Key takeaways

• Bonds can provide a stable source of income and can protect the money you invest.

• They can generally be considered less risky than growth assets like shares and property in normal market conditions and can help to diversify your investment portfolio.

• Bond prices and interest rates move in opposite directions.  

Last year was an extraordinary one for the bond market, with a series of interest rate hikes eroding the value of bonds in 2022.

However, as 2023 rolls on, can bonds once again deliver their traditional virtues of reliable income, capital appreciation, and relatively low volatility? Below, we look at why you might consider investing in bonds and what might be ahead for the bond market.

What are bonds?

Bonds are defined as fixed income investments issued by corporations or governments to raise funds to finance projects and operations.

When investors lend money to companies or governments, (who issue the bonds), they typically receive regular interest or coupon payments with the face value paid at the bond’s maturity. The bond is issued with a face value and length or term of maturity with a promise to repay the issue price at a specific time. Interest or coupons are usually paid quarterly or every six months at either a fixed or floating rate or return.

Importantly, a bond’s market price prior to the maturity date can vary from its face value. But the bond’s price will be affected by factors including changes in interest rates, the credit or default risk of the issuer, the level of liquidity, and the time to the bond’s maturity.

How can investors gain access to bonds?

The primary issuers of bonds in Australia are governments and companies. Investors can gain access to unlisted bonds through several channels, including:

• Australian Government Bonds (AGBs) represent sovereign debt issued by the Federal Government. The bonds typically guarantee a rate of return if held until maturity and can be bought on the Australian Securities Exchange (ASX) at market value with a brokerage fee incurred.

• The Federal Government also issues inflation-linked or indexed bonds with coupon payments and the face value of the bonds increasing in-line with changes in the Consumer Price index (CPI).

• Semi-Government bonds (semis) are semi-sovereign debt issued by Australian states and territories, bought and sold through treasury corporations.

• Corporate bonds are primarily issued and traded on the over-the-counter (OTC) market. The minimum amount required to trade is typically up to $500,000. As with government bonds, investors will recoup the face value of the corporate bond at maturity unless the issuer defaults. But investors should consider the credit risk of corporate bonds before they buy, while consulting the issuer’s prospectus and product disclosure statement (PDS).

• Investors can also gain access to ASX-listed Exchange Traded Bonds (XTBs).

Why invest in bonds?

Bonds can play several key roles in an investment portfolio, providing diversification, stability and income, while potentially acting as a deflation hedge (deflation is when the prices of goods and services decrease across the entire economy, increasing the purchasing power of consumers – it is the opposite to inflation).

Steady income stream: bonds can provide a steady stream of income to investors, with coupon payments made on a quarterly, half-yearly or annual basis.

Diversification: bonds can generally be less volatile in normal market conditions, reducing overall investor portfolio risk, while providing defensive qualities during sharemarket declines.

Capital preservation: bonds can provide capital stability, enabling an investor to preserve capital with the face value returned to the investor at maturity.

What are the risks of investing in bonds?

Just like all kinds of investments, investing in bonds does carry some risks, such as liquidity, interest rate, duration, market, inflation and credit risks.

Liquidity risk: The liquidity of some bond or fixed income securities may be lower than other ASX-listed securities, such as shares.

Interest rate risk: For fixed income securities that pay a fixed return, there is a possibility that the rate of interest received may not be in line with the market rate at the time. Changes in interest rates and the accrual of interest since the last coupon payment may also impact the price of the fixed income investment. In an environment where interest rates are rising, the bond would lose value in the secondary bond market if sold or mark-to-market on a daily basis like share prices.

Market risk: If the bondholder sells the bond prior to its maturity through a broker or financial institution in the secondary market, the investor will receive the current market price at the time of the sale. But the selling price could result in a gain or loss on the bond investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.

Inflation risk: Rising rates of inflation typically reduce fixed income investment returns. For example, if fixed-rate debt security pays a 4% return and the inflation rates is 6%, the investor receives a -2% total return in real terms.

How interest rates affect bond returns

Bonds are usually a relatively stable investment that can provide a regular income. And historically, bonds have done just this. Since 1981, the Bloomberg Barclay’s U.S. Aggregate index has produced a year with a negative total return only four times.

However, global bond markets suffered unprecedented losses in 2022. After a 40-year bull market, investors in government bonds and other fixed interest securities experienced their first bear market and the biggest losses in the bond market since the 1970s. So, why did this happen?

Bond markets have borne the brunt of central bankers being wrongfooted by spiking inflationary pressures – largely caused by historically-tight labour markets, rising commodity prices due to the war in Ukraine, and Covid lockdowns in China, which further disrupted global supply chains.

The Reserve Bank of Australia, as well as the central banks of the United States, New Zealand and Canada, to name a few, started and continue to increase their official interest rates to address these high levels of inflation. And, as interest rates around the world have risen, bond prices have fallen.

But why are bond prices affected by rising interest rates? A fundamental principle of fixed income is that interest rates and bond prices generally move in opposite directions. So, when interest rates rise, the price of bonds fall.

This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up. The reason: The price of a bond reflects the value of the income it delivers through its coupon (interest) payments.

If prevailing interest rates (notably rates on government bonds) are falling, older bonds that offer higher coupon rates become more valuable. The investor who holds these bonds can charge a premium to sell them in the secondary market.

Alternatively, if prevailing interest rates are increasing, older bonds become less valuable because their coupon payments are now lower than those of new bonds being offered in the market. The price of these older bonds drop and they are described as trading at a discount.

So are bonds a good investment?

The Covid environment of near-zero interest rates was never sustainable, and while this transition out of the Covid environment has seen bond markets fall, the expectation is that the outlook may improve over the longer-term.

Market indicators seem to show that an economic slowdown may be expected over the next 6-12 months. That said, market expectations also seem to demonstrate that inflation will be brought back to the target of around 2-3%.

Even if their prices don’t rise much in 2023, bonds will still pay interest at rates that are set when they are issued and they will also still have a face value that the bondholder will receive when the bond matures, provided that the bond cannot be called by its issuer. These facts of bond life are especially meaningful for investors who are in or near retirement and are more interested in predictable income than in potential capital appreciation.

Not only are yields up, prices of many high-quality bonds are down as a result of the 2022 selloff. That means opportunities exist for those with cash to buy relatively low-¬risk assets at bargain prices even as they pay yields that are higher than they have been in decades.

Choosing your investment strategy usually means using an appropriate mix of asset classes, rather than just bonds. Just like any investment, when you buy bonds you take on market risk, including loss of principal. Just like stocks, bonds go down also. However, year-to-date, bonds have been less negative than most equities. Appropriate diversification should help to strike a balance between growing (usually via use of growth assets such as shares) and protecting (usually via more defensive assets such as bonds or cash) an investment based on your own personal situation including how close you are to retirement.

However, everyone’s situation is different and depending on your stage of life, retirement plans and other specific goals, you may want to speak to a financial adviser.