Understand the simple maths that underpins bonds and you’ll understand why it makes sense to include bonds in your investment portfolio.
Life is complicated – bonds are not
(Rick Van Ness – Why Bother With Bonds, 2015)
Despite their apparent complexity, bonds are simple investments. Once you understand the simple maths underpinning the rationale for investing in bonds, you’ll understand why it makes sense to include bonds in your investment portfolio.
The first thing to remember is that a bond is a simple interest only loan, made to a government, semi-government authority or company.
The second – and important – thing to keep in mind is that with bonds, there are no surprises…bonds are predictable!*
You loan a certain amount of money for a specific amount of time and receive scheduled interest payments of fixed amounts at fixed times. At end of the term, you get your money back if you bought the bond at issue, or its face value if you bought during the bond’s term.
Corporate bonds are reliable and predictable
If a government or a corporate want to borrow money – whether to fund research and development, an infrastructure project, an acquisition – it has two options. It can borrow from a bank or issue bonds and borrow from investors.
While it’s well accepted that government bonds, particularly those issued by stable governments in developed nations, are reliable and predictable, investors don’t always view corporate bonds the same way.
Although there is always the risk of default – in which case the bond would be neither reliable nor predictable – avoiding the ‘junk bond’ end of the corporate bond market can considerably reduce this risk.
Read more about why companies issue bonds.
Figure one: A bond’s cashflow
Source: Australian Corporate Bond Company
As illustrated in figure one, when a bond matures, the loan – otherwise known as the ‘principal’ or ‘face value’ – is repaid.
If you buy the bond at issue, you receive the same amount – the face value – at maturity.
If you buy the bond after it’s been issued, you may pay less or more than the face value – you still receive the face value at maturity.
TABLE 1: The Maths
|PRICE PAID||AMOUNT RECEIVED AT MATURITY|
Also illustrated in figure one is your income; during its lifetime, a bond delivers a steady stream of income, normally paid quarterly or semi-annually, known as the coupon.
What’s more, you know exactly how much you will receive and when. That makes planning for fixed expenses a whole lot easier!
TABLE 2: The Maths (assuming an investment of $100,000)
|KEY MEASURES||$100,000 BOND INVESTMENT|
|Total interest for bond held for three years||$15,000|
Correlation of bonds and equities
Correlation is another mathematical concept, and one that every investor should understand.
At its simplest, the correlation of assets is a measure of whether the prices of each move together or independently from one another. Low or negative correlation means they generally move independently.
Conventional wisdom suggests an inverse relationship, or low correlation, between shares and bonds. In other words, when share prices go down, bond prices go up. While that’s a simplistic way of looking at a complex relationship, it does make sense. When sharemarkets are volatile and equity risk increases, investors flock to the relative safety of bonds.
The upside for investors with bonds in their portfolio is twofold:
- Firstly, the predictability of income and return of face value at the bond’s maturity does not change despite volatility.
- Secondly, overall portfolio returns benefit, as the positive return from bond investments can offset losses from the equity exposure.
The net effect of investing in negatively correlated assets is a smoother profile of returns for your portfolio. The large upside is reduced, but importantly, so is the large downside. This is why for many years asset allocators include a portion of both Bonds and Equities in their portfolio. It is often referred to as ‘diversification’.
The Maths – Negatively correlated assets, even one another out in a portfolio
Bond funds and ETFs
Until recently, average parcel sizes of $500,000 made it hard for many investors to get direct access to corporate bonds. As a result, most investors have exposure to bonds via managed funds or Exchange Traded Funds (ETFs).
Investment managers offer a range of bond funds, spanning domestic and global bonds. These funds invest in an array of government and semi-government bonds, corporate bonds and high yield credit.
As well as being difficult to keep up-to-date with the composition of bond funds, there is one crucial factor all investors should be aware of, bond funds and ETFs are perpetual investments. Perpetual investments cannot deliver the same level of predictability that individual bonds can. It’s these predicable investment outcomes that make bonds such a reliable inclusion in your investment portfolio.
A bond fund will receive the face value when each bond in the portfolio matures, however this is generally reinvested into new bonds, not returned to investors for you to choose how to invest it.
