Understanding Asset Classes: Fixed Interest & Bonds
Bonds are a type of fixed term investment, similar to term deposits in that capital invested is scheduled to be returned at a known future maturity date.
When a SMSF invests in a bond it is effectively providing a loan to another party – typically government or corporations such as large companies. The bond is issued for a set amount – ‘face value’, for example $1,000 and the issuer agrees to pay interest on specified dates and at specified rates with repayment of the face value of the bond at maturity.
There is a very large bond market that enables bonds to be traded with other investors seeking to buy or sell. This market provides liquidity for bonds in much the same way as does the stock market for equities.
Direct access to the bond market can be difficult for SMSFs, as while the face value of a bonds is relatively small, to participate in the market, the size of bond transactions can amount to several hundred thousand dollars.
However, SMSFs are able to access bonds in smaller transaction sizes using ‘packaged’ solutions where specialist bond managers will access the bond market, acquire a large parcel of bonds and split into smaller investment parcel sizes – say, $100 face value. In this way SMSFs can access the liquidity of the bond market in smaller amounts.
Depending on the credit rating of the issuer, the rate of return offered on the bond will vary accordingly. A well rated issuer can offer a lower rate of return based on a higher likelihood that the bond holder will receive their money back at maturity.
The Australian Government issues a range of bonds – Australian Government Bonds (AGBs), which are issued to raise money to carry on the business of running the country. Given the high credit rating of the Australian Government, the return on AGBs is relatively low. For this reason, they may be seen by SMSFs as a secure investment, albeit at a low return.
Australian Companies raise capital to run their business, with corporate bonds forming part of the company’s capital structure alongside shareholder equity – it is another way of raising capital.
Corporate bonds can provide a further way for SMSFs to invest in a company, but potentially at lower risk than being a shareholder, as bonds rank above equity in the capital structure, meaning that in the event of the company being wound up, bond holders would be paid before shareholders.
The global bond market is very large, deep and liquid. It too is characterised by government issuance as well as from corporates. Notable differences include the size of some of the companies that issue bonds and the breadth and nature of the business sectors they represent.
Investing in global bond markets may be good for diversification, however a SMSF may choose to use a specialist bond manager to guide investments decisions and to invest through a managed fund that specialise in these markets.
Bond investments should not be made on yield alone. In considering a bond investment, SMSFs should research the underlying credit ratings of the issuer. An issuer with a low credit rating may need to offer a high coupon to attract investors.
Returns can also vary according to the broader market interest rates; if rates are higher than the bond rate, the bond price could fall.