Bonds are one of the four major assets classes, but they’re probably the least understood. Here’s why they’re an important part of many portfolios.
What are bonds?
Bonds are essentially loan arrangements that governments and large companies use to raise money.
These loans generally have a fixed term and a fixed interest rate, with the interest either paid in full at the end of the term (i.e. at the ‘maturity date’) or in instalments along the way.
How do you invest in bonds?
A simple way to invest in bonds is through managed funds or Exchange Traded Funds (ETFs). This generally means your money is pooled with other investors in a diversified bond portfolio, which reduces the risk that any one borrower will default on the loan.
You can also invest in bonds through your super – bearing in mind that a typical ‘Balanced’ investment option allocates around 30% of its assets to bonds (also referred to as ‘fixed income’) and cash.
Why invest in bonds?
1. They provide a reliable source of income
Investing in bonds with high-quality borrowers (e.g. governments and blue-chip corporates) can give you a steady and reliable source of income over a set time period. This often makes bonds a good option for retirees or investors who want to generate ongoing income.
2. They offer higher potential returns than cash
Bonds typically pay a higher rate of interest than cash and term deposits, compensating investors for the additional risk associated with lending money.
Unlike cash investments, bonds also offer the potential for capital appreciation – which tends to happen when interest rates fall. This is because new bonds are typically issued with lower interest rates than older bonds, making the older bonds more valuable when traded.
This feature of bonds makes them a good hedge against dwindling returns from cash investments in a falling interest rate environment. The flipside is that bonds may lose value when interest rates rise.
3. They can be a good hedge against share market volatility
Bonds provide diversification benefits for investors because they tend to behave very differently to shares.
The table below shows the performance of Australian shares, Australian bonds and cash over the last 10 financial years, plus the average return over the last 30 years.
As you can see, some of the strongest years for bonds are when shares are in negative territory.