Bond Investing

Plain Talk

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Contents
Introducing bonds 1
What is a bond? 1
Types of bonds 3
How do bonds work? 4
How interest rates affect bond prices 5
Investing in bonds 6
Bond credit ratings 9
What role do bonds play in your portfolio? 10
Bonds versus cash and term deposits 13
The allocation decision 14
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Introducing bonds
An allocation to bonds can play a vital role in helping reduce risk in your overall
portfolio and enhance your prospects of growing your wealth.
Bonds and other xed interest assets can sometimes seem quite daunting to many
investors as they typically use structures and investment concepts that seem complex
or unusual. In this Plain Talk Guide we aim to break through any confusion and provide
a clear explanation of what bonds are, how they work and how adding them to your
portfolio can give you a better chance of meeting your long-term nancial goals and
expectations.
What is a bond?
A bond sits within a portfolios xed income allocation alongside products such as
cash and term deposits. These assets are classied as income assets as they provide
a steady and reliable stream of income. They are also known for their lower risk prole
which is why they dont offer the same capital growth potential that riskier growth
assets such as shares offer.
A bond operates like an IOU, whereby you lend your money to an issuer for a set
period of time in return for interest payments over the term of your investment. Your
investment, or capital, is then paid back to you in full at the end of the term known as
maturity.
Whether your objective is to generate
income, achieve greater diversication
or reduce volatility in your portfolio, an
investment in bonds can be a smart choice.
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Types of bonds
As an investor you can choose from a wide array of investment options as bonds
come in a range of credit qualities and maturities and from a variety of issuers.
The main types are:
Government bonds
Issued directly by a government and are explicitly guaranteed. For example, in
Australia the Federal Government issues Commonwealth securities to help pay for
major government projects.
State government, quasi-government or supranational bonds
Not issued directly by a government but might have a direct or implied guarantee.
For instance, state governments and other entities that have a government guarantee
(such as the World Bank, which has multiple government guarantees) issue bonds to
support their nancial needs or to nance public projects.
Corporate bonds
Issued by large public companies to fund expansion and other major projects,
corporate bonds differ in two important ways to government bonds, in yield and credit
quality. Generally, corporate bonds are thought to have a higher level of risk than
government or state government bonds, so they typically offer higher interest rates.
Bond markets
Did you know that bond markets are the largest capital markets in the world?
Most people dont realise that they dwarf sharemarkets in size. Bond markets
are extremely liquid and play an important role in the worlds nancial systems.
Nearly all economies around the world have bond markets, each bringing its own
set of issuers, investors and intermediaries, and its own set of xed interest
securities.
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How do bonds work?
As Figure 1 below shows, all bonds have the same basic structure: a schedule of
coupon (or interest) payments and the return of the capital amount upon maturity.
Incidentally, the interest you receive on a bond is called a coupon because in the past,
investors actually clipped coupons from paper bonds and presented them to get their
interest. The coupon reects the term of the loan, the prevailing level of interest rates,
and the borrowers creditworthiness at the time of the loan.
As well as holding bonds to maturity, you can also trade them in the secondary market
before maturity. Existing bonds are constantly being traded around the world and their
value changes along with market interest rates. These secondary markets are usually
the domain of professional investors such as large banks, brokers and fund managers
which trade bonds in order to prot from price uctuations or generate coupon income
among other objectives.
Figure 1. A bonds lifetime
Coupon
Payment
Coupon
Payment
Coupon
Payment
Coupon
Payment
Principal
Paid
Principal
Returned
T1 T0 Period
Bond Issued Bond Matures
Cashflow in
Cashflow out
T2 T3 T10
Interest rates fall
Interest rates rise
Investors can buy bonds
with higher yield.
Have to sell bond at less
than face value.
New bonds are offered
with lower yield.
Bond can be sold for more
than what was paid.
Investment in a 10-year bond
A bonds lifetime
Source: Vanguard.
Bond yield
B
o
n
d

p
r
i
c
e
Slide 2
Fig 4
Fig 2
Slide X
Fig 1
Bond characteristics
Source: ECB, January 2012
2005 2006
0
5
10
15
20
25%
2007 2008 2009 2010 2011 2012
1
0
Y

