually researched and graded by experts.

Step 3: Get a clear picture of how the chosen bond works
Consider this example: a company issues five-year, $100 face value bonds with 10 per cent coupon paid quarterly. Assuming an investor only buys one unit, this means the bondholder can expect $2.5 each quarter— the equivalent to $10 annual interest divided by four. At the end of four years, the bondholder would have collected $40 in interest payments.

When the bond matures on the fifth year, the bondholder can expect their $100 face value plus the last $2.5 to complete the year’s interest payment. In total, the bondholder earned $50 from their $100 initial investment.

Depending on the type of bond that was purchased, the $50 coupon earnings may be subject to taxes.

Step 4: Invest!
If the terms of the bond are acceptable considering the risks or lack thereof, an investor may purchase bond units from their stockbrokers.

However, just like any brokered investment, investors must understand that there are accompanying fees. Discuss this with the stockbroker to see how much they charge for transactions, and if it is worth the amount of investment that will be purchased.

Types of bonds

Apart from knowing how bonds work, it is important to know the different types of bonds available for investing. Take a look at the different types of bond options in the market.

Government bonds
Government-issued bonds are usually the safest because stable governments don’t just crash overnight. The stability government bonds offer bondholders assurance that they will definitely receive coupon payments quarterly or semi-annually.

This assurance also means government bonds offer more liquidity since they can easily be traded anytime. However, if a bondholder decides to sell their government bonds at any time within the term, it will be subject to market value, which means it may be sold for a lower price than its purchase price.

The Commonwealth of Australia issues two types of bonds in the ASX, and both pay interest that are exempt from non-resident withholding tax. These are called Exchange-traded Treasury Bonds (eTBs) and Exchange-traded Treasury Indexed Bonds (eTIBs), and their differences are explained below.

Exchange-traded Treasury Bonds work like typical fixed-interest debt security that is payable semi-annually until maturity. Investors may purchase a minimum of one eTB unit with an equivalent $100 face value and hold it until maturity or sell it anytime.

While generally a low-risk investment, those who purchase eTBs face two possible risks. The first is the risk of changing market prices and interest rates, which could lower the value of the bond, and the second is the risk of conversion by the government.

Conversion means the government would convert the eTBs’ holdings to that of the underlying treasury bonds in the Commonwealth Stock Registry. In the event of eTB conversion, bondholders only have three months (from the date of announcement) to trade in the ASX. Bondholders would still receive the promised returns, but conversion removes the eTBs’ liquidity because it can no longer be sold in the ASX.

Exchange-traded Treasury Indexed Bonds work in a similar manner and face the same risks as eTBs, but it offers an extra layer of protection against inflation in the form of quarterly adjusted face value.

The interest rate does not change until maturity, but the face value adjustments based on Consumer Price Index (CPI) movements mean bondholders will not receive a fixed amount quarterly.

Government bonds are not limited to eTBs and eTIBs because states, cities, and other forms of government also issue debt securities called municipal bonds. Eligibility for tax exemptions, however, would depend on the issuing institutions.

Corporate bonds
Corporate bonds are a good option for investors who want to take a little more risk for potentially higher returns, but without resorting to trading shares.

Companies issue bonds when they need to raise funds for projects and various expenses, but this type of bonds usually present greater risks compared to government-issued bonds. Earnings are usually taxable at the bondholder’s marginal income tax rate.

Investors should remember this: the more attractive the face value and interest rate a company issued bond offers, the greater risk they present to the initial investment.

Corporate bonds may be secured or unsecured, and it can also be a complete risk, so potential investors may want to confirm a bond’s type before purchasing.

Secured bonds, also called debentures, are always fixed-rate investments. Its main risk, especially for long-term investments, are inflation and interest rates. This is because yield from fixed investments may have lower actual value by the time the bond matures.

In case the company shuts down during the bond’s term, bondholders may still be paid back what they are owed because payments to lenders are prioritised when company assets are sold— if there’s any left after paying the bigger lenders.

Unsecured bonds may be offered with fixed interest or floating rate wherein the latter is designed to move with inflation so bondholders may receive higher or lower income, depending on the benchmark rate and how the coupon is computed.

Unlike debentures, a company that goes under may or may not be able to pay their debts, so bondholders face a higher risk with their investment.

Junk bonds pose the greatest risk to investors even with their very tempting potential returns. This is because most junk bonds are issued by companies with low bond rates, which means experts have doubts that they can meet financial obligations.

Investors that purchase junk bonds could potentially receive high returns if the bond issuer delivers on its promise, but they could also lose all of their invested money.

Investment bonds
Investment bonds are two-in-one investment products offered by professional fund managers. The first part is a life insurance policy and the other is an investment option with varying levels of risk. Contrary to its name, the underlying investments in these products are not limited to bonds.

The actual investments will depend on the investor’s risk profile, as well as the array of investments the fund management company is involved in.

The investment portion has a tax paid status for a 10-year period where earnings will be taxed at the marginal rate of 30 per cent. Once the investment completes this period in compliance with the 10-year rule, the investment will achieve a tax-free status.

Long-term investors with a marginal tax rate higher than 30 per cent may benefit from investment bonds if they take advantage of to 10-year rule, but those with lower marginal tax rate may end up paying higher taxes.

What is the 10-year rule?

This rule means that any earnings from the investment will not incur additional taxes if and only if the investor satisfies both conditions below:

  • No withdrawals were made in the first 10 years; and,
  • The investor’s additional contributions may not exceed 125 per cent of the previous year’s contribution.

Any withdrawal within the first 10 years will result in taxes at the investor’s marginal tax rate minus a 30 per cent tax offset, though the actual amount to be added as assessable income changes on the last two years.

A withdrawal made on the ninth year means ⅔ of the earnings will be assessed at the investor’s marginal tax rate minus a tax offset of 30 per cent;
Withdrawals within the 10th year means ⅓ of the earnings will count towards the investor’s assessable income.

In the case of top ups, zero contributions for any year within the 10-year period means no more allowable top ups until the period ends since 125 per cent of 0 is still 0.

For example, a $1,000 contribution on the first year would mean a limit of $1,250 contribution on the second year and $2,812.50 on the third, and so on. If the investor does not make an additional contribution on the third year, however, the 10-year rule will reset.

When the 10-year rule resets, the investment would look as if it is only in its first year of being tax paid which means an investor will only reap the benefits of tax-free earnings 10 years after their last contribution.

In the example above, this means the investors will actually have to wait 12 years after the initial investment before they stop paying additional taxes for it.

Potential investors should be aware that investment funds are offered by professional fund management companies, which means there are fees for transactions related to the fund (i.e., establishment, management, withdrawals, etc.).

Companies also offer different types of investment bonds so it is important to read and understand the products before making a commitment.

 

This information has been sourced from Australian government bonds, ASIC's Moneysmart and Nest Egg.

How does investing in bonds work
How does investing in bonds work
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