A bond fund will receive the regular income from each bond in the portfolio, but it’s not passed through to investors. Rather, the income is distributed, adjusted for capital gains and losses, half-yearly or quarterly. You won’t know exactly how much that will be, or if losses will mean there is no income to distribute.
There are three key features of bond funds or bond ETFs that investors should be aware of. THEY LACK:
1. A fixed date for a return of capital;
2. A fixed amount you will receive; and
3. Predictable income.
These features negate the purpose of fixed income, which is all about a return of capital and income predictability.
The Maths: ETFs are designed to track the return of a specific index, minus fees.
The chart below compares ETFs, the relative indices and a portfolio of XTBs.
IAF – iShares Core Composite Bond ETF. VAF – Vanguard Australian Fixed Interest Index EFT. VACF – Vanguard Australian Corporate Fixed Interest Index ETF
Source: Australian Corporate Bond Company & Bloomberg**
XTBs – every day access to corporate bonds
Exchange-traded bond units – or XTBs – provide investors with easy access to corporate bonds. Through XTBs, you can benefit from the mathematical genius that is corporate bonds!
- the same coupons – the regular income paid by the bond issuer, and
- the same repayment of principal – the face value of the bond paid back by the issuer when the bond matures, that they would have received had they invested directly in the bond itself.
Add to that, you can buy and sell XTBs on ASX just as you would shares in a listed company. By accessing corporate bonds through XTBs, you effectively lend money to an ASX-100 company. You can either preserve your capital by holding the XTB to maturity, or sell on ASX at any time during the life of the XTB to realise the capital.
With each XTB priced from $100 ~ $120, incorporating corporate bonds into your portfolio has never been easier. Being exchange-traded means they can be bought and sold at any time, providing you with liquidity and flexibility.
Exchange-traded bond units, or XTBs for short, are becoming increasingly popular due to their simplicity, affordability and convenience. Because they are traded on ASX, investors can easily monitor the value of their investment, as they do with their share portfolios. This transparency makes it easy to see that it’s maths – not magic – that makes XTBs a worthwhile addition to your investment portfolio.
Find out more about How to Buy and Sell XTBs
Watch the video of How to Buy and Sell XTBs
Making the maths easy
To help you select a portfolio of XTBs to meet your needs, we have devised some easy-to-use tools that do all the maths for you.
Cash Flow Tool
This online tool enables you to build a portfolio of XTBs and see exactly what income you could receive. It allows you to pick up to 10 XTBs and chart the income you would receive year to year, and over the lifetime of your chosen bonds.
You may elect to use one of our ‘starter portfolios’; each of which is a portfolio of pre-selected XTBs developed by our CIO, Ian Martin. These portfolios help take the guesswork out of investment selection. Each starter portfolio has up to five individual XTBs. You can choose one of these portfolios and, if desired, add other XTBs to it, or you can create your own portfolio. Use the Cash Flow Tool to model your decisions and ensure the cash flow is appropriate for you.
The results are presented in an interactive graph that displays your income payments across the lifetime of investment, or across a single year. It shows exact payment dates and income payments, as well as income and capital outlay of the portfolio and net return; this way you can track how your XTB portfolio will perform over time. No magic, just total transparency.
Check out the Cash Flow Tool
Available XTBs Interactive Table
The list of available XTBs can be sorted on a range of parameters such as yield or maturity date. It can also be filtered by several criteria. Want to invest responsibly? You can filter for that. Interested in floating-rate securities? You can filter for that too.
It also provides a handy average functionality at the bottom of the table. This allows you to check how your portfolio is shaping up.
Check out the Available XTBs Table
The yield calculator helps you to calculate the Yield to Maturity of an XTB or corporate bond based on the traded price. It can help you determine which XTB may be a more suitable investment for you, by comparing the Yield and/or Trading Margins available.
The calculator can be used to:
- Calculate the yield to maturity based on the XTB price or
- Calculate the XTB price based on the required YTM
The tool works for both fixed-rate and floating-rate XTBs. It also provides details of all interest payment date and ex-coupon dates.
Check out the Yield Calculator
*Assuming no default
** Some of the ETFs invest in bank deposit accounts, Australian Treasury, Australian semi-government entities, supranational and sovereign entities as well as Australian corporate entities, while XTBs provide exposure to Australian corporate bonds only.