This article has been written by expert contributor, Vanguard’s global economics and markets team.
Bonds can play an important role in investment portfolios, but what exactly are they, what are their benefits, and how do you invest in them?
What are bonds?
Bonds are a type of investment security that enable investors to lend their money to a bond issuer for a set term in return for regular income payments based on a fixed or floating interest rate.
Bond issuers are typically governments, large organisations and companies, which often choose to borrow large amounts of money for different purposes from a pool of investors via the global bond market.
When the term of a bond issue expires the issuer is expected to repay investors their principal investment amount in full.
What are the benefits of bonds?
Bonds are often described as defensive assets. While the capital value of bonds can fluctuate along with changing economic conditions, the issuers’ ability to repay the principal, and interest rates, they are generally less volatile than growth assets like shares and property.
If you hold a bond until the end of its term (maturity), you know how much to expect back at maturity (the face value) and how much you’ll receive along the way (coupon payments).
If you buy or sell bonds before maturity, you are exposed to more volatility as the capital value can fluctuate along with interest rates and market conditions.
Interest rates are one of the primary drivers of bond pricing, with prices typically moving inversely to interest rates. I.e. when interest rates rise bond trading prices fall, and when interest rates fall, bond trading prices rise.
However bonds generally provide more capital stability for medium to long-term investors than shares, which don’t offer an agreed schedule of dividend payments or the full principal repayment at the end of a given term.
As well as providing diversification from shares, property and other assets, investing in a broad range of bonds can also help diversify your returns.
Historically, bond prices have tended to be positive when share prices have been negative. This typical inverse relationship between bonds and shares can provide balance to your investment portfolio.
How do you invest in bonds?
You can buy government and corporate bonds through public offers when they are first issued or on the secondary bond market. High minimum transaction sizes may apply as these markets are considered ‘wholesale markets’.
While some bonds are available to buy and sell on the Australian Securities Exchange with lower transaction minimums, the range can be limited, restricting your ability to build a diversified portfolio.
Managed bond funds and exchange traded funds (ETFs) can be a more flexible, less restrictive way of building a broad portfolio because they are able to purchase more securities that have high transaction minimums due to scale.
The different types of bond funds can give you access to different markets and sectors, providing greater opportunity to diversify your portfolio.
Watch this video with Jean Bauler, Vanguard’s Head of Asia-Pacific Bond Indexing, to learn more about investing in bonds.
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The above material has been republished with the permission of Vanguard Investments Australia Ltd. Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.