Here’s why you might consider adding government bonds to your investment portfolio.
When considering where to store personal savings, most would think of term deposits and savings accounts. For investing, it’s usually shares or property. But what about bonds? Where do they fit in the mind of the everyday punter, if anywhere at all?
It’s likely many investors either don’t understand bonds or don’t consider them as ‘sexy’ an investment option as stocks or property.
But when properly utilised, this often underrated asset can be a valuable component of your investment portfolio.
What are Australian government bonds?
A bond is a low-risk investment product. There are two main types of bonds – government bonds, which we’re focusing on here, and corporate bonds. With a government bond, investors lend money to the government (state or federal) for a set period of time at a pre-determined rate of return. Bond owners receive regular interest repayments in addition to their lump sum investment at the end of the term.
They’re low-risk because you’re lending to the government, who are unlikely to default on this debt. As an asset, bonds are generally considered to have the second-lowest risk, after cash (i.e. money in savings accounts or term deposits, which are protected by the government deposit guarantee. Theoretically, governments can raise taxes or create extra currency to meet their bond obligations at maturity.
Some Australian government bonds can be traded on the Australian Securities Exchange (ASX) as exchange-traded treasury bonds or exchange-traded treasury index bonds. We’ll go into more detail about these later.
Australian government bond interest rates
Technically, bonds don’t have standard interest rates. Instead, they have two components: the yield to maturity (YTM) and the coupon interest rate.
Coupon interest rates on government bonds
The ‘coupon’ interest rate on a bond is a fixed rate set by the Australian Government for the life of the bond. This rate varies depending on the length of the bond.
|Australia Bond 2 Year Yield||5.75% p.a.|
|Australia Bond 5 Year Yield||2.75% p.a.|
|Australia Bond 10 Year Yield||3.25% p.a.|
|Australia Bond 15 Year Yield||2.75% p.a.|
Source: Bloomberg, January 2019.
Investing $100 into a hypothetical government bond with a 5.00% p.a. coupon interest rate would pay you $2.50 every six months, before paying your $100 back at the end of the bond’s term.
There are some bonds that have a floating rate – that is, the rate changes with fluctuations in benchmark interest rates. If interest rates drop the value of your bonds will increase, and vice versa.
These types of bonds have potential for higher highs but also lower lows.
Yield to maturity on government bonds
The yield to maturity is the rate of return on your bond if purchased at the current market price and held until the maturity date. This will be different to the coupon interest rate, and it will vary through time with changes in the bond’s price and length of time until it reaches maturity.
|Australia Bond 2 Year Yield||$108.93||1.82%|
|Australia Bond 5 Year Yield||$103.90||1.96%|
|Australia Bond 10 Year Yield||$108.76||2.28%|
|Australia Bond 15 Year Yield||$102.82||2.52%|
Source: Bloomberg, January 2019.
Returns on government bonds
According to the ASX’s 2018 Long-Term Investing Report, Australian fixed income (the asset class bonds belong to) averaged returns of 6.20% p.a. over the past 10 years, which is less than Australian residential property (8.00% p.a.) but more than Australian shares (4.00% p.a.) over a period which encompassed the global financial crisis.
10 Year Yields on Australian Government Bonds
How and where to buy Australian government bonds
Institutional investors buy and sell Australian government bonds on what are known as the primary and secondary markets, but for everyday ‘mum and dad’ investors it’s simpler to invest in exchange-traded Australian government bonds on the ASX.
This can be done through your stockbroker/financial adviser, or via an online share trading account. These exchange-traded government bonds can be bought and sold on the ASX like shares. The ASX actually has a comprehensive list of all government bonds here.
There are actually two types of exchange-traded government bonds listed on the ASX:
- Treasury bonds: medium-to-long term debt securities that use the same coupon interest method as discussed above
- Treasury indexed bonds: medium-to-long term bonds where the capital value is adjusted for movements in the Consumer Price Index (CPI) and interest is paid quarterly at a fixed rate.
Buying one unit of a bond on the ASX is the equivalent of $100.
Are government bonds risk-free?
Government bonds are one of the safest investment options since no Australian government has ever defaulted on its debt. But bonds are never entirely risk-free. You’ll generally always receive the face value of your bond back if you hold it until maturity. But if you sell it before maturity, then the bond will be sold at the current market value, which is a price people are willing to pay for it. This price will depend on both inflation and interest rates, so you could theoretically make a capital gain or loss on a bond if you sell it before it reaches maturity.
