What are bonds?

You may be familiar with shares and property, but what about bonds? This asset class can bring stability to your portfolio by offering a steady income stream and balancing out higher-risk investments.

If you're looking to diversify, understanding how bonds work is a crucial step. This guide covers the basics, from the different types of bonds to how they're traded.

A bond is a type of loan. You lend money to a government or a company and in return, they pay you regular interest, often called coupon payments. When the bond's term ends (or matures), the issuer pays back your original loan amount, known as the principal.

Bonds are generally seen as less risky than shares. 

Bonds can be a smart way to complement a portfolio of growth assets like shares. Here are a few key benefits:

Bonds are a great way to earn steady income and usually have less price fluctuation than stocks, making them a stable part of a diversified portfolio. However, they do carry risks:

Interest rate risk – When central bank interest rates go up, bond values can drop in the secondary market. 

Opportunity cost – Locking money into bonds can mean missing out on higher returns if better investment opportunities arise.

Default risk – There's always a chance the bond issuer might not repay what they owe, or miss paying a coupon payment.

There are several types of bonds available in Australia. When choosing, you'll want to think about your financial goals and risk tolerance.

Australian Government Bonds (AGBs): Also called Treasury Bonds, these are issued by the Australian government. They're considered very low risk because the government guarantees the return if you hold them until they mature.

Semi-Government Bonds (Semis): These are issued by Australian state and territory governments. While still low risk, they usually offer slightly higher returns than AGBs.

Corporate bonds: Issued by companies, these bonds typically offer higher interest rates than government bonds to make up for a higher level of risk. The main risk is that the company might not be able to make its payments.

Fixed-rate bonds: These offer fixed interest payments throughout the life of the bond. 

Floating-rate bonds: The interest rate on these bonds can go up or down. The rate is usually tied to a benchmark, like the cash rate, plus an extra margin.

Inflation-indexed bonds: These bonds provide interest payments linked to the Consumer Price Index (CPI), which protects your investment against inflation.

Zero-coupon bonds: These bonds don't pay regular interest. Instead, they're sold at a discount to their face value. The investor receives the full face value when the bond matures, with the difference being their return.

For more information, check out the Australian government's website on exchange-traded bonds.

A bond's price is the amount investors are willing to pay for it on the secondary market. This is where you buy previously issued bonds. 

A bond's yield is the total return you can expect to receive each year if you hold it until its maturity date. It's a key figure for comparing different bonds.

The most common measure is the yield to maturity (YTM). This calculates the average annual return of a bond from the day you buy it until it matures, if you hold to maturity. It gives you a complete picture of a bond's value over its lifetime, making it easier to compare with other potential investments.

A key concept to understand is the inverse relationship between a bond's price and its yield.

Think of it this way: a bond pays a fixed coupon amount (e.g. $2 a year). If you pay more for that bond (a higher price), the $2 coupon represents a smaller percentage of your investment, so your yield is lower. If you pay less for the bond, that same $2 coupon gives you a higher yield.

Bond ratings are grades given by credit rating agencies, like Moody's, S&P, and Fitch. They assess how likely it is that the bond issuer can make its interest payments and repay the principal.

Ratings range from AAA (highest quality, lowest risk) to D (in default). Bonds with higher ratings are safer and tend to offer lower yields. In contrast, bonds with lower ratings (often called high-yield or junk bonds) carry more risk and must offer higher yields to attract investors.

A yield curve shows how bond interest rates (yields) change over time. For example, if 2-year bonds have a 3% yield and 10-year bonds have a 4% yield, it's a normal curve, meaning longer terms pay more. Yield curves are mostly used for government bonds, like Australian Government Bonds, because they show economic trends.

You can buy and sell Australian Government Bonds on the Australian Securities Exchange (ASX) through a licensed stockbroker, much like buying shares. These are known as Exchange-traded Treasury Bonds (eTBs).

Another option is to invest in bond funds via Exchange-Traded Funds (ETFs). These funds hold a portfolio of different bonds, offering instant diversification and saving you the job of choosing individual issuers.

You can invest in equities, ETFs, bonds and more through the HSBC WorldTrader online platform. You'll need to have an existing HSBC investment account or open one first to use the WorldTrader app. 

Wholesale and sophisticated investors can access investment-grade corporate and government bonds across a range of currencies through HSBC Investment Service. 

Bonds can be a great way to diversify your portfolio, generate steady income and manage risk. From stable Australian Government Bonds to higher-yield corporate bonds, adding this asset class may help you reach your financial goals.