bond investing guide

8/12/2019 Bond Investing Guide

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Bond Investing

Plain Talk Library


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Contents

Introducing bonds 1

What is a bond? 1

Types of bonds 3

How do bonds work? 4

How interest rates affect bond prices 5

Investing in bonds 6

Bond credit ratings 9

What role do bonds play in your portfolio? 10

Bonds versus cash and term deposits 13

The allocation decision 14


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Vanguard Plain Talk Guides 1

Introducing bonds

An allocation to bonds can play a vital role in helping reduce risk in your overallportfolio and enhance your prospects of growing your wealth.

Bonds and other xed interest assets can sometimes seem quite daunting to manyinvestors as they typically use structures and investment concepts that seem complexor unusual. In this Plain Talk Guide we aim to break through any confusion and providea clear explanation of what bonds are, how they work and how adding them to yourportfolio can give you a better chance of meeting your long-term nancial goals andexpectations.

What is a bond?A bond sits within a portfolios xed income allocation alongside products such ascash and term deposits. These assets are classied as income assets as they providea steady and reliable stream of income. They are also known for their lower risk prolewhich is why they dont offer the same capital growth potential that riskier growthassets such as shares offer.

A bond operates like an IOU, whereby you lend your money to an issuer for a setperiod of time in return for interest payments over the term of your investment. Yourinvestment, or capital, is then paid back to you in full at the end of the term known asmaturity.

Whether your objective is to generateincome, achieve greater diversicationor reduce volatility in your portfolio, aninvestment in bonds can be a smart choice.


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Types of bonds

As an investor you can choose from a wide array of investment options as bondscome in a range of credit qualities and maturities and from a variety of issuers.

The main types are:

Government bondsIssued directly by a government and are explicitly guaranteed. For example, inAustralia the Federal Government issues Commonwealth securities to help pay formajor government projects.

State government, quasi-government or supranational bondsNot issued directly by a government but might have a direct or implied guarantee.

For instance, state governments and other entities that have a government guarantee(such as the World Bank, which has multiple government guarantees) issue bonds tosupport their nancial needs or to nance public projects.

Corporate bondsIssued by large public companies to fund expansion and other major projects,corporate bonds differ in two important ways to government bonds, in yield and creditquality. Generally, corporate bonds are thought to have a higher level of risk thangovernment or state government bonds, so they typically offer higher interest rates.

Bond marketsDid you know that bond markets are the largest capital markets in the world?Most people dont realise that they dwarf sharemarkets in size. Bond marketsare extremely liquid and play an important role in the worlds nancial systems.Nearly all economies around the world have bond markets, each bringing its own

set of issuers, investors and intermediaries, and its own set of xed interestsecurities.


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4

How do bonds work?

As Figure 1 below shows, all bonds have the same basic structure: a schedule ofcoupon (or interest) payments and the return of the capital amount upon maturity.

Incidentally, the interest you receive on a bond is called a coupon because in the past,investors actually clipped coupons from paper bonds and presented them to get theirinterest. The coupon reects the term of the loan, the prevailing level of interest rates,and the borrowers creditworthiness at the time of the loan.

As well as holding bonds to maturity, you can also trade them in the secondary marketbefore maturity. Existing bonds are constantly being traded around the world and theirvalue changes along with market interest rates. These secondary markets are usuallythe domain of professional investors such as large banks, brokers and fund managerswhich trade bonds in order to prot from price uctuations or generate coupon income

among other objectives.

Figure 1. A bonds lifetime

CouponPayment

CouponPayment

CouponPayment

CouponPayment

Principal

Paid

PrincipalReturned

T1T0Period

Bond Issued Bond Matures

Cashflow in

Cashflow out

T2 T3 T10


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How interest rates affect bond prices

The inverse relationship between bond prices and interest rates can be confusing, butwe can think of it as a kind of seesaw. Suppose you are invested in a 10-year bond

that pays 4.5% in interest. If interest rates rise to 5.5%, other investors will be able tobuy new bonds that pay better. So if no one is willing to pay full price for a 4.5% bond,and you want to sell your bond, you would have to take less than its face value. But ifinterest rates fall instead, and new bonds are issued with a 3.5% rate, youll probablybe able to sell your bond for more than you paid.

Investors who invest in bond funds as part of a long-term strategy shouldnt worrytoo much about these price declines. In fact, for a long-term investor, news that bondprices are falling is a real positive. Why? Because the fund will be able to invest in new

bonds that pay higher interest rates. Over the long term, reinvested interest paymentswill be the source of most of the wealth accumulated in an investment in bonds.

Figure 2. The relationship between interest rates and bond prices

Interest rates fall

Interest rates rise Investors can buy bonds

with higher yield. Have to sell bond at less

than face value.

New bonds are offeredwith lower yield.

Bond can be sold for morethan what was paid.

