Australian Bond Market Facts
The Australian sharemarket is one of the largest in the world, but did you know the fixed income/bond market is nearly the same size?
According to Deloitte, just one part of the Australian bond market, corporate bonds, is worth about $1 trillion -- equivalent to 70% of the Aussie sharemarket's value!
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WTF is a Bond?
It sounds a bit like an English action movie, we know, but bonds are another word for 'debt'. It's also called credit or 'fixed income' because... well... when the first bonds were issued they promised to pay investors a 'fixed income'.
A bond is a promise
A bond is a promise to repay money that is owed. The most simple example is a large company (say, a bank) needs money to run its business. It will offer/issue bonds worth $100 to investors in the bond market. It promises to repay the $100 bond in full in 10 years, and make a 3% payment (called a coupon) each year to the investors.
So, the issuer (the bank) gets $100 to run its business and the bond investors expect to receive $3 each year (a "fixed income").
Bonds are issued by different types of organisations:
- Governments (Australian treasuries)
- State Governments (e.g. Victoria, WA, etc.)
- Non-government / corporates (e.g. banks, telcos, foreign companies, etc.)
Are bonds safer than shares?
Bonds are often considered safer than shares because debt/bond investors get their money back before the shareholders -- in the event of a bankruptcy or default by issuer (e.g. the bank).
Think of it like a mortgage on your house -- the bank who 'issued' you the mortgage (a form of debt) will get its money before you get your money.
It's the same in the bond market. For example, if a company goes under the highest rated bond owners get their money first.
Bonds for income or growth?
According to Deloitte, more than 70% of corporate bond investors in Australia own them because they want to receive a consistent income from their investment. Remember, most bond investors receive a 'coupon', which is like a regular interest payment.
The market price of a bond can also change from day-to-day, so it's possible to make a capital gain on your investment. Keep reading...
Interest rates and bonds
Interest rates are the most important consideration for bond investors. Why?
It comes back to a few things, including the risk of the issuer, the coupons and the length of the bond -- that is until the bond matures and the issuer pays back the $100.
For example, imagine an Australian Government bond issued over 10 years will pay investors a 3% coupon per year. You buy the bond for $100.
But let's imagine that 6 months after you buy that bond the Reserve Bank of Australia (RBA) raises interest rates to 5%. Now, all new bonds are 'yielding' 5% per year in fixed income.
What do you think would happen to the value of your bond? The bond that pays less in interest?
The price of your bond will fall. Why?
Because other investors have two choices:
- Buy a 5% bond for $100, or
- Buy your 3% bond for $100
Obviously, the 5% bond is better. So your 3% should be worth less than the one issued at 5%.
If you're confused -- don't worry, everyone else is feeling it too -- just remember this:
If interest rates go UP, a typical bond will be worth LESS. If interest rates go DOWN, a bond will be worth MORE.
If you want to learn more, please head to the Rask Finance website to keep learning.
Key Bond Terms
- Bondholder: This is the investor who receives the income and the final cash back. In the case of ETFs, the bondholder is the ETF.
- Maturity: this is the date when or time until the 'face value' (see below) of a bond is due to be repaid.
- Face value: this is the amount a bondholder receives when the bond hits its maturity date (e.g. '$100 paid back in 10 years')
- Coupon: think of these things like dividends from shares, except it is commonly set in advance (e.g. $5 per $100 bond). These are often paid six-monthly or yearly.
- Bond price: the price of a bond in the market today. Please note there are many bonds (often called 'money market' or 'discount' bonds) that DON'T PAY A COUPON. The investor makes money by buying a bond for less than $100 and waiting until it matures at $100. For example, if you could buy a bond today for $70 and hold it for 5 years until it matures it means you will make $30 in profit over 10 years. This amount is usually expressed as a percentage. See below.
- Yield: this is a yearly percentage (%). It represents the yearly 'expected return' for owning a bond from now until it matures. Remember how the bond price (see above) doesn't always equal $100? Remember how some bonds pay coupons (kind of like dividends) and some don't? Well, the yield or "yield to maturity (YTM)" is an interest rate percentage which estimates the yearly return from owning a bond (or a bond ETF). For math nerds like us, it's the Internal Rate of Return or IRR. If you total up all of the expected coupons (e.g. $3 per year) and the final 'face value' (e.g. $100) of a bond, the yield measures the interest rate which makes the future returns equal today's bond price.
Australian Bond Market Risks
There are many risks to investing in Australian bond ETFs. Here are some of the risks (note: it's not a complete list):
- Index risk - Unlike sharemarket indices (e.g. ASX 200), most bond market indices use an incredibly poor construction methodology. In the sharemarket, the biggest companies get a bigger weighting in an index because they are valued by their market capitalisation (number of shares x total shares). This rewards a company for growth. However, in the bond market, most indices use the total amount of debt to weight companies in the index. Meaning, companies with the most debt are the biggest part of the index (and hence part the index fund ETF). As you can imagine, lots of debt can be a bad thing!
- Liquidity risk - Unlike shares, some bonds trade infrequently. For example, many big pension funds or investors will buy a bond and never sell it (they'll just collect the coupon payments until it matures). A problem arises because ETFs need to let investors in-and-out (buy-and-sell) each day. If the ETF issuer can't buy the bonds in the index for you they'll have to find other ways to provide the bond market exposure. Ultimately, this 'lack of liquidity' means the ETF's unit price can deviate from the value (NTA) of the bonds (called a "premium" or "discount"). For this reason, you need to pay careful attention to the ETF's discount and premium when you're buying or selling and consider sticking to reputable ETF providers. This risk tends to be worst during a market crash or a rapid recovery - when trading activity steps up.
- Concentration risk - Diversified portfolios balance their exposure across many different issuers, sectors, countries and credit ratings. That is, owning bonds issued by companies or countries from just one sector or geography can create an unnecessary risk. In Australia, the bond market is heavily skewed towards corporate bonds. That is, bonds issued by big companies. And within the corporate bond sector, many of those bonds are issued by Australia's banks (Commonwealth Bank, ANZ, Westpac, etc.). If too much of a bond portfolio is concentrated towards one sector of the market an investor may be overly exposed to risks only in that sector. That's we think it's best for bond portfolios to be evenly diversified across all markets, bond types, issuers, industries and credit ratings.
- Credit risk - Companies and countries that issue bonds are 'rated' by expert credit rating agencies (S&P, Fitch, Moody's, etc.). If there's a big chance the company/government could go bankrupt, the bond will have a lower/worse credit rating (e.g. CCC). The safest bonds are issued by stable governments and given a 'AAA' rating. "Junk bonds" are typically rated BBB- or lower and have a higher chance of default.