Traditionally, decisions about the best places to invest revolve around cash, property and shares. There are the property enthusiasts who feel happy only when they're in bricks and mortar; share aficionados who will stick with shares through thick and thin; and the nervous ones who can't sleep at night unless their money is in interest-bearing accounts.
There is another asset – bonds. They were in the news during the recent presidential election counting with headlines alleging many people were fleeing to the perceived "safety of gold and bonds". The key word here is "perceived". After an initial rally, gold prices fell and bond yields rose – this meant bondholders took a bath. About $1.2 trillion was wiped off the value of bonds worldwide while shares added about $1 trillion as base metals leapt.
![Gold prices recently fell and bond yields rose, meaning bondholders took a hammering.](/web/20161204213105im_/http://www.theage.com.au/content/dam/images/g/s/j/a/o/u/image.related.articleLeadwide.620x349.gsrjp9.png/1479431697033.jpg)
In this context the word bond does not mean a deposit paid by a tenant, nor an investment bond, which is a tax paid investment with capital gains tax advantages. It means debt instruments issued by the Commonwealth government, state governments and semi-government bodies and large corporates. These bonds are traded in large amounts daily on the fixed interest market.
The confusing thing about bonds is that they fall in price as interest rates rise. Therefore you may see headlines such as "bond market in chaos as yields jump" or read that "bond prices fell as interest rates moved higher on inflationary fears".
This is because a bond is an investment that offers a capital sum repayable at a fixed future date, combined with a fixed income until that date.
If both interest and principal are government guaranteed, you may feel they are a secure investment, and there is little doubt you will receive the face value of the bond when it eventually matures.
The big problem is inflation – it will erode the value of the bond's income, as well as the principal that is repaid on maturity.
Suppose you buy a 5 per cent $100,000 government bond with 10 years to maturity. This means that it carries a guarantee from the government that it will be redeemed for $100,000 in 10 years' time, and will pay you interest at 5 per cent a year (the coupon rate) until then. If inflation runs at 3 per cent a year, the value of that $100,000 you will receive in 10 years is only $74,000 in today's dollars. Furthermore, the real value of the income will also reduce by 3 per cent a year.
Bonds are readily tradable; you don't have to wait till the maturity date, but the current market value of the bond will depend on inflation. If inflation starts to fall, interest rates in general should also start falling, and the nominal yield of the bond will fall. The bond will rise in price. Also its fixed coupon rate becomes relatively more attractive compared with other investments, because rates generally have dropped.
Conversely, if there are expectations of higher inflation, investors wishing to buy bonds will seek a higher nominal yield. The coupon rate on the bond cannot change (being fixed), so the price of the bond will fall to produce a higher yield.
Whether you should switch part of your money to bonds is something to discuss with your adviser, and the decision should turn on your risk profile and your belief as to where inflation is heading.
Keep in mind that a Commonwealth Government bond maturing in five years bought today will yield about 2.15 per cent – a real yield of little more than zero if inflation is 2 per cent. Worse still, if interest rates start to rise, you will cop a capital loss.
The Australian sharemarket is delivering a gross yield of about 4.3 per cent a year, roughly equivalent to 6 per cent after franking.
For my money, despite the uncertainty of a stock market, I would rather have the higher yield.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. Email: noel@noelwhittaker.com.au