The investment return on a bond reflects its interest payments and any appreciation or depreciation in its price from general interest rate movements. As a general rule, the potential for capital gains or capital losses on bonds tends to be lower compared with other riskier investments.
So why are they such popular investments? The main reason is that, unlike equities, they generally provide greater certainty as to their income stream and return of capital. For retirees or others who need a predictable source of income, a bond’s regular interest income and principal repayments at maturity provide a comforting level of security. There are other advantages too, including:
- investment diversification, which can either reduce risk or improve a portfolio’s overall rate of return (because, with bonds as an anchor for a portfolio, an investor may feel more comfortable taking on greater risk with other investible assets in the hope of achieving a greater return);
- in the case of corporate bonds, a better return than some other debt investments – for example, income from corporate bonds is typically higher than the interest paid on bank deposits (although the same is not true with government bonds);
- in the case of government bonds, high levels of liquidity and security; and
- the opportunity to profit from anticipated movements in interest rates.
Risks from investing in bonds
Any investment carries with it some risk. This applies as much to bonds as it does to other investment types. Usually the greater the perceived risk, the higher the expected return required to compensate investors for that risk. So, bonds that are perceived to have higher risk attached will generally attract a higher coupon rate, while bonds that are perceived to have lower risk (such as government bonds) will generally attract a lower coupon rate. Some key risks to consider when investing in bonds are interest rate risk, credit risk and liquidity risk. Each of these risks is covered in more detail below.
Interest rate risk – the effect of changing interest rates on yields and prices
If the coupon rate on a bond is floating, the yield on the bond can usually be expected to stay in line with current interest rates, so movements in interest rates generally should have very little impact on its price. However, if the coupon rate is fixed, the yield on the bond can only keep pace with changing interest rates if the price of the bond changes.
Credit risk is related to the financial strength of the issuer. Generally, the higher the credit quality of the issuer, the lower the risk associated with the bond and therefore the lower the yield required by investors. For this reason, government bonds typically pay a lower interest rate than corporate bonds and other interest rate products, because the credit risk is lower. Similarly, secured corporate bonds typically pay a lower interest rate than unsecured corporate bonds, because the credit risk is lower. However, this does not mean that your investment is risk-free.
Credit risk also includes credit spread risk. This arises when investors demand a higher spread for bonds with higher credit risks compared to lower risk bonds, such as government bonds. This is often associated with a downturn in economic conditions, leading to an expectation of higher levels of default on higher risk bonds.
Liquidity or marketability risk
Liquidity risk is the risk of not being able to sell your investment quickly and easily in the market if you need to. For some corporate bonds, particularly those with small numbers on issue, liquidity may be poor. At the other end of the spectrum, government bonds are highly liquid, being traded not only on ASX but also actively in the wholesale market. For some bonds (like Exchange-traded AGBs), ASX has dedicated market makers whose job is to ensure that there is always a fair price for you to trade against, should you need to.