Bonds are classed as a defensive asset because they can reduce your portfolio’s vulnerability to share market returns. Take this graph from Vanguard Investments for example: from 1991 to 2011, only two years out of 20 saw bonds give negative returns.
Consider getting professional financial advice from ASIC’s financial adviser’s register to discuss if you should add government bonds to your portfolio.
Alternatives to government bonds
Corporate bonds operate in a similar way to government bonds, except you lend money to finance business activities. In return for money, the company issuing the bond pays you the regular interest plus the initial principal at the maturity date.
You can buy corporate bonds through a public offer or through the ASX. Corporate bonds can give greater returns than government bonds but have a higher degree of risk, since companies seeking to raise money can run into difficulties at any time. This is why you should do thorough research on a company before buying a corporate bond from them, looking into their financial performance, the debt-to-equity (gearing) ratio, their ability to pay interest on their debts and so on.
If the company becomes insolvent, you may not get any of your money back!
Insurance (or investment) bonds are a long-term investment offered by insurance companies, designed to be held for at least 10 years. They’re similar to managed funds in that your money is pooled together with other investors, with a portion of these funds then invested in something that each investor chooses, between cash, fixed interest, shares, infrastructure, property and more.
If no withdrawals are made on the investment bond in the first ten years and you limit your contributions to up to 125% of your previous investment every year, then the bond will be tax-free, according to ASIC. To learn more about insurance bonds and their tax implications, read ASIC’s guide.
Savings accounts & term deposits
You might think that bonds are essentially the same thing as savings accounts and term deposits given their similarities, but they’re really quite different. The latter two are more savings vehicles than they are investments. Due to the present low cash-rate environment, you’re not going to see any spectacular returns on either savings accounts or term deposits – the infographic below shows what you can expect. By contrast, bonds can give you higher returns in exchange for slightly higher risk. Both of them offer near-certainty of returns, but bonds give you a greater range of choice.
If you’re looking to save for a short-term goal, then either a savings account or term deposit is probably your best bet. These two options also come with a government guarantee of $250,000, meaning that under the financial claims scheme up to $250,000 of your savings will be returned to you in the extremely unlikely event your institution collapses.
|Investment||Risk||Capital growth||Potential returns||Investment time horizon||Liquidity||Diversification|
|Cash (savings accounts & term deposits)||Lowest||None||Lower||Short and long||Varies. Savings accounts can be withdrawn from at will, but term deposits may require a notice period.||Low – choice is limited to institutions and the interest rates they provide.|
|Bonds||Low/medium||Limited||Higher||Longer||High. You can enter and exit daily.||Higher – different types of bonds (fixed-rate, inflation-linked) with varying yields.|
More commonly known as stocks, equities are quite different to bonds, although with corporate bonds both of them invest in companies in different ways. Here are some ways you can invest in stocks:
- Individual stocks: you can buy ASX listed stocks through a stockbroker or online share trading platform
- Exchange traded funds (ETFs): a type of investment that buys and tracks a group of stocks, giving enhanced diversification in exchange for slightly lower average returns
- Managed funds: your money is pooled together with other investors and actively managed by a fund manager, who buys and sells stocks on your behalf.
According to the ASX’s Long-Term Investing Report for 2018, Australian shares have averaged returns of 4.0% p.a. over the past 10 years. Global shares fare much better at 7.2% p.a. There is less predictability of returns with shares – the market could completely tank one day and lose you 50% of your investment, but it’s commonly accepted that over time the market will rise. Since 1992, the S&P/ASX 200 index has risen from around 1,500 points to almost 6,000 points in January 2019 – that’s an increase of nearly 300%. It’s sometimes just a matter of riding out the loses to experience gains.
S&P/ASX200 Historical Performance
Source: Yahoo Finance.
Savings.com.au’s two cents
Don’t forget about the merits of bonds when looking at your investment portfolio. Shares and property might be flashier, but bonds have a good mix of decent returns and lower risk. Given the turbulence the share and property markets have experienced recently, having defensive assets like bonds and other fixed-income assets in your portfolio can provide some much-needed stability.
Consider consulting a financial advisor before making any investments and keep in mind that past performance is not an indicator of future performance.