G
o
v
e
r
n
m
e
n
t

B
o
n
d

Y
i
e
l
d
France Germany Ireland Greece Spain Portugal Italy
Sharply diverging yields in the Eurozone
Calendar year returns for Australian equities and bonds
From 31 December 1989 to 31 December 2011
Sources: UBS, IRESS, Vanguard calculations, January 2012.
Year ended 31 December
Bonds (UBS Composite Bond Index)
Equities (ASX 300 Index Chained to All Ordinaries Index before 31/3/2000)
-50
-40
-30
-20
-10
0
10
20
30
40%
06 05 04 03 09 11 08 07 94 93 92 91 98 97 96 95 02 01
2000 2010
99
A
n
n
u
a
l

R
e
t
u
r
n
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How interest rates affect bond prices
The inverse relationship between bond prices and interest rates can be confusing, but
we can think of it as a kind of seesaw. Suppose you are invested in a 10-year bond
that pays 4.5% in interest. If interest rates rise to 5.5%, other investors will be able to
buy new bonds that pay better. So if no one is willing to pay full price for a 4.5% bond,
and you want to sell your bond, you would have to take less than its face value. But if
interest rates fall instead, and new bonds are issued with a 3.5% rate, youll probably
be able to sell your bond for more than you paid.
Investors who invest in bond funds as part of a long-term strategy shouldnt worry
too much about these price declines. In fact, for a long-term investor, news that bond
prices are falling is a real positive. Why? Because the fund will be able to invest in new
bonds that pay higher interest rates. Over the long term, reinvested interest payments
will be the source of most of the wealth accumulated in an investment in bonds.
Figure 2. The relationship between interest rates and bond prices
Coupon
Payment
Coupon
Payment
Coupon
Payment
Coupon
Payment
Principal
Paid
Principal
Returned
T1 T0 Period
Bond Issued Bond Matures
Cashflow in
Cashflow out
T2 T3 T10
Interest rates fall
Interest rates rise
Investors can buy bonds
with higher yield.
Have to sell bond at less
than face value.
New bonds are offered
with lower yield.
Bond can be sold for more
than what was paid.
Investment in a 10-year bond
A bonds lifetime
Source: Vanguard.
Bond yield
B
o
n
d

p
r
i
c
e
Slide 2
Fig 4
Fig 2
Slide X
Fig 1
Bond characteristics
Source: ECB, January 2012
2005 2006
0
5
10
15
20
25%
2007 2008 2009 2010 2011 2012
1
0
Y

G
o
v
e
r
n
m
e
n
t

B
o
n
d

Y
i
e
l
d
France Germany Ireland Greece Spain Portugal Italy
Sharply diverging yields in the Eurozone
Calendar year returns for Australian equities and bonds
From 31 December 1989 to 31 December 2011
Sources: UBS, IRESS, Vanguard calculations, January 2012.
Year ended 31 December
Bonds (UBS Composite Bond Index)
Equities (ASX 300 Index Chained to All Ordinaries Index before 31/3/2000)
-50
-40
-30
-20
-10
0
10
20
30
40%
06 05 04 03 09 11 08 07 94 93 92 91 98 97 96 95 02 01
2000 2010
99
A
n
n
u
a
l

