Understanding Bonds

7/30/2019 Understanding Bonds

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TheP

lainTalkLibrary Understandingbonds


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Contents

Introduction 1

Bonds a simple definition 2

What is a bond fund? 6

Benefits of bonds 8

Know the risks 11

Costs 14

Take charge with Vanguard 15

Why Plain Talk? 16

Contacting Vanguard Inside back cover

Note: Unless otherwise stated data sources are Vanguard, using market data.

'Vanguard' and the ship logo are registered trademarks of The Vanguard Group, Inc.

Copyright 2003 Vanguard Investments Australia Ltd. All rights reserved.Vanguard Investments Australia Ltd. ABN 72 072 881 086

AFSL number 227263 effective 1 July 2003


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1.

Introduction

Bonds play an important role in many investors portfolios. Adding bonds to your

portfolio of shares and property securities can reduce your overall risk by

diversifying your holdings.

Even though the stock market attracts more attention from the financial media,

Australians have invested more than $160 billion in bond funds to 30 June 2002.*

Bonds can be purchased one of two ways either directly or through a managed

fund and are an excellent option if youre looking to increase your exposure to

interest bearing investments.

Before you decide to invest in bonds, you need to fully understand the

fundamentals including the potential risks and rewards.

Compared to shares, bonds generally sit at the middle to lower end of the risk

spectrum. Cash is a lower risk investment than bonds and over the long term,

bonds are expected to provide a higher rate of return.

Typical risk spectrum

ListedCash Bonds Property Shares

Low Risk High Risk

This plain talk guide demystifies bonds. It explains how bond funds work, their

benefits and risks and how to minimise the costs and maximise your returns from

investing in them.

* Source: Rainmaker Roundup June 2002.


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2.

Bonds - a simple definitionSo what are bonds?

A bond is a fixed interest type of investment thats simply a promise to repay

money, with interest, on a certain date in the future.

Bonds are securities that enable governments and large companies to borrow

money. So if you decide to buy bonds, youre in essence lending a specific sum of

money (the face value) to the bond issuer (a corporation, a government or some

other borrowing institution) for a specific length of time (the term).

Typically, the issuer promises to make regular payments of interest at a rate thats

set when the bond is issued and to repay the face value at maturity. This is why

theyre referred to as fixed interest investments. So a bond is somewhat like a

term deposit.

Unlike a term deposit, a bond can be bought and sold. This will often be at a value

that is different to its face value.

The value of a bond can change continually due to many factors, including interest

rate movements, supply and demand and changes in the financial health of the

bond issuer.

Bond values and interest rates

For many investors, one of the most confusing aspects of investing in a bond fund

is how its unit price relates to interest rates. It is important to have an

understanding of this relationship before considering investing in bonds.

Firstly, bond prices and interest rates move in opposite directions and, like shares,

a bonds value can go up or down.


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3.

If you sell a bond before its maturity and interest rates have risen, the bonds value

will fall. For instance, bonds paying 6% interest are obviously worth less if new

bonds are offering 7%. The opposite is also true: old bonds paying 9% interest aremore attractive an investment and are worth more than new bonds only yielding 8%.

For a given issuer, the longer the maturity of a bond, typically the higher the

expected return.

" Remember: when interest rates increase, bond prices fall

and when interest rates decrease, bond prices rise."

Who issues bonds?

In Australia and overseas, bonds are issued by governments, semi-government

organisations and corporations.

1. Government bonds

Government bonds are issued directly by a government and are explicitly

guaranteed. For instance, here in Australia the Federal Government issues

Commonwealth Securities to help pay for major government projects.

2. Semi-government bonds

These bonds are 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, like the World Bank, issue bonds to support their financial

needs or to finance public projects.

3. Corporate bonds

Large public companies also issue bonds to fund expansion and other major

projects. Corporate bonds differ in two important ways to government bonds

yield and credit quality. Generally, corporate bonds are thought to have a higher

risk level than government or semi-government bonds, so they typically offer

higher interest rates.


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4.

4. International bonds

An international bonds stability depends on its country of origin, its issuer and its

credit rating. Experience shows that some countries bonds will be less stable than

others.

Investing in foreign bonds also introduces you to currency risk as a result of

fluctuations in the value of the Australian dollar and foreign currencies. Currency

risk is specifically covered in more detail later in the section Know the Risks on

page 11.

Currently, Australia represents less than 1% of the worlds bond market. So it

makes sense to consider a combination of both Australian and international bonds

in your portfolio. This way, you can diversify your holdings and gain exposure to

both local and overseas markets.

