A case for the defence

Investors who want to avoid sharemarket volatility and possible loss of income have a more predictable alternative

- DAVID THORNTON

High-quality bonds are arguably the leading defensive asset for retail investors, lauded for their capital preservation qualities. But what exactly are they, how do you buy them and what role do they play in a portfolio?

Bond machinations can be complicated. In one sense they’re quite simple, but dig a little deeper and you’ll find a pretty big rabbit hole to fall down.

Bonds are essentially loan contracts issued by either governments or companies. You lend them money and in exchange, you receive a coupon payment (yield), usually once or twice a year. At the end of the agreed term, the initial loan amount (face value) of the bond will be repaid to the bondholder – provided the issuer is solvent.

Australian government bonds are AAA-rated – the top credit rating – so creditors will almost certainly be paid.

On the other hand, lower-quality corporate bonds provide income yield comparable to dividends. But unlike issuers of dividends, issuers of bonds are legally obliged to pay the coupons. For these reasons bonds have carved out a well-earned place as fixed-income stalwarts.

But here’s where it gets complicated.

Investors can hold bonds until they mature, or sell them before then on the secondary market.

“The valuation of bonds in the secondary market is simply about the return that’s required to offset the risk of not being repaid,” says Jonathan Sheridan, from FIIG Securities.

How risk is calculated

Risk depends on two factors. The first is the creditworthiness of the issuer or, put another way, the credit risk for holding the bond. Bonds issued by governments or large companies are considered a safe asset, second only to cash.