A layman’s guide to understanding bonds

Given that they come in so many shapes and sizes and are heavily influenced by what’s playing out in the economy and other forces, including central bank policy, bonds tend to be the asset class Australian investors struggle with most.

As a defensive asset that provides a stable source of income, while protecting the money you invest, bonds can be a worthwhile way to diversify, and especially within today’s highly volatile share market.

While no Australian government has ever defaulted on the debt it owes bondholders, a lot of investors steer clear of bonds, simply because they don’t understand them and lack the confidence to buy them.

To make matters worse, financial media and the advice sector has made a pig’s ear out of both explaining bonds and championing the role they can play alongside other asset classes.

Here's the Market Index educational series on All-Things-Bonds.

To help you get your head around bond, Market Index will be running a series of articles on bonds within an Australian context.

Each article will, in layman’s language, address a handful of key fundamentals you need to know before dipping your toes in the bond market.

Here’s article one to get you started.

Making sense of bonds

A bond is what’s called a debt instrument, and like other debt instruments sitting under the fixed income asset class umbrella (like term deposits), bonds are a form of lending.

But when it comes to bonds, it’s you that’s doing the lending typically to fund government or corporate activity.

As the bond issuer, a government or corporate entity undertakes to pay you (as the creditor) regular interest, plus its face value in exchange for your loan.

Shades of risk

But while governments that borrow money in their own currency are considered risk free – meaning they’ll never really default – private-sector borrowers are riskier to lend money to, and this explains why they pay a higher rate of interest.

So, if the five-year bond rate is, for argument’s sake 1.5%, you’d need a corporate rate a lot higher over the same term for it be worth your while taking on the added risk.

How is the bond rate set?

When it comes to government bonds, the rates on offer are typically a function of what the market expects the average future central bank cash rate setting to be, among other factors.

While many financial indicators and technical factors go into determining the bond rate, one newsworthy example right now is the outlook for inflation.

The current outlook for inflation serves to illustrate where bonds will be heading.

For example, if inflation is likely to exceed the RBA’s (or any central bank’s) expectations in future years, the market will factor (price) in rising interest rates on the expectation the central bank will lift interest rates to bring inflation back within its comfort level.

You decide how long you lend your money for

Remember, with bonds, you’re in the driver’s seat when it comes to deciding how long you lend your money for – and the terms (loan duration) can vary from one to ten years-plus – and how your interest is paid.

You decide when you get paid (...to be continued)

There are three types of interest you can be paid, depending on which option you choose, but let’s go into detail on that in Part II.