Credit ratings

A bonds credit rating depends on the issuers ability to pay interest and ultimatelyto repay the principal upon maturity. Independent bond-rating agencies, like

Standard and Poors, evaluate the financial health of bond issuers and issue

alphabetical credit-quality ratings. Usually a lower credit rating means the issuer

has to pay higher interest to offset the higher risk that the principal and interest

wont be repaid on time.

For instance, Standard and Poors ratings can range from AAA for the best qualitybonds, to D for those considered as having poor prospects of repayment.


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5.

Rating Description

AAA Judged the best quality with the smallest degree of credit risk.

AA Regarded as high quality and only marginally different from AAA.

A Possess many favourable investment attributes, and are regarded

as high to medium-grade bonds.

BBB Considered medium grade neither highly protected nor

poorly secured.

Bonds rated BB, B, CCC, and CC are regarded as having

significant speculative characteristics, with BB the least degree

and CC the highest degree of speculation.

BB Judged to have some speculative elements. The future of these

bonds cannot be considered well ensured.

B A generally vulnerable investment, lacking desirable characteristics.

CCC Considered poor quality with danger of default.

CC Regarded as highly speculative and often in default.

R The issuer is under regulatory supervision due to its

financial condition.

SD and D SD stands for selective default and D refers to default where the

issuer has defaulted on one or more of its obligations when due.

Source: Standard and Poors.

To limit credit risk, Vanguards bond funds use bonds with credit ratings of A or better for

Australian bonds and predominantly BBB or better for overseas bonds.


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6.

What is a bond fund?

Bonds can be purchased directly however many investors prefer the benefits of a

bond managed fund.

A bond fund pools the money from many investors and uses the money to buy

securities that meet the funds investment objectives.

This not only allows you to invest in a variety of bonds, but also enjoy greater

diversity than you could by directly investing in a single bond issue, especially if

bonds from a wide range of different countries (international bonds) are also

represented. So in a diversified fund, if one issuer fails to pay interest or the

principal, it only has a slight overall effect on the fund and its investors.

A bond fund also maintains its risk/return profile by ensuring continued

representation of a range of bonds (usually both short term and long term) that

meet the funds objectives. The risk/return profile of a single bond can change and

effectively reduces as the bond moves closer to maturity.

The benefits of an index fund

Not all managed funds are the same. You have the choice of investing in either an

actively managed fund or an index managed fund.

An actively managed fund tries to pick the direction of interest rates and

continuously buys and sells bonds in an attempt to outperform the market index.

This can impact on costs, because a high turnover of fund assets will increase

transaction costs. So active funds tend to be more speculative and short-term in

focus, than index funds.

Index funds, on the other hand, are based on a long-term buy and hold strategy,

providing returns in line with their market index. The index fund manager uses

the proceeds from maturing bonds and investor cash flows to maintain the funds

risk/return profile.


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7.

For the seven years to 30 September 2002 the majority of actively managed bond

funds have failed to outperform their corresponding market index, after ongoing

charges are taken into account.*

The chart below shows the median return of retail bond funds and the return of

their comparable indexes. In both instances, the index has returned more than the

median.

* Source: Vanguard using Mercer data.

Source: Vanguard using Mercer data.

Median annual return of bond retail managed funds (after ongoing charges)

vs comparable index (before ongoing charges) - 1 October 1995 - 30 September 2002

0

2

4

6

8

10

Australian Fixed

Interest Funds

UBS Warburg AustralianComposite Bond Index

Return % p.a.

International Fixed

Interest Funds (Hedged)

SSB World GovernmentBond Index (Hedged in A$)

Median Fund

Index


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8.

Benefits of bonds

Depending on your needs and your tolerance to risk, bonds can offer investors a

number of significant benefits:

Portfolio diversification

Diversification is the key element of a prudent investment strategy. A combination

of Australian and international bonds can complement a portfolio of shares, cash

and other investments by exposing you to different markets. This typically has the

effect of smoothing out returns and reducing your overall risk.

Bonds can benefit a share portfolio

A common perception is that shares will outperform most other asset sectors.

Historically, over the long term, for most periods, this has been true. However,

there have been periods when bonds have outperformed shares. Holding both

types of investments can temper the inevitable fluctuations in the value of your

investment portfolio.

The following charts show the range of returns for Australian and international share

market indexes compared to Australian and international bond indexes.

