Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market
Over recent months the Reserve Bank of Australia (RBA) has increased the cash rate by 50 basis points from 4.75% to 5.25%. For many people, this will not only affect their mortgage repayments, but also their return on Bonds and Hybrid
Securities listed on the ASX.
As interest rates rise, the market value of fixed Interest Rate Securities (Bonds and Hybrids) falls. This is a result of buyers moving away from issues at old rates and taking up new issues at the higher interest rates.
Current holders of fixed interest securities also tend to move out of their holdings seeking these new higher rates of return. Consequently as the demand for old fixed interest securities decreases and their supply increases, their market price tends to fall.
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it “matures,” or comes due.
Among the types of bonds you can choose from are: U.S. government securities, municipal bonds, corporate bonds, mortgage and asset—backed securities, federal agency securities and foreign government bonds.
In the australian market it is also similar to australian rate securities
Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This “extra” comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you’ll get back if you hold the security until maturity.
For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you’ll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you’ll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you’ll get your $1,000 back.
Interest Rate Securities with a floating rate of return have the ability to buck this trend. By virtue of their yield calculation being made as a margin over a current market rate (generally the Bank Bill Swap Rate), their yield is free to move upwards in line with increased rates. These securities are listed on the ASX Interest Rate Market and are known as Floating Rate Notes.
Also listed on the ASX Interest Rate Market are Hybrid Securities. The market price of Hybrids will act in the same way as Bonds. However Hybrids do have additional features beyond a standard Bond. Hybrid securities are able to offer investors a dividend payment as opposed to a coupon payment. If the dividend is fully franked then holders of the Hybrid will be eligible to receive a tax benefit. Put simply, if a Company has already paid tax on their profits and then pass these profits on to you the investor, the dividend will not be taxed a second time.
Conventional theory dictates that rising interest rates will tend to have a negative or bearish effect on the sharemarket.
Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market.
1) Retirement – The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills.
2) Shorter time horizons – Say a young executive is planning to go back for an MBA in three years. It’s true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment
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Interest rate investments provide investors with a steady and reliable income stream, whereas returns from share investments fluctuate in line with the profitability of the company. Interest Rate Security holders can be seen as creditors of an entity and their return is a fixed rate of interest paid regularly until the face value of the security (the loan principal) is repaid by the entity at maturity. Being creditors, Interest Rate Security holders have prior claim on the entity’s assets relative to shareholders in the event of winding up.
Interest Rate Securities can help you reduce risk and diversify your investment portfolio. By combining Interest Rate Securities and shares in a portfolio, investors can maximise return, minimise risk and achieve an ‘optimised portfolio’ where risk equals reward.
Diversification is achieved by having a number of different asset classes in an investment portfolio as well as increasing the number of individual investments within an asset class.
Interest rate investments can also be used for a number of different and concurrent reasons, including to stabilise a portfolio, to reduce its overall risk or to provide a temporary haven for profits. In the short term, they can also be useful in helping preserve the value of an investor’s capital while you wait for new investment opportunities.
The Bonds & Hybrids booklet can enable you to learn more about Interest Rate Securities. It explain the characteristics of the securities, factors that influence their value and how to trade them
> Bonds & Hybrids Booklet (pdf 215 KB)
Check out some australian bonds here below