Investment in a 10-year bond

One of the most important relationships toknow about when investing in bonds is thatbond prices and interest rates tend to movein opposite directions. When interest rates

rise, bond prices fall; when interest rates fall,bond prices rise.


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Investing in bonds

Individual bondsOne of the primary advantages of investing in individual bonds is the ability to control

cash ow by matching a bonds maturity date with your specic income needs.

It can, however, be quite costly to buy a portfolio of bonds with an adequate level ofdiversication. There are typically large transaction costs involved and there is only arelatively small selection of bonds available to trade in small parcels. This is why mostparticipants trading in these markets are major nancial institutions or large investors.

Bond fundsIt can be much more convenient, and cost effective, to capture bond market returns by

investing in a bond fund rather than individual bonds.

Bond funds come in a variety of bond investment strategies, across government andcorporate issuers, and are a much cheaper means of acquiring an exposure to a broadset of bonds. Investing this way costs less because managed funds have access toinstitutional pricing (that is on far more favourable terms than retail pricing) bytransacting in much larger market parcels.

Types of bond fundsBond index fundsThese funds are collections of bonds that are intended to mirror the performance of aparticular market benchmark or index. The primary advantage of bond index funds istheir low costs.

Bond exchange traded funds (ETFs)Bond ETFs are similar to conventional bond index funds. However, as ETFs aretraded throughout the day like individual securities, bond ETFs offer additional trading

exibility not available from conventional bond index funds.

Actively managed bond fundsThese funds are managed by individual investment managers that pick bonds with theintention of outperforming a funds benchmark. Actively managed bond funds offerinvestors the opportunity for higher returns than bond index funds, though usually atrelatively higher costs.


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Factors to consider when investing in bond fundsCredit qualityIndependent credit rating agencies, such as Standard & Poors and Moodys InvestorsService, evaluate the ability of bond issuers to meet their coupon and principal

payment obligations. These agencies assign credit ratings ranging from Aaa or AAA(highest quality) to C or D (lowest quality).

When considering a funds credit quality, most investors should be looking forthose that hold investment grade bonds, that is, Baa or BBB and above. This isbecause investment grade bonds reect a very low probability of default comparedto sub-investment grade bonds. ( See the table on the page 9 for a complete list ofStandard & Poors and Moodys bond credit ratings .)

Yield to maturityA funds weighted average yield to maturity can be thought of as its expectedannualised return if all bonds in the portfolio were held to maturity, and future couponand principal receipts are reinvested at the yield to maturity. However, the fund willgenerally need to sell bonds before they reach maturity in order to reect changesin benchmark from new bond issuance, and interest rates will change through time.So while the yield to maturity wont be the exact return you receive, it can provide agood guide.

When the yield to maturity on a bond fund rises, this implies that the market pricesof the underlying bonds have fallen, which then leads to a decline in fund value. Theopposite is also true when yields decrease.


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What role do bonds play in your portfolio?

Bonds have traditionally fullled four important roles in a portfolio:

Income streamMost of the investment return for bonds is coupon income. For a broad portfolioof bonds, these coupon (or interest) payments can constitute a reliable stream ofincome. Figure 3 shows that in contrast to shares, which have historically providedincome and capital appreciation, the total return for bonds has primarily beencomprised of income.

Capital preservationBonds can also provide capital stability. A bonds principal is returned to you as theinvestor when it matures, which makes a bond an effective capital preservation tool,assuming of course that the issuer is of high credit quality. For example governmentbonds, which are backed by the full faith and credit of a sovereign government, areoften referred to as risk-free because a government theoretically can raise taxes orcreate additional currency to meet its obligations when its bonds mature.

Figure 3. Components of total return, 1997-2012

Capital growthIncome

Source: Vanguard Australian Shares Index Fund and Vanguard Australian Fixed Interest Index Fund

0

2

4

6

8%

Australian shares Australian bonds


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Store of liquidityBonds can be used as a store of liquidity. In fact, many central banks around theworld exchange cash for bonds when they implement monetary policy and whenthey act to stabilise turbulent markets. Smaller investors are also able access this

liquidity in a cost-effective way through bond funds which usually allow you entry orexit on a daily basis.

Diversication of returnsBonds can also help to reduce the risk in your portfolio by dampening the volatility of,and providing diversication to, sharemarket returns. This is why bonds are describedas a defensive asset. While the prices of bonds will uctuate according to interestrate and economic cycles, they historically have been nowhere near as volatile asshare prices.

As we can see in Figure 4 below, bonds returns have tended to be positive evenwhen returns on shares have been negative. This is what analysts are referring towhen they say there is a low or negative correlation between the returns of bondmarkets and sharemarkets. It is this low or negative correlation between assetclasses that provides the diversication every well-balanced portfolio needs.

Figure 4. Calendar year returns for Australian shares and bonds

From 31 December 1989 to 31 December 2011

Sources: UBS, IRESS, Vanguard calculations, January 2012.