R
e
t
u
r
n
One of the most important relationships to
know about when investing in bonds is that
bond prices and interest rates tend to move
in opposite directions. When interest rates
rise, bond prices fall; when interest rates fall,
bond prices rise.
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Investing in bonds
Individual bonds
One of the primary advantages of investing in individual bonds is the ability to control
cash ow by matching a bonds maturity date with your specic income needs.
It can, however, be quite costly to buy a portfolio of bonds with an adequate level of
diversication. There are typically large transaction costs involved and there is only a
relatively small selection of bonds available to trade in small parcels. This is why most
participants trading in these markets are major nancial institutions or large investors.
Bond funds
It can be much more convenient, and cost effective, to capture bond market returns by
investing in a bond fund rather than individual bonds.
Bond funds come in a variety of bond investment strategies, across government and
corporate issuers, and are a much cheaper means of acquiring an exposure to a broad
set of bonds. Investing this way costs less because managed funds have access to
institutional pricing (that is on far more favourable terms than retail pricing) by
transacting in much larger market parcels.
Types of bond funds
Bond index funds
These funds are collections of bonds that are intended to mirror the performance of a
particular market benchmark or index. The primary advantage of bond index funds is
their low costs.
Bond exchange traded funds (ETFs)
Bond ETFs are similar to conventional bond index funds. However, as ETFs are
traded throughout the day like individual securities, bond ETFs offer additional trading
exibility not available from conventional bond index funds.
Actively managed bond funds
These funds are managed by individual investment managers that pick bonds with the
intention of outperforming a funds benchmark. Actively managed bond funds offer
investors the opportunity for higher returns than bond index funds, though usually at
relatively higher costs.
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Factors to consider when investing in bond funds
Credit quality
Independent credit rating agencies, such as Standard & Poors and Moodys Investors
Service, evaluate the ability of bond issuers to meet their coupon and principal
payment obligations. These agencies assign credit ratings ranging from Aaa or AAA
(highest quality) to C or D (lowest quality).
When considering a funds credit quality, most investors should be looking for
those that hold investment grade bonds, that is, Baa or BBB and above. This is
because investment grade bonds reect a very low probability of default compared
to sub-investment grade bonds. (See the table on the page 9 for a complete list of
Standard & Poors and Moodys bond credit ratings.)
Yield to maturity
A funds weighted average yield to maturity can be thought of as its expected
annualised return if all bonds in the portfolio were held to maturity, and future coupon
and principal receipts are reinvested at the yield to maturity. However, the fund will
generally need to sell bonds before they reach maturity in order to reect changes
in benchmark from new bond issuance, and interest rates will change through time.
So while the yield to maturity wont be the exact return you receive, it can provide a
good guide.
When the yield to maturity on a bond fund rises, this implies that the market prices
of the underlying bonds have fallen, which then leads to a decline in fund value. The
opposite is also true when yields decrease.
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Bond credit ratings
Bond credit ratings are important because they indicate how much an issuer must
pay to borrow money and compensate investors for assuming credit risk. This is the
chance that a bond issuer will fail to pay interest and principal in a timely manner or
that negative perceptions of the issuers ability to make such payments will cause the
price of a bond to decline.
The lower a bonds credit rating, the higher the interest rate the borrower must pay to
entice investors to purchase the bond. Moodys and Standard & Poors are the major
bond credit-rating agencies and though their rating systems are similar, they are not
identical.
A bonds credit rating reects the independent rating
agencys opinion of the issuers ability to pay interest
on the bond and, ultimately, to repay the principal at
maturity. If payments arent made in full and on time, the
issuer has defaulted on the bond.
Moodys and Standard & Poors bond-rating codes
Moodys S&P Rating
Investment-Grade
Bonds
Aaa AAA
Highest quality with lowest risk; issuers are
exceptionally stable and dependable.
Aa AA
High quality, slightly higher degree of long-term
risk.
A A
High-medium quality, many strong attributes
but somewhat vulnerable to changing economic
conditions.
Baa BBB
Medium quality, adequate but less reliable over
the long term.
Below
Investment-Grade
Bonds
Ba BB
Somewhat speculative, moderate security but
not well safeguarded.
B B Low quality, future default risk.
Caa CCC Poor quality, clear danger of default.
Ca CC Highly speculative, often in default.
C C Lowest rating, poor prospects of repayment.
D In default.
Source: Standard & Poors and Moodys Investors Service
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What role do bonds play in your portfolio?
Bonds have traditionally fullled four important roles in a portfolio:
Income stream
Most of the investment return for bonds is coupon income. For a broad portfolio
of bonds, these coupon (or interest) payments can constitute a reliable stream of
income. Figure 3 shows that in contrast to shares, which have historically provided
income and capital appreciation, the total return for bonds has primarily been
comprised of income.
Capital preservation
Bonds can also provide capital stability. A bonds principal is returned to you as the
investor when it matures, which makes a bond an effective capital preservation tool,
assuming of course that the issuer is of high credit quality. For example government
bonds, which are backed by the full faith and credit of a sovereign government, are
often referred to as risk-free because a government theoretically can raise taxes or
create additional currency to meet its obligations when its bonds mature.
Figure 3. Components of total return, 1997-2012
Capital growth Income
Source: Vanguard

Australian Shares Index Fund and Vanguard

Australian Fixed Interest Index Fund

0
2
4
6
8 %
Australian shares Australian bonds
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Store of liquidity
Bonds can be used as a store of liquidity. In fact, many central banks around the
world exchange cash for bonds when they implement monetary policy and when
they act to stabilise turbulent markets. Smaller investors are also able access this
liquidity in a cost-effective way through bond funds which usually allow you entry or
exit on a daily basis.
Diversication of returns
Bonds can also help to reduce the risk in your portfolio by dampening the volatility of,
and providing diversication to, sharemarket returns. This is why bonds are described
as a defensive asset. While the prices of bonds will uctuate according to interest
rate and economic cycles, they historically have been nowhere near as volatile as
share prices.
As we can see in Figure 4 below, bonds returns have tended to be positive even
when returns on shares have been negative. This is what analysts are referring to
when they say there is a low or negative correlation between the returns of bond
markets and sharemarkets. It is this low or negative correlation between asset
classes that provides the diversication every well-balanced portfolio needs.
Figure 4. Calendar year returns for Australian shares and bonds
Fig 4
Calendar year returns for Australian equities and bonds
From 31 December 1989 to 31 December 2011
Sources: UBS, IRESS, Vanguard calculations, January 2012.
Year ended 31 December
Bonds (UBS Composite Bond Index)
Shares (ASX 300 Index, prior to 31/3/2000 All Ordinaries Index)
-50
-40
-30
-20
-10
0
10
20
30
40%
06 05 04 03 09 11 08 07 94 93 92 91 98 97 96 95 02 01
2000 2010
99
A
n
n
u
a
l

