Bond Investing. Plain Talk Library

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Bond Investing

Plain Talk

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Library

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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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Plain Talk Guides 1

Introducing bonds

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

Bonds and other fixed interest assets can sometimes seem quite daunting to many investors as they typically use structures and investment concepts that seem complex or unusual. In this Plain Talk Guide we aim to break through any confusion and provide a clear explanation of what bonds are, how they work and how adding them to your portfolio can give you a better chance of meeting your long-term financial goals and expectations.

What is a bond?

A bond sits within a portfolio’s fixed income allocation alongside products such as cash and term deposits. These assets are classified as income assets as they provide a steady and reliable stream of income. They are also known for their lower risk profile which is why they don’t offer the same capital growth potential that riskier growth assets such as shares offer.

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

“maturity”.

Whether your objective is to generate income, achieve greater diversification or reduce volatility in your portfolio, an

investment in bonds can be a smart choice.

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Plain Talk Guides 3

Types of bonds

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

The main types are:

Government bonds

Issued directly by a government and are explicitly guaranteed. For example, in Australia the Federal Government issues Commonwealth securities to help pay for major government projects.

State government, quasi-government or supranational bonds

Not 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 to support their financial needs or to finance public projects.

Corporate bonds

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

Bond markets

Did you know that bond markets are the largest capital markets in the world?

Most people don’t realise that they dwarf sharemarkets in size. Bond markets are extremely liquid and play an important role in the world’s financial 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 fixed interest

securities.

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How do bonds work?

As Figure 1 below shows, all bonds have the same basic structure: a schedule of coupon (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 their interest. The coupon reflects the term of the loan, the prevailing level of interest rates, and the borrower’s creditworthiness at the time of the loan.

As well as holding bonds to maturity, you can also trade them in the secondary market before maturity. Existing bonds are constantly being traded around the world and their value changes along with market interest rates. These secondary markets are usually the domain of professional investors such as large banks, brokers and fund managers which trade bonds in order to profit from price fluctuations or generate coupon income among other objectives.

Figure 1. A bond’s lifetime

Coupon

Payment Coupon

Payment

Principal Paid

Principal Returned

T1 T0

Period

Bond Issued Bond Matures

Cashflow in

Cashflow out

T2 T3 T10

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 offered with lower yield.

• Bond can be sold for more than what was paid.

Investment in a 10-year bond

A bond’s lifetime

Source: Vanguard.

Bond yield

Bond price

Slide 2

Fig 4

Fig 2

Slide X Fig 1

Bond characteristics

Source: ECB, January 2012

2005 2006

0 5 10 15 20 25%

2007 2008 2009 2010 2011 2012

10Y Government Bond Yield

France

Germany Spain Greece Ireland Italy Portugal

Sharply diverging yields in the Eurozone

Calendar year returns for Australian equities 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)

Equities (ASX 300 Index Chained to All Ordinaries Index before 31/3/2000) -50

-40 -30 -20 -10 0 10 20 30 40 %

06 05 04

03 07 08 09 11

94 93 92

91 95 96 97 98 99 2000 01 02 2010

Annual Return

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Plain Talk Guides 5

How interest rates affect bond prices

The inverse relationship between bond prices and interest rates can be confusing, but we 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 to buy 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 if interest rates fall instead, and new bonds are issued with a 3.5% rate, you’ll probably be able to sell your bond for more than you paid.

Investors who invest in bond funds as part of a long-term strategy shouldn’t worry too much about these price declines. In fact, for a long-term investor, news that bond prices 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 payments will be the source of most of the wealth accumulated in an investment in bonds.

Figure 2. The relationship between interest rates and bond prices

Coupon

Payment Coupon

Payment

Principal Paid

Principal Returned

T1 T0

Period

Bond Issued Bond Matures

Cashflow in

Cashflow out

T2 T3 T10

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 offered with lower yield.

• Bond can be sold for more than what was paid.

Investment in a 10-year bond

A bond’s lifetime

Source: Vanguard.