Year ended 31 December

Bonds (UBS Composite Bond Index)

Shares (ASX 300 Index, prior to 31/3/2000 All Ordinaries Index)

-50

-40

-30

-20

-10

0

10

20

30

40%

06050403 09 11080794939291 98979695 0201

2000 2010

99

n n u a

e

t u r n


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Bonds versus cash and term deposits

Given their apparent similarities, many investors mistakenly consider cash and termdeposits as a substitute or alternative to bonds. However, while these investments all

offer features such as capital preservation, liquidity and income, there are signicantdifferences in their proles.

Cash and term deposits can be better described as savings vehicles rather than aninvestment. They are better suited to help cover known short-term liabilities or meetnear-term nancial goals.

Investment in term deposits can also lead to reinvestment risk. That is, becauseyour principal is fully returned to you at the end of each year you are exposed to any

interest rate changes that have occurred in this time. This can have a substantialimpact on your return the following year if attractive interest rates are no longer onoffer.

In addition, if you are holding term deposits while you wait for the ideal time toenter the sharemarket this introduces liquidity risk. That is, there are generally penaltyfees imposed if you need to quickly release your cash.

In contrast, bonds will offer higher expected returns over the long term for investorswilling to take on slightly more risk. These higher returns are compensation forinvestors taking on increased levels of interest rate risk and credit risk exposure.In this sense, bonds generally suit an investor with a longer investment time horizon.

Bonds versus cash and term deposits

Investment type

Riskprole

Capitalgrowth

Creditrisk

Totalreturnpotential

Investment timehorizon

Liquidity

Cash/Termdeposits Low No Lower Lower Up to1 year Varies. Term depositsare only accessiblebefore term withpenalty fees.

Bond funds Low toMedium

Limitedpotential

Higher Higher 3 year High. Generally allowentry or exit on a dailybasis.


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The allocation decision

So what is the correct level of bonds to include in your portfolio and how do you goabout incorporating bonds into your asset mix to gain this exposure? Any decisions on

asset allocation should start by establishing goals, working out a timeframe (how longuntil you need to cash in your investment) and then evaluating your risk prole. Onceyou develop and execute your asset allocations, regular rebalancing helps to keep theportfolio on track.

Your risk prole relates to how comfortable or otherwise you are with levels of riskin the investment mix. Generally, the higher the expected return of an investment,the higher the risk, so on the spectrum cash follows bonds, follows property, followsshares. And generally risks are lessened the longer the investors holding period.

If you consider yourself a conservative investor, a rule of thumb that Vanguardsfounder, Jack Bogle, likes to cite to determine what the portfolio mix should be, isthat the defensive allocation should be proportional to your age. For example, if youare 40 you should hold 40 per cent xed-interest assets (therefore 60 per cent growthassets); at 60 you should have a 60/40 split between bonds and shares, and so on.

This approach may not be suitable for everyone, which is why a good nancial advisercan add signicant value by considering your overall nancial situation and help todetermine your propensity for risk.


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The indexing pioneers

Vanguard pioneered the concept of indexing, introducing the rst retail index fundin the US in 1976. Since then, The Vanguard Group, Inc. has grown into one of the

worlds largest and most respected investment management companies. Vanguardnow has global presence with ofces in the US, Australia, Asia and Europe. In Australia,Vanguard has been helping investors meet their long-term nancial goals with low-costindexing solutions for more than 15 years.

Vanguards range of managed funds and ETFs

Vanguard offers a complete range of funds across all asset classes that can be used

as a diversied standalone portfolio solution, or in conjunction with active funds aspart of a core-satellite approach.

For more information on our product offerings please visit www.vanguard.com.au.

Vanguards range of Plain Talk Guides

At Vanguard, we believe it is just as important to know about the potential risks of yourinvestments as well as the rewards. Thats why we publish our Plain Talk Guides ona range of popular investment topics. After all, better informed investors make betterinvestment decisions.

Our PlainTalk range includes: Understanding indexing; Realistic sharemarket expectations; Building your investment portfolio;

Investing for income; Self managed super funds; Superannuation; Managed funds;

Exchange traded funds; and Bond Investing


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DisclaimerNote: All currency is in Australian dollars unless otherwise stated. Unless otherwise stated data sources are Vanguard, using market

data. To view current performance data, visit our website www.vanguard.com.au Vanguard Investments Australia Ltd(ABN 72 072 881 086 / AFSL 227263) is the product issuer of the interests in the Vanguard Investor Index Funds which are offeredthrough a Product Disclosure Statement (PDS) only. We have not taken your circumstances into account when preparing thispublication so it may not be applicable to your circumstances. You should consider your circumstances and our PDSs before makingany investment decision. You can access our PDS at www.vanguard.com.au or by calling 1300 655 101. Past performance is not anindicator of future performance This publication was prepared in good faith and we accept no liability for any errors or omissions

Connect with Vanguard The indexing specialist > vanguard.com.au > 1300 655 101

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