Bonds are a simple concept, but if you mention bonds to many people their eyes glaze over or they immediately think of underwear.
Bonds are securities issued by companies, or governments, to raise money for their activities – essentially like a debt or a loan.
When buying a bond, the issuer promises to pay you back with interest – like a term deposit – often at a premium to cash.
If you bought a one year bond earning 6% with your $10,000, you’d be paid $600, in two $300 distributions across the year.
When the bond matures, you get your $10,000 back.
Usually this is the case, but such simplicity has led people to believe bonds are risk free.
The assumption being, shares are wild and crazy like Charlie Sheen, while bonds are more dependable like Denzel Washington.
While bonds are often safer, there are bonds which have more in common with Charlie than with Denzel – this is called credit risk.
Credit risk involves the borrower – the organisation you lent your money to – being unable to repay your money, this is avoided by choosing the most credit worthy issuers.
The other consideration is maturity risk.
Holding bonds in a high inflation environment means distributions would be less than market returns because newer bonds will probably be issued with a higher interest rate, also the bond would be worth less on the open market – if sold before maturity.
Conversely, as inflation and interest rates fall, bonds become more valuable.
For the majority of investors, their bond exposure is through a managed fund or superannuation fund.
These funds buy bonds from a range of issuers, with a variety of different maturity dates and return rates.
This diversification spreads the risk and helps eliminate portfolio volatility, ensuring bonds are as important to your portfolio as they are to your underwear draw!
Peter Mancell is a director of Mancell Financial Group and FYG Planners AFSL 224543. This information is general in nature and readers should seek professional advice specific to their circumstances. If you’d like help with your financial future, we might be Australia’s best financial planner. We think we’re the best financial advisers in Tasmania.
