Recently we have been able to gain exposure for our clients to the wholesale corporate bond market. We see this as a great alternative to the recently issued bank preference shares as they are lower risk, and offer greater protection in the advent of a market downturn.
Firstly, what is a bond and how do they work?
A bond is simply a loan or an IOU from an investor to an issuer (such as the government, a bank or corporation). Think of the loan you take out from the bank to buy a house. The bank expects to be repaid interest and principal. If you fail to make the payments you break the contract and the bank has rights to recover its funds. Bonds work in much the same way. The investor agrees to lend money to the issuer who must then honour that legal obligation by paying back interest and principal. The interest payments (coupons) are typically made by the issuer twice a year and the principle is paid back at maturity.
Bonds are traded on a market much like shares and their price fluctuates from day to day. Generally speaking, we will aim to hold the bonds until maturity when they are paid back at face value – usually $100. As such, we are not overly concerned with the day to day fluctuations in price and holding bonds until maturity will also reduce brokerage as there will be no exit charge. If, however an investor wants to sell their bonds before maturity they do expose themselves to the risk of selling below their purchase price and they will incur brokerage.
Different Types of Bonds:
Fixed Rate bonds – A fixed rate bond pays a fixed amount for the life of the bond, known as the coupon rate.
Floating rate bonds – A floating rate bond pays income linked to a variable benchmark. The margin over the benchmark is fixed and set when the bond is first issued, and income will rise and fall over time as the benchmark changes.
Inflation linked bonds (ILBs) – An ILB is a security linked to the consumer price index (CPI) or inflation. Therefore the capital value of the bond grows with inflation.
Some key benefits of bonds include:
- Regular income – the bonds interest accrues daily and is generally paid twice a year.
- Diversification – bonds provide a different type of return to shares and property.
- Liquidity – although it is our intention to hold the bonds until maturity, bonds can be bought and sold prior to maturity.
- The minimum investment for bonds is $10,000. This is much lower than a managed fund where the minimum is usually $20,000.
- Lower risk – many of the recent bank hybrids contain caveats that put the owners capital at risk in the advent of a downturn. These hybrids also do not allow the holder to be rewarded should the bank perform better than expected.
Ian Maloney is the manager of the share trading division at Capricorn Investment Partners and the Pentad Group with over 10 years’ experience. He has a back ground in direct equities and fixed interest investments and sits on the Investment Committee.