Investing in bonds - what am I missing?

Hi all,

I'm a person new to investing and currently I'm looking into how the bonds work and have a question.

For example, when I go to
RBA: CGS Bond Prices - March 2010

I can see that the highest coupon value for the bond listed is 6.50%, like this:

Series Number . Coupon . Maturity . Closing Yield . Gross Price . Accrued Interest . Capital Price
TB118 . 6.50% . 15 May 13 . 5.260 . 105.964 . 2.442 . 103.522

Also, this bond trades at 103% of face value, which means that if the bond is kept to maturity, the real profit is way smaller than 6.5%

A quick google search tells me that the ANZ offers 6.2% on its term deposits. There are banks that offer more, with larger minimum deposit amounts.

Now, I understand that the word "bond" usually goes with "diversifying the portfolio". And diversifying the portfolio means that I will not lose everything at once, and also, if some part of the portfolio loses, another part will probably win depending on the various factors.

The government bond security is guaranteed by the government. The bank deposits are also guaranteed by the government (up to some amount, as I remember - 250,000?). Looks like they are about equal in risk from this point of view.
Generally, bonds are considered to be slightly higher in risk than cash and provide higher rate of return (but, obviously, I'm missing the mechanism - how do they provide a higher rate of return?)

So, the question is - what is the reason to invest into bonds (as a small individual investor)? Something that makes them at least as attractive as keeping money in the bank?
Let's look at the long term investing returns, assuming I'm not trying to speculate on bond price fluctuations.

(Can we also assume for simplicity that the interest rates remain constant and we're not trying to predict which direction they move in the future?)

Thank you.

 

Bond Basics: Introduction
Bond Definition
Investopedia.com: Bonds Articles and Insight
http://debtreview.treasury.gov.au/content/subs/039.pdf

Also, good reading about bonds is in the book "Fast Money4" written by Edna Carew (p139-174).

 

Hi Evgeny

This what I have learnt about bonds as part of an indexing portfolio.

Bonds go up when interest rate go down.
Bonds go down when interest rates go up.

Bonds are less volatile than shares but have a lower average return.

Govt. bonds are backed by the Australian Government but corporate bonds have higher coupons.

Cash can have its day as the highest earning vehicle. Bonds were high in the late 80's.

If you are into diversity, hold cash, term deposits, Bonds and foreign credit.

You can buy individual bonds or a bond index. With an individual bond, you know the exact day your capital will be returned. Bond index's such as those that follow the UBS Australian Composite Bond Index are never ending as they ladder short, medium and long term bonds.

Hope this helps.




Johny.

 

They do seem very similar on the face of it, but with a term investment in the bank, you get the interest plus your capital back, and that's it.

With a bond, you also get the interest plus your capital back (you hope), but there's an added opportunity.

Consider this: right now, you might have a term deposit of $100 paying 6%. Way back in the mists of time (the 80's?), it was possible to get a term deposit at 17%. Imagine I had a financial time machine and could teleport a $100 investment paying 17% to modern times.

How much would you pay me for my $100 investment?

More than $100, that's for sure.

And so it is with bonds - you can pay more or less than face value, depending on how the rate for new bonds moves.

There's two different games with bonds

a) buy the bond, hold it until maturity, and get your capital plus interest.

b) buy the bond off someone else, hold it for a while, then sell it. You never expect to hold it until maturity.

Obviously (a) is akin to having a term deposit, and obviously (b) is a very different thing - more suited to a trader than an investor.

Disclaimer: I don't trade bonds, so really don't know what I'm talking about.

 

The Ups and Downs of the Bond Market.

If the credit rating of a company goes down (ei. AAA to B) the value of a bond goes down and visa-versa.

If inflation goes up (ei bond 5%, inflation ^6%) the value of a bond goes down.

The worse the liquidity of the bond, the lower the value of the bond.

As the bond's maturity increases, the coupon increases.

Interest Rates: if a bonds coupon = 5% and the interest rates go to 10%, then the value of the bond goes down (ei. sold at a discount).

If a bonds coupon = 5% and the interest rates go to 1% the the value of the bond goes up (ei. sold at a premium).

Also, bondholders are payed Before shareholders in a default.




Johny.

 

I would like to thank everyone who answered that, there is some food for thought there.