A layman’s guide to understanding bonds: Part VI

To help you get you head around bonds, Market Index recently launched a series of articles on bonds within an Australian context.

In part I we talked about making sense of bonds, shades of risk, how the bond rate is set, and how long you need to lend your money for.

In part two we looked at the three basic options for having your interest paid, and what happens if you decide to ask for your money back early (aka before maturity).

In part three we looked at the role bonds can potentially play in your portfolio, and why you might buy a bond.

In part IV we looked at the risks of owning bonds

In part V we look at how bonds have behaved during an abnormally low yield environment.

Part VI: How many different types of bonds are out there?

While you can count the main types of bonds on one hand, they’re generally grouped into three main categories, based on repayment terms. These include short-term bonds (one to five years; intermediate-term bonds (five to 12 years); and long-term bonds: 12 to 30 years.

As well as measuring how long it will take an investor to be repaid, the duration of the bond also determines the bond’s price and how price-sensitive the bond is to changing interest rates.

While bonds can come any number of issuers, here are the main categories of bonds currently operating in Australia:

Government bonds: Are issued by the Treasury on behalf of a government, and as such are also referred to as sovereign debt.

Typically governments issue bonds to finance new projects or government infrastructure. For example, Australian Government Bonds (AGBs) are the safest type of bonds, and if you buy and hold them to maturity, you're guaranteed a rate of return.

There are two main types of Australian Government Bonds (AGBs) that are listed on the ASX:

Treasury Bonds: These are medium to long-term debt securities that carry an annual rate of interest fixed over the life of the security. Interest is paid every six months at a fixed rate, which is a percentage of the original face value of $100. The bonds are repayable at face value on maturity.

Treasury Indexed Bonds: These are medium to long-term bonds. The capital value of the bonds is adjusted for movements in the Consumer Price Index (CPI), which measures inflation.

Interest is paid quarterly, at a fixed rate, on the adjusted face value. At maturity, investors receive the capital value of the bond – the value adjusted for movement in the CPI – over the life of the bond.

Corporate bonds share many characteristics with other types of bonds but are issued by companies looking for a source of funding to help grow their business.

While Australians could up until fairly recently only access corporate bonds through a managed fund or Exchange Traded Fund (ETF) that is no longer the case.

Recent innovations have extended the accessibility of corporate bonds beyond the traditional domain of institutional or ‘sophisticated’ high-net wealth investors.

This means self-managed super funds and individual investors can now buy bonds directly from the issuer through a public offer (known as the primary market) at face value, or on the ASX after they have been issued in the primary market.

While investors are attracted to corporate bonds due to their higher yields, the rule of thumb is the higher the yield, the greater the risk.

Given that corporate bonds are issued against the underlying security, the single biggest risk is the company going bust, in which case you could lose your capital and forfeit receiving any coupon payments. Unlike government bonds, there is no government guarantee to pay you back if a company you own bonds in goes bust.

In part VII we will look at different types of corporate bonds that are available.