Australian bond index vs Australian shares index

Quarterly returns (1 January 1985 - 30 September 2002)

(1) S&P/ASX 300 Index

(2) UBS Warburg Australian Composite Bond Index

-50

-40

-30

-20

-10

0

10

20

30

40

Australian shares index (1)

Australian bond index (2)

Sept-02Sept-86 Sept-88 Sept-90 Sept-92 Sept-94 Sept-96 Sept-98 Sept-00

%


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9.

In both examples, bond returns have lower volatility than share market returns.

The chart below illustrates how the introduction of bonds to a pure share portfolio

can reduce the risk of the portfolio.

Risk is defined as the probability of a negative return.

International bond index vs International shares index

Quarterly returns (1 January 1985 - 30 September 2002)

(1) Salomon Smith Barney World Government Bond Index

(2) MSCI World ex-Australia Index

-30

-20

-10

0

10

20

30

40

International bond index (1)International shares index (2)

Sept-02Sept-86 Sept-88 Sept-90 Sept-92 Sept-94 Sept-96 Sept-00Sept-98

%

Risk return trade off

Increasing

Return

Increasing Risk

10% Shares

90% Bonds

30% Shares

70% Bonds

50% Shares

50% Bonds

70% Shares

30% Bonds

90% Shares

10% Bonds


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10.

Bond returns

One of the benefits of a bond is that it can provide a regular income stream as well

as an opportunity for growth. The total return of a bond fund has two components

income distributions and change in unit value (capital growth).

Over the long term the total return generated by a bond fund can be expected to

be higher than the income earned by a cash investment, although cash is a lower

risk investment than bonds.


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11.

Know the risks

All investments carry some form of risk (risk being defined as the probability of a

negative return). After tax and costs are taken into account, even cash investments

have the potential to produce a negative return. And while bonds have not

generally fluctuated in value as much as shares, the figure below shows that bond

prices can still go up and down and both the capital and interest components are

subject to rises and falls in value. The diagram also shows the volatility of other

asset sectors as a comparison.

Before purchasing a bond fund, its important to be comfortable with both the

potential risks and possible rewards of your investment.

Risk of major asset sectors - range of returns

Over 1, 5 and 10 year periods (1 January 1985 - 30 September 2002)

-40

-20

0

20

40

60

80

100

%

1 5 10

Cash

1 5 10 1 5 10 1 5 10 1 5 10 1 5 10

Australian

FixedInterest

InternationalFixed

Interest

ListedProperty

Securitites

Australian Shares

International Shares


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12.

Interest rate risk

A bond funds value goes down when interest rates rise and increases when interest

rates fall. The risk that a bond fund will rise or fall in value is known as interest

rate risk and the longer a bonds maturity or duration, the greater its interest rate

risk. A diversified bond fund with a mix of both short-term and long-term bonds

can reduce this risk.

The table below shows the expected price change (in face value) for a bond with

a duration of 2 years after interest rates have moved.

Effect of change in interest rates

% % % %

Change in interest rates +2.0 +1.0 -1.0 -2.0

Price change of bond -4.0 -2.0 +2.0 +4.0

Credit risk

Bond investors can lose money if an issuer defaults or if a bonds credit rating is

reduced. Because a managed fund invests in many different bonds and usually

only highly rated ones the possibility of a single default significantly hurting

investors is reduced.


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13.

Currency risk (for international bonds)

Fluctuations in the value of the Australian dollar and foreign currencies can

seriously affect the returns from overseas investments. A weaker Australian dollar

increases the value of foreign holdings, benefiting the Australian investor with, for

instance international bonds exposure. On the other hand, if the value of our dollar

rises, the value of foreign assets falls.

In an unhedged international bond fund, currency returns are significantly more

volatile than bond returns, and can overwhelm the fixed interest nature of the

fund. When international investments are hedged, gains and losses (changes in

value) due to currency fluctuations are offset by opposing losses and gains on

the currency hedges. Returns are then only a result of movements in the fixed

interest market.

This is the reason many fund managers choose to hedge the foreign currency

exposure of international bonds.

Political risk

Like changes in the value of a countrys currency, political changes can also have a

large impact on the value of overseas investments. For instance, a change in

economic policy, trade restrictions or the nationalisation of industries can lead to

market declines and affect returns from overseas investments.


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14.

Costs

Regardless of the type of investment, you should always pay close attention to fees

and expenses because they directly reduce a funds total return. These costs are

particularly important to bond fund investors, as theyre often the most important

difference between comparable funds.

