what exactly are bonds and why should i have some in my portfolio?

What are bonds?

Bonds operate like a loan except you are the lender.

You lend some money (could be to a company or government who need money for various purposes) for a period of time and in return you receive regular payments at a set rate of interest. At the end of the term, you are paid back in full the amount that was originally lent.

For example, you might lend $100 at 5% for 20 years, receive regular interest payments annually of $5 and then after 20 years receive the original $100 back.

Despite being generally considered less risky than shares, governments and companies can default on their bond commitments so there is some risk attached.

What types of bonds are there?

Bonds differ greatly from country to duration to features and to the issuer.

They can be lower risk federal government bonds to higher risk corporate bonds (which in turn could be smaller companies, larger companies, companies in distress and needing money or companies wanting to undertake a project perhaps).

Interest payments might be fixed or variable or in some cases inflation linked so they can be quite diverse.

Bonds can be bought directly or they can be bought as part of a group of diversified bonds through funds.

How do bonds work and why might different prices exist?

You can hold a bond until it matures (whereupon you will get the full amount back) or you can trade them on markets to someone else (e.g. through the ASX) before they reach maturity where they will have a trading value. This value over time may be more or less depending on demand or supply of the bond and the amount of risk the market attributes to it.

For example, if the $100 originally lent to the Greek Government has a heightened risk of defaulting, the price of the bond might fall well below $100 as the bond loses its appeal. Money is lost by the holder unless the bond is held until maturity providing like any debt relationship it does not default by then (this is an extreme example obviously).

Another example might be if market interest rates fall, the income received from the bond would be more valuable to a potential holder so the trading value of the bond would rise.

So economic and market conditions can determine prices of bonds at any point in time as can the quality of the borrower. The borrower’s quality is known as its credit risk – or the likelihood the holder will get their money back.

Why should I consider holding both shares and bonds?

Bonds generate income, diversify your investments and reduce volatility.

Over the last 20 years, an average Australian bond fund has provided a return of 5% income and 1% growth. Conversely an average Australian share fund has provided 4% income and 4% growth. During that time when shares have provided negative returns, Australian bonds have provided strong positive returns (in 1991 shares fell 17% and bonds rose 18%, in 2008 shares fell 35% and bonds rose 12% and in 2011, shares fell 10% and bonds rose 9%. Over the last 20 years, a portfolio with half the balance in shares and half the balance in bonds has outperformed a portfolio with solely shares.

Bonds can have negative returns too. Statistically Australian bonds have provided a negative return once every 15 years but they are less volatile than shares with Australian shares providing a negative return once every 4 years.

Naturally it will depend on the investor’s goals, length of time to invest and aversion to risk. An investor in retirement should as a rule of thumb hold more bonds than the super fund of a 30-year-old investor.