How to invest in bonds
We take you through the basics of bonds.
With savings accounts and bank term deposits offering dismal returns, you might be looking elsewhere to park your money. Bonds can offer an alternative if you’re chasing better returns. Some companies are offering bonds with returns of five percent or more. But with higher returns come higher risks.
We break down the basics of bonds and the risks you need to consider before investing.
What are bonds?
Bonds can be issued by government, councils and companies to raise money. When you buy a bond, you’re lending money to the issuer for a set period. The issuer agrees to pay you fixed interest – often called a coupon payment – over the term of the bond.
In general, if you hold a bond until maturity, or the end of the term, you’ll get back what you paid plus the interest, provided that issuer doesn’t default.
Bonds are generally considered lower risk than shares. If a company goes under, bondholders are paid out before shareholders, although there’s no guarantee there’ll be enough left in the company’s coffers to repay you.
Bonds can be a way to spread investment risk. This is especially the case if you’re buying a bond from the government, which has the highest creditworthiness and therefore the lowest risk. That said, government bonds are currently only offering returns of 0.1 to 0.2 percent.
In contrast to shares, bonds can provide a more predictable income stream. For example, bonds may be attractive to retirees living off their savings as they’ll receive coupon payments at known intervals over the bond’s term.
Shares and bond prices fluctuate with the market. When the market swings sharply up or down, it’s called volatility. A share or bond with high volatility is considered higher risk because its value can change dramatically in a short period. Unlike shares, a bond’s coupon rate is fixed.
Like all investments, bonds carry risks. The issuer’s credit rating is crucial in determining the risk of a bond. Those with high credit ratings – think government, council and corporate bonds – are lower risk. Some bonds also have their own credit rating.
Credit ratings are issued by agencies such as Standard and Poor’s, Fitch Ratings and Moody’s Investors Services. To be considered an investment-grade bond issue, the company or bank must have a credit rating of at least “BBB”.
A “B” rating is considered to have a one in five chance of defaulting within five years, which means you might lose out on your interest and what you paid for the bond. These bonds are often called “junk” or “speculative” bonds.
Bonds are also ranked according to seniority. This indicates where the bond sits in the issuer’s repayment priority list. For example, unsecured bonds rank lower in seniority than secured bonds.
A downside of having money tied up in bonds means you could also lose out if market interest rates rise above your bond’s coupon rate. You’ll be earning less from the bond than you would from other investments.
If you’re stuck with a bond with a low interest rate, it may be harder to sell on the secondary market and you risk getting back less than what you paid.
Inflation is another risk. If you hold a bond paying a 1.5 percent coupon rate, and inflation is at 2 percent, your return is negative (-0.5 percent).
How to buy bonds
Bonds are traded through the primary and secondary markets. The primary market is where the issuer sells new bonds. In this situation, the issuer provides a product disclosure statement (PDS), which contains the terms, conditions and features of the bond.
The secondary market is where brokers buy and sell existing bonds. There are two kinds: listed markets, such as the NZX Debt Market (NZDX), and wholesale markets. Here bonds are traded at their market price, which may be higher or lower than the original value of the bond.
You can buy bonds through registered banks, NZX-accredited brokers, chartered accountants, solicitors and online trading websites, or directly though the issuer via a public offer.
You can also buy bonds through a managed fund or an exchange traded fund (ETF), which spreads investors’ money across a mix of bonds (often in different countries and industries). This means your money isn’t invested in just one bond. Funds are one of the easiest ways to invest in bonds.
The most common way of buying bonds is through a broker. There’s a list of accredited brokers on the NZX website. The broker will set up a securities trading account for you, which you need before you can purchase a bond.
You’ll receive a “contract note” every time you buy or sell a bond. This is a legal record of the transaction, including details such as the bond issuer, the amount bought, the price, the bond maturity date, the coupon rate and the face value of the bond.
Before you start investing, ask your broker about fees, as these can vary. Typically, you pay a minimum brokerage fee for each bond order placed. Percentage fees and broker commissions may apply, which can nibble into your returns.
Bond issuers are required to publish annual reports to keep investors informed of their financial health. You should consider these essential reading.
Interest rates compared
In October, term deposit interest rates offered by the main banks ranged from 0.1 (12 months) to 1.85 percent (3 years). Credit unions were offering 1 (12 months) to 1.95 percent (4 years).
Coupon rates for senior bonds ranged from 1.5 to 6.85 percent and credit ratings of the issuers from AA to BBB-. The yield to maturity, a key factor to consider, ranged from 0.36 to 3.4 percent.
The yield to maturity calculates the average annual return of a bond from the day that you buy it (at market value) until the date of maturity. It assumes you reinvest the coupon payments from the bond at the same interest rate the bond is earning.
When a bond is new, the yield to maturity and the coupon rate are the same. But they can differ over time because the yield to maturity takes into account the bond’s market value (what it’s worth today) as well as when coupons get paid, the size of payments, the amount you invested, and when the principle is due to be paid back at maturity date.
Terms of the trade
Bond laddering: is a strategy where you buy bonds that have different maturity dates. This gives you access to cash at different times.
Callable and redeemable: are bonds that the issuer can choose to pay back at an earlier maturity date.
Debentures, unsecured notes and capital notes: are types of bonds that often carry more risk. They may have features closer to shares.
Debt security: is the legal term for an investment where you have a right to be repaid the money you invest, or interest on that money, by the issuer.
Kiwi Bonds: are government bonds offered directly to Kiwis living here.
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