A beginner's guide to bonds


If you’ve looked at your superannuation statement in detail, you may have come across an asset class called bonds – but what are they and how do they work? Financial expert Ray Trevisan explains.

Types of asset classes


Why are cash and shares the only two asset classes I seem to hear about in my travels and discussions with investors of all persuasions? There are actually five asset classes:

  1. Cash – liquid and powerful to buy anything immediately. This includes liquid funds, saving accounts, online wallets and hard cash. 
  2. Equity – owning part of a business. This includes stocks/shares, ETFs, equity mutual funds, index funds, and startup funding. 
  3. Fixed income – lending money (and getting it back). This includes bonds, endowment policies, debt mutual funds, debentures, fixed deposits, recurring deposits, and EPF/PPF/NSC.
  4. Real estate – owning a physical space. This can include commercial property, plots, real estate investment trusts (REIT).
  5. Commodities – owning something that has an end use. Key commodities include crude oil, copper, silver, gold, and wheat. 

I understand why commodities are not widely discussed. Gold, silver, lithium and the like all have vibrant active markets attached to them. But they are mostly difficult to understand and require expertise well beyond the average consumer. The uninformed who venture into this space usually get burned. And while we are a real estate crazed country, they usually require much larger sums to participate. 

Today, I wish to investigate the world of bonds. Why? Because the world of low interest rates is now baked into first world economies. The chase for yield is more important than ever as a bevy of investors (many including retirees trying to eke out a living on their cash savings) are wondering where to place their money.

What are bonds?


Put simply, a bond is a loan. If you have ever borrowed money from a bank for a home, a car, a small business, that loan is a 'bond'. Bonds engender key principles that have been in place ever since money was invented and lenders worked out a way to make a profit by loaning funds.

Understanding the jargon


Clean Energy Bonds


Australian Government Bonds are where investors lend money to the government, to help finance major projects or infrastructure. 

Large-scale renewable energy production and storage is urgently needed to help meet emissions targets, stabilise the electricity network and keep electricity prices low. Many projects, like Snowy Hydro 2.0, are being built over the next few years. Some of these are being financed by government and require significant investment to bring them to life.

National Seniors Australia is calling for the establishment of Clean Energy Bonds to give older Australians the opportunity to invest in renewable energy production and storage capacity. This will provide them with access to another safe and simple option to invest their savings and delivers meaningful environmental and economic benefit.

Learn more about the proposed scheme and join our Clean Energy Bonds campaign.

When we borrow money from the bank, we usually understand:

  • How much we’re borrowing (principle)
  • How long we’re borrowing for (term)
  • The interest we’re paying (coupon rate)
  • Any security or collateral the loan is set against (mortgage on a house, lien on a car or unsecured)
  • Terms and conditions of the loan (early payments, what happens if I don’t pay on time or ever?)

Tables are turned


When investing in bonds, you need to position yourself on the other side of the transaction. You are now providing your money to someone else (like a company, investment trust or similar).

Therefore, what terms and conditions are you happy to accept for someone else to have your cash, and when do you want the cash returned?

Investing in bonds


I can’t stress this enough – investing in bonds can be as risky or as safe as you make it. Like any other investment, you need to understand what you’re getting into, and if you don’t understand – don’t invest.

Ask yourself these questions (also known as the Six Key Factors of Bonds):

  • Reputation: Is the country or company a good corporate citizen? Do they pay their debts? Do they have a solid track record?
  • Maturity: Does the loan suit your liquidity needs (i.e. when you need your money back)?
  • Return v risk: Is the return for risk realistic? Does the coupon rate or interest paid match the type of investment or use of the capital? Always remember, the higher the yield, usually the higher the risk.
  • Collateral: Is the security asset/collateral real? Can it be turned back into cash quickly if needed?
  • Plan B/alternative actions: Are you comfortable with the terms if the money comes back in a different form – like equity in the company or convertible notes in the future?
  • Tradeable: Are the bonds tradeable in an open marketplace? Can I turn the bond back into cash before its maturity date?

Types of bonds


  • Government/Treasury – as the name implies, they are issued by countries in their fiat currency (government-issued currency not backed by a commodity such as gold) or major currencies like USD, Swiss Francs, Euro, Yen etc.
  • Municipal/corporate – issued by companies or lower government agencies looking for funds outside of their usual equity raising to fund expansions, stockholder buy outs or any other use.
  • Investment grade – issued by investment vehicles like trusts, funds, broking houses that have been rated by reputable agencies like Moodys or Standard & Poor. While they are rated, it doesn’t necessarily make them less risky. They simply have been reviewed by a ‘third party’ agency.
  • Mortgage backed – issued by investment trusts and funds that use real estate assets (usually) to secure loans in case of default by the borrowers.
  • Others – any kind of loan that fits the criteria of providing credit, but without any regulation, government rules or protection and might include schemes to fund projects that don’t necessarily meet usual ‘standard’ terms and conditions – AKA ‘the Wild West’, such as Bitcoin investing.

How do I invest in bonds?


Quite easily. Bonds are available from specialist broking companies that sell a range of bonds, directly with the bond issuer themselves which include investment trusts, companies issuing corporate bonds, mercantile boards of trade and stock exchanges. If you wish to have a wider coverage of bonds, Exchange Traded Funds (ETFs) can assist too, as bond-based ETFs are usually tradeable on stock exchanges around the world.

Conclusion


Bonds can be as safe or as dangerous as you make them. When you are able to break down the jargon and terminology into simplistic terms that relate to an everyday loan that you have been used to, then investing in bonds – that is, being the provider of the borrowed funds – should hopefully be a safer ride than most think.

The golden rules in investing still apply to bonds including:

  • Check against the Six Key Factors of Bonds.
  • If it seems too good to be true, it probably is.
  • If you don’t understand what you’re investing, don’t invest.
  • If it doesn’t make sense – don’t invest.

This article was first published on SMSF courtesy of OTG Capital. The views expressed by Ray Trevisan in this article are his own. The information provided is general in nature and doesn't take into account your individual circumstances and we recommend seeking independent financial advice before making any investment decisions.