Many investment portfolios often include a portion of bonds, which aim to help balance out risk over time. If you have Kiwisaver, it’s likely that you’re already investing in bonds. So what are bonds, and why do people invest in them?
What are Bonds?
Bonds are a type of asset class. A bond is a loan to a borrower that pays investors a specific percentage return over a specific time frame.
When you buy bonds, you are loaning your money to a government or company (a bond issuer) for a specific amount of time that they will use for a specific purpose, such as raising money or funding operations. Bonds are also referred to as ‘fixed income instruments’. In return for your investment/loan, the bond issuer agrees to pay you a fixed amount of interest over a set period of time.
How bonds work
Let’s run through an imagined scenario in which we buy something similar to a Bond. We’ll call it a Bourne. You decide that buying bonds aligns with your investment goals. You research different types of bonds, look at the bond yield and the term, Bourne is the one you’re choosing to go with.
When you buy the Bourne bond directly, you are lending money to the bond issuer, in this case to fund its new Treadstone project. The Bourne bond you have purchased has a 12 year fixed term, and you are expecting to collect interest of 4% every six months for the term of the investment until its maturity date. On the maturity date, as long as the company hasn’t collapsed, you’ll receive a fixed amount of money.
What is bond yield?
Bond yield is the annual return that an investor can expect to get each year over the term of the bond. It is calculated as a percentage of the total amount of money you have invested.
Low bond yield often indicates lower risk, and higher bond yields can be a sign of riskier investments. Bond price and yield are inversely related; if a bond’s price goes up, its bond yield goes down.
What influences bond prices?
Like shares, bond prices are impacted by changing economic conditions and market sentiment, but they’re impacted in a different way. Bonds are inflation-linked investments. During times of high inflation, bond yields go up, making them a strong performer when other asset classes like stocks and property might be trending down.
How can I invest in bonds?
Hatch offers investors exchange-traded funds that invest in bonds called ‘bond ETFs'. Some include bonds as a proportion of the holdings alongside other asset classes, while others focus solely on a specific type of bond. We’ll look at some of the different types of bonds, and bond ETFs that you can invest in through Hatch.
Different types of bonds: What are Government bonds?
There’s a positively shocking number of different types of bonds, but we don’t have all the time in the world to explain them, so we’ll look at three of the most common types. Each type has a different seller, buyer, purpose, risk and return.
- Government bonds (aka Treasury bonds)
Backed by the government, treasury or government bonds are considered the least risky when it comes to investment, but also typically offer the lowest bond yield (returns).
Government Bond ETFs include (GBF, VWOB, TLH, PLW)
- Corporate bonds
Companies looking to raise money might issue corporate bonds. Unlike shares, owning bonds does not give you ownership or voting rights to a company.
Corporate Bond ETFs (SPLB, PHB, LQD)
- Municipal bonds
This type of bond is issued by a city or municipality. Also called ‘Muni bonds’ (cute) they don’t carry the weight of a government behind them so are slightly more risky than government bonds. They are however tax free! (Federal tax free, you’ll still pay other taxes)
Municipal bond ETFs (CMF, MMIN, VTEB)
There are also total Bond Market ETFs (BND, AGG) that track the performance of a market-weighted bond index.
Why people invest in bonds
Bonds are often mentioned when talking about the diversity of your portfolio, and how ‘risky’ it is, and are considered an important part of a balanced portfolio. If stock markets are trending down (coasting down a hill, or plummeting off a precipice), bonds can help to reduce the impact because they are a different asset class, with different behaviours and characteristics to stocks.
Bonds are a type of fixed-income investment, and some investors choose to invest in bonds to get an income stream in the form of regular interest payments
If you’re looking to add bonds or a bond ETF to your investment portfolio, consider your investment goals, and how much risk you’re willing to take on before you decide on which bonds to invest in.
