A bond is like a loan. When an investor buys a bond, they are effectively lending money to the issuer of the bond.

The issuers of bonds can include the Australian federal and state governments, foreign governments, Australian and international companies and other entities.

Bond mix

Bonds have three major components: face value, coupon rate and maturity date. The face value (also called the ‘principal’) is the amount repaid to the bond owner at the maturity date unless the bond issuer defaults or fails to meet their obligations under the bond. The coupon rate is an annual rate of interest payable on the face value of the bond. The higher the coupon rate, the higher the interest payments the bond owner receives over the life of the bond. Typically, bonds make interest payments semi-annually.

Bonds have a stated maturity date. Generally, this is the date bond issuers repay the money that bond owners loaned them. Bonds could have a maturity date that is typically over a year and up to ten years or more.

What factors affect the value of bonds

The market value of bonds can be affected by interest rates, the credit quality of the bond issuer (the borrower), inflation expectations and the length of time to maturity. As inflation expectations increase or credit quality of the issuer decreases, the price of the bond decreases, reflected as a higher market interest rate for the bond. The price of bonds with longer maturity dates are typically more affected by these factors compared to bonds with shorter maturity dates.

Rest revalues its portfolio of bonds on a regular basis to take account of the changes in the market value of bonds, which could rise and fall.

Our investment managers for each asset class are listed in the How We Invest section of our website.

How do interest rates affect bond values?

Over the life of a bond its market value (i.e. price) will go up and down. One of the key drivers of the price of bonds is changes in interest rates. The price of a bond rises when interest rates fall. Conversely, the price of a bond falls when interest rates rise. Expectations of changes in interest rates can also affect the price of a bond before interest rates actually change, as investors anticipate the change.

For example, let’s say you buy a 10-year bond when the market interest rate is 2%. If market interest rates then rise or are expected to rise to 3% soon after and you want to sell that bond, the person buying it will not want to pay for an asset only paying an income of 2% when they can expect to earn 3% on a similar bond. Therefore, you would have to sell the bond at a lower price than what you paid – resulting in a capital loss. Conversely, buying a bond at a 3% yield and selling it at a 2% yield would result in a capital gain (all else being equal).

Why invest in bonds?

Investing in bonds provides:

  • Regular and defined income in the form of coupon payments
  • Returns with typically less volatility than investing in growth assets like shares, thereby playing an important role in portfolio diversification

What are the risks?

Key risks of investing in bonds include:

  • Credit risk - the risk that the bond issuer cannot pay the bond coupons and/or the bond principal
  • Interest rate risk - the risk that a change in interest rates will affect the value of the bond
  • Liquidity risk - the risk that the bondholder cannot easily trade the bond and is therefore forced to sell at a discount to market value

The risk of a bond also depends on where it ranks within an issuer’s capital structure and terms and conditions specific to each bond contract:

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Holders of senior secured bonds are ranked highest in the capital structure and have priority claim to the assets of the issuer in the event of default. Holders of senior unsecured bonds will have next priority, followed by subordinated bond holders and so on in moving down the rankings within the capital structure.