Debt investments: an introduction

How does a loan work?

So how exactly is a bond like a loan then?

Bonds are one of the most common types of debt investments. That’s why you’ll often hear people flip between terms like fixed income, bonds and debt investments.

A bond is a type of loan that a company or government will ‘sell’ or issue when they need to raise funding.

As an example, the Queensland Government may issue a $2.5 billion, 10-year bond to raise money for an infrastructure project like a new highway (please note this example is for illustrative purposes only). In this example:

• The bond is paying an interest rate (also called a coupon rate) to investors of 4.50% which is paid annually.
  
  
• Rest invests $10 million in that bond, and so are providing the Queensland Government with a loan for 10 years.
  
  
• There will be other investors also investing into that same bond with Rest, as the Queensland Government is looking to raise $2.5 billion.

• In exchange for that loan, the Queensland Government will make regular annual interest / coupon payments to Rest at a rate of 4.50% per annum.
  
  
• After 10 years, the Queensland Government will repay the principal to investors (i.e. Rest receives back its initial $10 million investment). 

Payment schedule for Rest’s investment in a Queensland Government bond

A defensive investment, with regular income

Debt investments can play an important role in a diversified portfolio, with several key benefits:

• Regular income – debt investments typically offer a steady and generally more predictable stream of income through interest / coupon payments.
  
  
• Preservation of your initial investment - unlike many other types of investments (i.e. shares or property), the borrower must repay the original investment (or principal) to the investor at the end of the term of the loan.
  
  
• Diversification – Bonds are ‘defensive’ which means they are typically less volatile than growth investments like shares. That’s why debt investments can be appealing from a diversification standpoint as they may balance out portfolio performance, smoothing the ups and downs of other asset classes like shares.
  
  
• Liquidity – the global bond market is huge with many investors buying and selling bonds. That means that if you need to adjust your investment portfolio, it is generally easy to find a buyer for your bonds and convert debt investments into cash.

Investment risks

All investments carry risk and debt investments are no different. It’s important to remember though that debt investments are considered defensive and therefore lower risk. So, while they offer many benefits, they do typically provide lower returns than other riskier investments like shares, alternatives, infrastructure or property. While debt investments are considered to be a less risky form of investment they are still subject to risks including credit risk – the risk that the borrower fails to pay, and interest rate risk – the risk that higher interest rates will decrease the value of debt investments issued with a lower interest rate .