R
e
t
u
r
n
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Bonds versus cash and term deposits
Given their apparent similarities, many investors mistakenly consider cash and term
deposits as a substitute or alternative to bonds. However, while these investments all
offer features such as capital preservation, liquidity and income, there are signicant
differences in their proles.
Cash and term deposits can be better described as savings vehicles rather than an
investment. They are better suited to help cover known short-term liabilities or meet
near-term nancial goals.
Investment in term deposits can also lead to reinvestment risk. That is, because
your principal is fully returned to you at the end of each year you are exposed to any
interest rate changes that have occurred in this time. This can have a substantial
impact on your return the following year if attractive interest rates are no longer on
offer.
In addition, if you are holding term deposits while you wait for the ideal time to
enter the sharemarket this introduces liquidity risk. That is, there are generally penalty
fees imposed if you need to quickly release your cash.
In contrast, bonds will offer higher expected returns over the long term for investors
willing to take on slightly more risk. These higher returns are compensation for
investors taking on increased levels of interest rate risk and credit risk exposure.
In this sense, bonds generally suit an investor with a longer investment time horizon.
Bonds versus cash and term deposits
Investment
type
Risk
prole
Capital
growth
Credit
risk
Total
return
potential
Investment
time
horizon
Liquidity
Cash/Term
deposits
Low No Lower Lower Up to
1 year
Varies. Term deposits
are only accessible
before term with
penalty fees.
Bond funds Low to
Medium
Limited
potential
Higher Higher 3 year High. Generally allow
entry or exit on a daily
basis.
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The allocation decision
So what is the correct level of bonds to include in your portfolio and how do you go
about incorporating bonds into your asset mix to gain this exposure? Any decisions on
asset allocation should start by establishing goals, working out a timeframe (how long
until you need to cash in your investment) and then evaluating your risk prole. Once
you develop and execute your asset allocations, regular rebalancing helps to keep the
portfolio on track.
Your risk prole relates to how comfortable or otherwise you are with levels of risk
in the investment mix. Generally, the higher the expected return of an investment,
the higher the risk, so on the spectrum cash follows bonds, follows property, follows
shares. And generally risks are lessened the longer the investors holding period.
If you consider yourself a conservative investor, a rule of thumb that Vanguards
founder, Jack Bogle, likes to cite to determine what the portfolio mix should be, is
that the defensive allocation should be proportional to your age. For example, if you
are 40 you should hold 40 per cent xed-interest assets (therefore 60 per cent growth
assets); at 60 you should have a 60/40 split between bonds and shares, and so on.
This approach may not be suitable for everyone, which is why a good nancial adviser
can add signicant value by considering your overall nancial situation and help to
determine your propensity for risk.
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The indexing pioneers
Vanguard pioneered the concept of indexing, introducing the rst retail index fund
in the US in 1976. Since then, The Vanguard Group, Inc. has grown into one of the
worlds largest and most respected investment management companies. Vanguard
now has global presence with ofces in the US, Australia, Asia and Europe. In Australia,
Vanguard has been helping investors meet their long-term nancial goals with low-cost
indexing solutions for more than 15 years.
Vanguards range of managed funds and ETFs
Vanguard offers a complete range of funds across all asset classes that can be used
as a diversied standalone portfolio solution, or in conjunction with active funds as
part of a core-satellite approach.
For more information on our product offerings please visit www.vanguard.com.au.
Vanguards range of Plain Talk Guides
At Vanguard, we believe it is just as important to know about the potential risks of your
investments as well as the rewards. Thats why we publish our Plain Talk Guides on
a range of popular investment topics. After all, better informed investors make better
investment decisions.
Our PlainTalk range includes:
Understanding indexing;
Realistic sharemarket expectations;
Building your investment portfolio;
Investing for income;
Self managed super funds;
Superannuation;
Managed funds;
Exchange traded funds; and
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