Bond yield

Bond price

Slide 2

Fig 4

Fig 2

Slide X Fig 1

Bond characteristics

Source: ECB, January 2012

2005 2006

0 5 10 15 20 25%

2007 2008 2009 2010 2011 2012

10Y Government Bond Yield

France

Germany Spain Greece Ireland Italy Portugal

Sharply diverging yields in the Eurozone

Calendar year returns for Australian equities and bonds

Year ended 31 December Bonds (UBS Composite Bond Index)

Equities (ASX 300 Index Chained to All Ordinaries Index before 31/3/2000) -50

-40 -30 -20 -10 0 10 20 30 40 %

06 05 04

03 07 08 09 11

94 93 92

91 95 96 97 98 99 2000 01 02 2010

Annual Return

One of the most important relationships to

know about when investing in bonds is that

bond prices and interest rates tend to move

in opposite directions. When interest rates

rise, bond prices fall; when interest rates fall,

bond prices rise.

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Investing in bonds

Individual bonds

One of the primary advantages of investing in individual bonds is the ability to control cash flow by matching a bond’s maturity date with your specific income needs.

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

Bond funds

It 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 and corporate issuers, and are a much cheaper means of acquiring an exposure to a broad set of bonds. Investing this way costs less because managed funds have access to institutional pricing (that is on far more favourable terms than retail pricing) by transacting in much larger market parcels.

Types of bond funds Bond index funds

These funds are collections of bonds that are intended to mirror the performance of a particular market benchmark or index. The primary advantage of bond index funds is their low costs.

Bond exchange traded funds (ETFs)

Bond ETFs are similar to conventional bond index funds. However, as ETFs are traded throughout the day like individual securities, bond ETFs offer additional trading flexibility not available from conventional bond index funds.

Actively managed bond funds

These funds are managed by individual investment managers that pick bonds with the

intention of outperforming a fund’s benchmark. Actively managed bond funds offer

investors the opportunity for higher returns than bond index funds, though usually at

relatively higher costs.

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Plain Talk Guides 7 Factors to consider when investing in bond funds

Credit quality

Independent credit rating agencies, such as Standard & Poor’s and Moody’s Investors Service, 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 fund’s credit quality, most investors should be looking for those that hold investment grade bonds, that is, Baa or BBB and above. This is because investment grade bonds reflect a very low probability of default compared to sub-investment grade bonds. (See the table on the page 9 for a complete list of

Standard & Poor’s and Moody’s bond credit ratings.)

Yield to maturity

A fund’s weighted average yield to maturity can be thought of as its expected annualised return if all bonds in the portfolio were held to maturity, and future coupon and principal receipts are reinvested at the yield to maturity. However, the fund will generally need to sell bonds before they reach maturity in order to reflect changes in benchmark from new bond issuance, and interest rates will change through time.

So while the yield to maturity won’t be the exact return you receive, it can provide a good guide.

When the yield to maturity on a bond fund rises, this implies that the market prices

of the underlying bonds have fallen, which then leads to a decline in fund value. The

opposite is also true when yields decrease.

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Plain Talk Guides 9

Bond credit ratings

Bond credit ratings are important because they indicate how much an issuer must pay to borrow money and compensate investors for assuming credit risk. This is the chance that a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of a bond to decline.

The lower a bond’s credit rating, the higher the interest rate the borrower must pay to entice investors to purchase the bond. Moody’s and Standard & Poor’s are the major bond credit-rating agencies and though their rating systems are similar, they are not identical.

A bond’s credit rating reflects the independent rating agency’s opinion of the issuer’s ability to pay interest on the bond and, ultimately, to repay the principal at maturity. If payments aren’t made in full and on time, the issuer has defaulted on the bond.

Moody’s and Standard & Poor’s bond-rating codes Moody’s S&P Rating

Investment-Grade Bonds

Aaa AAA Highest quality with lowest risk; issuers are exceptionally stable and dependable.

Aa AA High quality, slightly higher degree of long-term risk.

A A High-medium quality, many strong attributes but somewhat vulnerable to changing economic conditions.

Baa BBB Medium quality, adequate but less reliable over the long term.

Below

Investment-Grade Bonds

Ba BB Somewhat speculative, moderate security but not well safeguarded.

B B Low quality, future default risk.

Caa CCC Poor quality, clear danger of default.

Ca CC Highly speculative, often in default.

C C Lowest rating, poor prospects of repayment.

D In default.

Source: Standard & Poor’s and Moody’s Investors Service

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What role do bonds play in your portfolio?

Bonds have traditionally fulfilled four important roles in a portfolio:

Income stream

Most of the investment return for bonds is coupon income. For a broad portfolio of bonds, these coupon (or interest) payments can constitute a reliable stream of income. Figure 3 shows that in contrast to shares, which have historically provided income and capital appreciation, the total return for bonds has primarily been comprised of income.

