What are bonds?

You've all probably borrowed money at some point in your life, whether buying something as big as a house or as small as a coffee. One way for companies to borrow money is by selling debt securities called bonds.

This article explains what bonds are and how companies can use them to raise additional capital. We also explain the pros and cons they offer to investors.

What are bonds?

We all need to borrow a little money sometimes. Well, companies and governments are no exception. They often need to borrow money when they want to launch new projects or buy new assets. One way they can do this is by issuing bonds.

You can think of a bond as basically an IOU. The borrower writes an IOU note for a specific amount of money, promising to pay it back over a particular timeframe, with interest. If the terms (like the timeframe and interest rate) of the IOU note are attractive, someone will come along and buy the IOU note. They lend the money to the borrower and are repaid according to the terms of the note.

This is basically how a bond works. But rather than one IOU note, companies will issue thousands of bonds at a time, each for a small portion of the total amount they wish to borrow. Investors can buy whatever quantity of bonds fits within their budget, much like when buying shares. 

And, like shares, once you own a bond, you can trade it on secondary markets to try and make a profit. The prices of bonds will fluctuate in response to changes in prevailing interest rates.

Put simply, bonds are a way for organisations to borrow money by breaking a loan down into smaller parts or 'bonds' and making them widely accessible to lenders of all sizes. Like shares, bonds can then be bought and sold by traders hoping to make a profit.

How do bonds work?

Bonds work in much the same way as a typical loan.

Let's say a mining company wants to raise money to finance a significant new project. To secure the funding, the company might issue bonds to investors. In exchange for their investment, the company will promise to repay them, plus interest, within a specified time frame.

One of the bonds they offer is a 10-year, $10,000 bond paying 6% interest. You think this is an attractive interest rate for a 10-year loan and decide to buy the bond. 

This means you have essentially loaned the mining company part of the capital they need to finance their new project. In exchange, the mining company promised to make periodic interest payments on the $10,000 loan (often called coupon payments) and to return the principal amount to you in 10 years.

How to make money from bonds

There are two ways to make money from bonds:

The first is to simply hold onto the bonds until they mature and kick back and collect the coupon payments. This means that by the time the bond matures, you will have received your initial investment back, and your profit will be whatever interest you gained during the loan period.

Bond interest is typically paid semi-annually, but it can also be paid quarterly or annually.

The second way you can profit from bonds is to sell them for a higher price than you initially paid. Let's say you purchased that 10-year, $10,000 bond from the mining company. In a year, the price of that bond may have increased to $11,000. You can sell that bond and pocket the $1,000 profit.

What affects the price of a bond?

There are two main reasons a bond's price might increase (or decrease):

The first (and most critical) factor is the interest rate. If the prevailing interest rate on newly issued bonds is below the interest rate paid on existing bonds, the existing bonds will increase.

So, using our example with the mining company, if they started issuing 10-year, $10,000 bonds paying just 4% interest, that would suddenly make your bonds, which pay 6% interest, relatively more valuable to own.

Of course, the opposite would also be true if the company started issuing bonds paying a higher interest rate, like 8%.

The second reason a bond's price might increase is if the issuing company's credit rating improves. This is particularly true if the company had a poor credit rating to begin with, as it means it is now more likely to be able to make the interest payments on the bond.

This makes it a less risky investment and increases its price. On the other hand, if the company's credit rating declines, it makes its bonds riskier and decreases their price.

Skilled bond traders will attempt to profit from these price fluctuations by actively buying and selling bonds on the bond markets.

Investing in bond funds

Individual bonds can be costly and are often beyond the reach of the typical retail investor. This is where bond funds come in. These funds pool together contributions from large numbers of individual investors and use the money raised to purchase a diversified portfolio of bonds.

This is an excellent option if you want broad exposure to the bond market but don't have much money to invest.

Many exchange-traded funds (ETFs) currently listed on the ASX offer exposure to various sections of the domestic and international bond markets. And because they trade on the ASX, you can buy and sell them like ordinary shares.

What types of bonds are there?

In Australia, there are two types of bonds:

Corporate bonds: These are bonds issued by companies. They tend to offer higher interest rates, but there is more default risk with small, growing companies than with large, blue-chip companies and government entities

Australian Government bonds: These are bonds issued by the federal government. Due to the lack of default risk, they are considered safer investments than corporate bonds and offer lower interest rates. Semi-government bonds are those issued by the Australian state and territory governments. 

How to buy them

There are several options for investing in bonds in Australia.

If you want to purchase bonds wholesale, you will typically need to engage a broker to execute your trades for you (in exchange for a fee). This is because most bonds are not publicly traded and are instead sold 'over the counter'. Purchasing bonds wholesale can often require a significant minimum investment (think upwards of $500,000).

Purchasing exchange-traded Australian Government bonds is another option if you don't have a spare 'half-a-mil' tucked under your mattress. These trade on the ASX and operate similarly to passive ETFs, but rather than track an index, their returns aim to mirror a specific bond.

For example, you could gain exposure to 3% interest-paying Australian Government bonds maturing in March 2047 by purchasing units in the Australian Government Treasury Bond GVM6WU (ASX: GSBE47).

Benefits of investing in bonds

• Less volatility: Bond prices tend to fluctuate much less than share prices, making them potentially a safer investment
• Income: The coupon payments on bonds can provide a predictable and stable revenue stream
• Diversification: Perhaps the most significant benefit of investing in bonds is the diversification they can bring to your portfolio. Although shares have outperformed bonds over the long term, holding a portion of your portfolio in bonds can help reduce your financial risk.

And the drawbacks

• Long time horizon: Most bonds won't mature for five, 10, or even 20-plus years, meaning that you may have to lock your money away for an extended period
• Interest rate risk: Because bonds typically have such long maturities, there is always the risk that interest rates will increase before your bond matures. Not only will that decrease the value of your bond – as we illustrated previously – but it also means that if you continue to hold your bond, you may miss out on earning a higher interest rate elsewhere
• Issuer default: While unlikely, there is still the real possibility that the bond issuer may default and be unable to meet their repayment obligations. This could potentially put both your interest payments and the return of your principal at risk
• Lack of transparency: Bond markets tend to be more opaque, particularly to retail investors, than equities markets. Because you typically need to engage a third party, like a broker, to execute trades on your behalf, you have less certainty that the price you pay or receive for your bonds is fair
• Smaller returns: Bonds also tend to offer a substantially lower return on investment than shares and other riskier financial assets.

Are bonds a worthwhile investment?

The only person who can truly answer that question is you. But here are some helpful scenarios for you to consider as you decide:

• If you are a risk-averse investor who wants to lessen the likelihood of losing money, bonds might be a suitable investment for you. Because bond prices tend to be reasonably stable, they usually offer a much safer store of value than shares. However, it is essential to keep in mind that your potential return is also significantly lower with bonds
• If you are already heavily invested in shares, purchasing bonds can help to diversify your portfolio and protect you against unwanted market volatility
• If you are entering retirement or already retired, you may prefer a more stable income stream to help support your lifestyle. This can be achieved by rebalancing your portfolio towards bonds rather than shares.