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Q&A - Investing in bonds

Q. I keep hearing that investors should have exposure to bonds but I don’t know much about them and how you can gain an exposure. Also the rates they pay seem low but I have heard that bonds have outperformed shares over the past ten years. And what are they talking about when they talk about the yield on a bond?

Jason, Palm Beach, QLD.

A. Bonds are mainly government bonds and they can be issued by the Federal Government, state governments and semi-government bodies, but there are also corporate bonds. Unlike the USA, it’s not as easy to access bonds, especially corporate ones, here in Australia. However, there’s talk that retail investors will soon get access to government bonds. Generally, the best way to get access to bonds is through funds that specialise in them. Outfits such as Vanguard have a bonds option but so do most of the financial institution’s funds and you should check out their websites, which often provide good explanations of what they do. These fund managers buy new and old bonds in large quantities and they try to use their knowledge of where interest rates are going to make higher yields than the face value of the bonds. Let me explain. Say they bought a $100,000 bond with a coupon rate of 5%. That means the bond returns $5,000 a year. But if interest rates rose to say 10%, then someone would always want a new bond with a higher interest rate than the 5% bond. For a fund to sell the bond with a coupon rate of 5%, it would have to reduce the price of the bond to a seller to $50,000 so that the 5% or $5,000 it pays each year is equal to a 10% yield. What we can see is that the price of the bond fell to increase the yield and the yield moves in the same direction as interest rates and in the opposite direction as bond prices. Smart guys in the bond market gamble on interest rates, and the profitability of corporations, and can make or lose a lot of money. Generally, the bond manager plays it pretty safe with most of the money but will take a few chances with some more risky bonds and that can bump up their returns from the more sedate 4% or 5% returns we often see. Corporate bonds are more risky than government bonds but it’s time we saw more big name Aussie companies offering bonds to the public. 

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Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published on: Saturday, August 08, 2009

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