Capital preservation

Bonds can also provide capital stability. A bond’s principal is returned to you as the investor 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 government bonds, which are backed by the full faith and credit of a sovereign government, are often referred to as risk-free because a government theoretically can raise taxes or create additional currency to meet its obligations when its bonds mature.

Figure 3. Components of total return, 1997-2012

Capital growth Income

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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Plain Talk Guides 11 Store of liquidity

Bonds can be used as a store of liquidity. In fact, many central banks around the world exchange cash for bonds when they implement monetary policy and when they 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 or exit on a daily basis.

Diversification of returns

Bonds can also help to reduce the risk in your portfolio by dampening the volatility of, and providing diversification to, sharemarket returns. This is why bonds are described as a defensive asset. While the prices of bonds will fluctuate according to interest rate and economic cycles, they historically have been nowhere near as volatile as share prices.

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

Figure 4. Calendar year returns for Australian shares and bonds

Fig 4 Calendar year returns for Australian equities and bonds

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%

06 05 04

03 07 08 09 11

94 93 92

91 95 96 97 98 99200001 02 2010

Annual Return

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Bonds versus cash and term deposits

Given their apparent similarities, many investors mistakenly consider cash and term deposits as a substitute or alternative to bonds. However, while these investments all offer features such as capital preservation, liquidity and income, there are significant differences in their profiles.

Cash and term deposits can be better described as savings vehicles rather than an investment. They are better suited to help cover known short-term liabilities or meet near-term financial goals.

Investment in term deposits can also lead to reinvestment risk. That is, because your 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 substantial impact on your return the following year if attractive interest rates are no longer on offer.

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

In contrast, bonds will offer higher expected returns over the long term for investors willing to take on slightly more risk. These higher returns are compensation for investors 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 Risk

profile Capital

growth Credit risk Total

return potential

Investment time horizon

Liquidity

Cash/Term

deposits Low No Lower Lower Up to

1 year Varies. Term deposits are only accessible before term with penalty fees.

Bond funds Low to

Medium Limited

potential Higher Higher 3 year High. Generally allow

entry or exit on a daily

basis.

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The allocation decision

So what is the correct level of bonds to include in your portfolio and how do you go about 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 long until you need to cash in your investment) and then evaluating your risk profile. Once you develop and execute your asset allocations, regular rebalancing helps to keep the portfolio on track.

Your risk profile relates to how comfortable or otherwise you are with levels of risk in 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, follows shares. And generally risks are lessened the longer the investor’s holding period.

If you consider yourself a conservative investor, a rule of thumb that Vanguard’s founder, Jack Bogle, likes to cite to determine what the portfolio mix should be, is that the defensive allocation should be proportional to your age. For example, if you are 40 you should hold 40 per cent fixed-interest assets (therefore 60 per cent growth assets); 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 financial adviser

can add significant value by considering your overall financial situation and help to

determine your propensity for risk.

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The indexing pioneers

Vanguard pioneered the concept of indexing, introducing the first retail index fund in the US in 1976. Since then, The Vanguard Group, Inc. has grown into one of the world’s largest and most respected investment management companies. Vanguard now has global presence with offices in the US, Australia, Asia and Europe. In Australia, Vanguard has been helping investors meet their long-term financial goals with low-cost indexing solutions for more than 15 years.

Vanguard’s range of managed funds and ETFs

Vanguard offers a complete range of funds across all asset classes that can be used as a diversified standalone portfolio solution, or in conjunction with active funds as part of a core-satellite approach.

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

Vanguard’s range of Plain Talk Guides

At Vanguard, we believe it is just as important to know about the potential risks of your investments as well as the rewards. That’s why we publish our Plain Talk Guides on a range of popular investment topics. After all, better informed investors make better investment 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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For more information

Contact us or speak to your financial adviser.

Personal investors Web vanguard.com.au Phone 1300 655 101

8:00 am to 6:00 pm

Monday to Friday (Melbourne time) Email [email protected] Mail Vanguard Investments Australia Ltd

GPO Box 3006 Melbourne Vic 3001

Financial advisers Web vanguard.com.au Phone 1300 655 205

8:00 am to 6:00 pm

Monday to Friday (Melbourne time)

Email [email protected]

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Disclaimer

Note: 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

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