Bank bonds offer a secure way to invest in Australia’s major financial institutions without the same level of risk as shares.
Since late 2007 and the arrival of the Global Financial Crisis (GFC), the Australian sharemarket has experienced a high level of volatility. Keen to avoid these rollercoaster ups and downs, many have looked for a safer place to invest their money, with bonds becoming a popular choice.
Also known as fixed-interest investments, bonds provide secure and steady returns and are well within the reach of everyday investors. Bank bonds from Australia’s “Big Four” – Commonwealth Bank, Westpac, NAB and ANZ – are well worth a look if you’re looking for a safe investment option, so read on to find out how they work and the benefits they provide.
What are bank bonds?
The fixed-interest market in Australia is often very poorly understood by investors, so it’s important to explain exactly how bonds work. A bond is a loan that you provide to a corporation (such as a bank) or government. The borrower issues a bond as a way of acknowledging the loan, and promises to pay interest at a fixed rate and repay the principal amount within a specified time frame of between one and 30 years.
In this way, bonds provide a fixed interest return on your investment. Bank bonds, other corporate bonds and government bonds are available through public offers or can be purchased on the Australian Securities Exchange (ASX) for as little as $100 a unit. In years gone by you needed a much larger amount of capital to be able to invest in bonds, usually several hundreds of thousands of dollars, so many investors are unaware of the ease with which they can now be accessed.
Why should I invest in bank bonds?
The main benefit of investing in bank bonds is security. Australia’s “Big Four” banks are some of the largest financial institutions in Australia and around the world, which means you have the security of investing in an established, trusted company that is extremely unlikely to go bust.
Bank bonds also offer the peace of mind of a fixed interest rate and guaranteed returns. While a quick glance at a graph charting the performance of the ASX over the past 10 years will show you just how volatile shares can be, bank bonds offer the security of getting your principal amount back while also earning interest at a fixed rate.
The interest earned from bank bonds can be used to provide a regular income. This provides added security for investors and, when combined with the fact that bonds tend to perform well while other markets struggle, is the reason why bonds are seen as a defensive investment strategy.
Trading bank bonds
As they’ve been described above, bank bonds provide a stable and secure investment option, but things can get a little more complicated and confusing if you don’t want to wait for your bond to reach maturity. Investors who don’t want to wait for maturity are able to buy and sell bonds much like they would shares.
But the value of bonds actually moves in the opposite direction to interest rates. For example, let’s say you have a bank bond with an interest rate (referred to as the coupon rate) of 2.5%. If interest rates rise to 5% and you want to sell your bond, you won’t be able to find a buyer. This is because investors can now purchase bonds for the exact same price, but earn interest at a rate of 5% rather than the 2.5% offered by your bond. As a result, the value of your bond decreases so that anyone buying it can receive the same 5% yield available elsewhere.
Other factors that can influence the value of a bond include the length of time until maturity and any developments concerning the financial stability of the bank or other corporation that issues the bond.
This volatility of course provides the potential for higher returns but also bigger losses when trading bonds. It allows you to buy and sell bonds based on your expectations of what will happen to interest rates in the coming months and years. However, it’s essential that you fully understand all the risks involved before you decide to trade bank bonds.
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What are the pros and cons of bank bonds?
The pros
- Safe and secure. If you buy a bank bond and hold it until maturity, you can enjoy the security of a safe investment and a guaranteed return.
- Fixed interest. As bonds feature a fixed interest rate, you know exactly how much money you will make from your investment. This can ensure that you receive maximum returns if market interest rates continue to fall.
- Invest in banks without the volatility. Australia’s biggest banks have a long history of financial success, but investing in bank shares brings with it an increased level of risk. Buying bonds allows you to invest in Australia’s major banks with little to no chance of losing your money.
- Not a large investment. Australian retail investors can now purchase bonds on the ASX for as little as $100, which makes them an easy investment opportunity for people who only have access to a small amount of capital.
The cons
- Rising interest rates. As bonds offer fixed interest rates, you won’t be able to take advantage of any interest rate rises that may occur before your bond reaches maturity.
- Can get complicated. Buying and selling bonds (rather than simply waiting for maturity) can be complex and also leads to an increased risk of suffering a financial loss.
How do bank bonds differ from government bonds?
While bank bonds are issued by Australian banks, government bonds are issued by the Commonwealth of Australia. These safe and secure investment products allow you to lend money to the government at a fixed interest rate for a specified period of time. The government pays the interest that accrues on the loan and also returns your principal amount once the loan reaches maturity.
Bonds issued by the Commonwealth of Australia are called Commonwealth Government Securities and can be traded on the ASX. They are listed on the ASX as “Exchange-traded Treasury Bonds” and “Exchange-traded Treasury Indexed Bonds”.
More information about bank bonds
Keep the following points in mind if you’re considering whether or not to invest in bank bonds.
Chance of loss is remote
The biggest risk when lending money in any circumstances is that the borrower will go bankrupt and be unable to repay their debts. This is extremely unlikely to happen with Australia’s major banks, and this transparency is one of the major benefits of bank bonds. Compare this to the risks associated with investing in shares, such as plummeting share prices and a drop in company profits leading to smaller dividends.
Flexible
If interest rates move in your favour before the bond matures and your bond increases in value, you have the option to sell it for a profit. However, if the value of your bond decreases, you can simply do nothing; you will still earn interest and get your initial investment back at maturity.
Interest payments
The interest you are paid on a bank bond, which can also be referred to as the coupon amount, is typically paid yearly. However, you also have the option of receiving interest payments half-yearly or quarterly.
Floating rates also available
Another option worth considering is floating rate bonds. The coupon rate on these types of bonds fluctuates in line with a benchmark interest rate, so the coupon amount you receive could vary up or down with each payment.
Ask for advice
Unsure whether bank bonds are right for you? Ask your financial adviser or broker to help you understand whether bank bonds could be a suitable investment.
