I am not sure if there are many other James Bond fans who read our blog but my personal view is that Sean Connery was one of the best ‘Bonds’ around! With tough times in the interest rate markets Bonds may be a way to enhance your income return without exposing your portfolio to capital risk. So what are Bonds? (the investment vehicle not the spy)..
In very simple terms a bond is an IOU between an investor and the issuer who can be either a business or Government.
Currently with investor confidence and interest rates being low Government Bond (are traditionally a safe haven – as long as you are not in Europe) however as these are Guaranteed by a Government the risk return trade off at present is quiet low with bond returning income (or yield) less than cash in the bank.
There are four basic concepts that will help you understand bonds:
1 – Face value – also known a par or principal value, is how much the bondholder will receive at maturity. A $1,000 face value bond will be worth $1,000 when it matures and this is where investors are offered ‘capital security’.
2 – Coupon – is the interest rate the bond pays. It is called the coupon rate because bonds originally came with a book of coupons, which the holder had to clip and send in to receive an interest payment. This interest rate does not vary over the life of the bond, although there are some bonds, which have a variable interest rate tied to an external index such as the 90 day bank bill rate these are called floating rate bonds.
3 – Maturity – refers to the length of time before the par value is returned to the bondholder. It may be as short as a few months, 50 years, or more. At maturity, the bondholder receives the par value of the bond.
3 – Income Payment (often also called Yield) – this term you will hear about bonds the most is about yield and it can be the most confusing.
Nominal Yield – This is the coupon or interest rate. Nothing else is factored in to this number. It is actually not that helpful when looked at in context of the investment.
Current Yield – The current yield considers the current market price of the bond, which may be different from the face value and gives you a different return on that basis. An example, if you bought a $1,000 par value bond with an annual coupon rate of 6% ($1,000 x 0.06 = $60) on the open market for $800, your yield would be 7.5% because you would still be earning the $60, but on $800 ($60 / $800 = 7.5%) instead of $1,000.
Yield to Maturity – Yield to Maturity is the most complicated, but the most useful calculation. It considers the current market price, the coupon rate, the time to maturity and assumes that interest payments are reinvested at the bond’s coupon rate. It is a very complicate calculation best done with a computer program or programmable business calculator. However, when you hear the media talking about a bond’s “yield” it is usually this number they are talking about.
Bonds can be a good solution to add fixed interest exposure to your portfolio while getting income return and capital stability (assuming purchased with good yield to maturity and knowledge of the underlying face value).
There are some limitations to direct bond investment in relation to total parcels of shares but there are a number of quality managed fund options which investors can also access.
If you need assistance in exploring these further talk to a professional but most importantly start your journey to being free around your money and creating wealth with understanding.
Scott Malcolm (scott@money-mechanics.com.au) is Director of Money Mechanics (ph: 6257 5557) a fee for service advice firm who are authorised to provide financial advice through PATRON Financial Advice AFSL 307379.
The information provided on this article is of a general nature only. It has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information you should consider its appropriateness having regard to your own objectives, financial situation and needs.