It's one method of potentially mitigating some of the risks that can come from share market volatility.
As one of the four asset classes - along with property, cash and shares - fixed income can include term deposits, government bonds and corporate bonds.
Bonds and term deposits have steady performance features that put them in the defensive part of your portfolio.
Bonds and fixed interest securities may be less volatile than shares and can be used to create a balanced portfolio.
How does it work?
- An investor lends money, known as the principal, to a borrower or issuer
- The issuer makes payments in interest, or coupons, to the investor of either a fixed amount, or an amount linked to a moving benchmark; income payments are made on a fixed schedule of dates
- The issuer pays back the principal on a fixed date, which is the end, or maturity, of the investment
A term deposit can be a secure way to invest and a potentially handy solution if you’re concerned about interest rates dropping in the coming months or years.
Your money is in a deposit account for a certain agreed period of time, known as the ‘term’.
An interest rate is locked in for that term so you know the interest you’ll earn on your initial investment amount.
Term deposits can’t be traded like shares, exchange traded funds (ETFs) and exchange traded bonds (XTBs), but they have a fixed life and can provide regular income during that life or at expiry.
Term deposits are one of the lowest-risk investment opportunities, particularly because the government guarantees term deposits up to $250,000 with an Authorised Deposit-taking Institution (ADI).
Australian Government Bonds
The Commonwealth of Australia issues bonds called Commonwealth Government Securities.
They have a predictable cash flow paid on a periodic basis with a specified maturity date.
They can be traded on the Australian Securities Exchange (ASX) in the form of exchange traded Treasury bonds and exchange traded Treasury indexed bonds through a financial advisor, stockbroker or through an online trading account, such as CommSec.
They are low risk, because you receive the face value of the bond if you hold it until maturity.
They provide regular income and they are easy to buy and sell on the ASX.
If you want to sell the bond before maturity, the market price can go up or down depending on the amount of time left until maturity, interest rate expectations and changes to the official cash rate set by the Reserve Bank of Australia (RBA).
For example, the Australian government’s benchmark 10-year bond touched a record low after the RBA cut the cash rate to an unprecedented 1.5% in August 2016.
Bond prices rise as the yield drops, which can occur when the cash rate falls (or the expectation is that it will fall) or when market sentiment increases demand for safe assets.
You can invest in government bonds, either domestic or global, through exchange traded funds (ETFs) or a managed fund to add diversity to your portfolio. An ETF can be a low-cost way of spreading risk across asset classes and can provide some protection against volatility, while a managed fund actively manages to seek higher returns by opportunistically buying and selling bonds.
Using an ETF or managed fund provides access to markets that might otherwise be difficult to enter and enables your portfolio to diversify beyond the Australian economy to gain exposure across regions at times of global economic uncertainty.
Companies have several ways to raise money from investors to finance business activities.
One way is to issue bonds that pay you interest and pay back the principal money you invested on a certain maturity date.
Because you are lending money to the company, you are a creditor, so you stand in front of shareholders for any return if the company goes into voluntary administration. However, there is no guarantee you would get your money back, if that were to occur.
Many investors, including SMSFs, have traditionally invested more than 50% of their funds in cash and Australian shares, with little exposure to fixed-interest investments such as corporate bonds.
Corporate bonds can provide a regular income and higher interest rates than what might be available on term deposits, other cash-based products or government bonds, and they carry less risk than shares.
They can be bought through a public offer, known as the primary market, or through a securities exchange, the secondary market.
Exchange Traded Bond units (XTBs) are securities traded on the ASX, which gives easy access, transparency and liquidity. XTBs are backed by the actual bond and all coupon and principal payments from the bonds flow through to the XTB investor.
Since launching just over a year ago, almost $100m worth of XTBs have traded on the ASX. XTB model portfolios can also be used to further diversify an SMSF and can focus on providing a monthly income stream or on high yield.
ETFs and managed funds are another way of gaining exposure to global corporate bonds to add international exposure and minimise the impact of Australian dollar volatility on returns.
Both government and corporate bonds are rated by agencies including Fitch Ratings, Standard & Poor’s and Moody’s Investors Service.
The rating provides an evaluation of the bond issuer’s financial strength, or its ability to repay the principal and interest.
Ratings range from investment grade, which can be AAA to BBB- (or Aaa to Baa3 at Moody’s), to what is known as ‘junk bonds’ which can carry anything from BB+ to D (or Ba1 to C at Moody’s).
Fixed or floating coupon bonds
The coupon is the annual income paid to investors on set dates throughout each 12-month period during the life of the bond.
This helps investors to accurately forward plan for income from bonds, a feature that is not always certain with other types of investments.
If the coupon is ‘fixed’, the amount will not change over the life of the bond.
A ‘floating’ coupon is adjusted in line with a benchmark rate and can change as the bond moves toward maturity. They tend to trade close to face value, so often they are preferred for investors who need liquidity or who are concerned about possible interest rate movements.