Because investors only receive the net yield (the yield after expenses) high costs

can eat up a substantial amount of your return.

For instance, if a bond fund has a gross return of 6.50% and a management expense

ratio (MER) of 1.55%,* its net return will only be 4.95%. If a similar fund has the

same gross return, but a MER of just 0.75%,** your net return would be 5.75%.

This means the interest earned by the low-cost fund would be around 16% greater

than that received by an investor in the higher-cost fund.

Some funds also charge entry and or exit fees that can further eat into the value of

your investment.

Funds with extremely high costs will have difficulty achieving competitive net

returns (after expenses) over time. Actively managed bond funds tend to have

higher operating costs than index bond funds as they attempt to outperform the

market index by aggressively buying and selling bonds regularly.

In contrast, index funds do not attempt to beat the market, merely to match it.

With fewer transactions, they have lower operating costs and are a very cost-

effective way to invest in bonds.

So it makes sense then to carefully investigate and understand the total costs of a

bond fund before you invest.

* Source ASSIRT, median MER for Australian bond funds as at November 2002.

** MER for the Vanguard Index Diversified Bond Fund for investments up to $50,000


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15.

Take charge with Vanguard

Vanguard Investments Australia Ltd is a wholly owned subsidiary of The Vanguard

Group, Inc., based in the US. It combines the skills of its team of Australian

investment professionals, with the strength and expertise of its international parent.

The Vanguard Group manages approximately $1 trillion for individual and

institutional investors.

Vanguard in Australia has established a strong reputation as the index specialist,

managing over $17 billion in index funds, primarily for large institutional investors.

Vanguard Investor Funds

If you are looking to access low cost investments, we have a range of asset sector

and diversified index funds. You can invest in our funds by contacting us directly

or through your financial adviser.

Asset sector index funds Exposure to bonds

International SharesHedged International Shares

Australian Shares

Property Securities

Diversified Bond 3

Cash Plus 3*

Diversified index funds

High Growth 3

Growth 3Balanced 3

Conservative 3

* Short term fixed interest only

TheVanguard Index Diversified Bond Fund offers the greatest exposure to bonds

with target asset allocations of 40% to Australian fixed interest securities and 60%

to international fixed interest securities (hedged to Australian dollars).

Vanguard Personal Superannuation Plan

Our low cost Personal Superannuation Plan offers a range of asset sector and

diversified investment options, some of which have exposure to bonds.


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16.

Why Plain Talk?

At Vanguard, we believe that one of the keys to investment success is being an

informed, knowledgeable investor.

Our growing Plain Talk Library covers a number of aspects regarding investing for

success. Our aim, through this library, is to offer candid, concise and easy to

understand information on a variety of topics.

Currently our Plain Talk Library includes:

Understanding Indexing

Asset allocation

Understanding bonds

International shares

Realistic expectations for share market returns

Understanding managed fund costs

Maximising your Super

Managing your investment portfolio

Like more information or to give us your feedback?

We would be happy to provide you with more information about our Investor Funds

or Personal Superannuation Plan. We also value your feedback.

Please contact Vanguard Client Services on 1300 655 101 or access our website

through www.vanguard.com.au or contact your financial adviser.

This brochure is provided for general information purposes and does not take into account individual

investor circumstances. Investors should consider their own investment needs or consult a professional

adviser prior to investing. The Vanguard Investor Funds are offered by Prospectus only. The Vanguard

Personal Superannuation Plan is offered through a Key Features Statement and Information Brochure.

Applications for investment may only be made on the application form attached to a current Prospectus

or Key Features Statement. A Prospectus, Key Features Statement and Information Brochure may be

obtained by contacting Vanguard Investments Australia Ltd ABN 72 072 881 086AFSL 227263 who

receives a fee for managing the Funds.

None of the Vanguard Group, including Vanguard Investments Australia Ltd, or related entities, directors

or officers guarantees the performance of, or the repayment of capital or income invested in, any of the

Vanguard Funds.


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Contacting Vanguard

Telephone

Vanguard Client Service Associates

are available from 8.00am to 6.00pm

Monday to Friday (Melbourne time)

1300 655 101

Internet

Visit our website at

www.vanguard.com.au

Mail

Vanguard Investments Australia Ltd

GPO Box 3006FF

Melbourne Vic 3001

In person

Level 21, 360 Collins Street

Melbourne Vic 3000

PT004 02/03


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