When you invest in bonds, you're lending money to a company or government. In return, you get regular interest payments, called coupon payments. If you hold the bond until maturity, you get back the face value of the bond.

Reasons to invest in bonds

The main reasons people invest in bonds are:

Stable income stream

Bonds pay interest (coupon payments) at regular intervals and can provide a stable and predictable income stream. The interest rate you can earn on a bond may be higher than a savings account or term deposit. Some bonds, especially government bonds, also have high liquidity, meaning they're easy to sell if you need to free up money quickly.

Lower risk

Bonds are defensive investments and lower risk than growth investments like shares or property.

The amount of risk depends on the issuer of the bond: either the Australian Government (lowest risk) or a company (higher risk).

Diversify your portfolio

Bonds are often used to diversify a portfolio. Diversification lowers the risk in a portfolio because no matter what the economy does, some investments are likely to benefit. For example, when interest rates fall, bond prices rise, while shares often fall at this time.

Issuers of bonds

There are two issuers of bonds in Australia:

• the Australian Government
• Companies

All bonds have a set value (called the face value) when they are first issued. This is how much you pay for the bond (usually $100 or $1,000). It is the amount you get back if you hold a bond until maturity.

Australian Government Bonds (AGBs)

AGBs are the safest type of bonds. If you buy and hold them to maturity, you're guaranteed a rate of return.

You can buy and sell government bonds on the Australian Securities Exchange (ASX) at market value. This may be higher or lower than the face value. You will also pay any brokerage fees.

To find out more, visit the:

• Australian Government bonds website
• ASX government bonds online course

Corporate bonds

Corporate bonds are riskier than AGBs. If the company goes out of business, you won't get coupon payments and may not get your principal back. To compensate for this, corporate bonds offer higher coupon payments than Government bonds.

But, bond are still less risky than shares. This is because if a company collapses, bonds holders are paid out before shareholders.

You can buy corporate bonds directly from the issuer through a public offer (known as the primary market) at face value. You can also buy some corporate bonds on the ASX after they have been in the primary market (known as the secondary market).

Read the prospectus or 'term sheet' to understand the risks and credit worthiness of the company before investing in bonds.

Interest on bonds

When you invest in bonds, you earn interest on the face value. You get this paid regularly as coupon payments.

There are three types of interest you can get paid:

Fixed rate

The interest rate is set when the bond is issued and it stays the same until maturity.

With fixed rate bonds, you get:

• fixed coupon payments
• face value returned to you if you hold it to maturity

Generally, people invest in fixed rate bonds for a stable, regular income stream and to diversify their portfolio.

Floating rate

The interest rate can go up or down over the term of the bond. The coupon rate you get is based on an underlying interest rate plus a specified percentage or margin (for example, the cash rate + 2%).

With floating rate bonds, you get:

• coupon payments — they'll rise if interest rates go up, but fall if interest rates go down
• face value returned to you if you hold it to maturity

Floating rate bonds help you get a stable income and protect your returns if interest rates rise.

Indexed

Indexed bonds protect against rising inflation, measured by the consumer price index (CPI).

Both coupon payments and the face value increase in line with changes in the CPI.

Investors use indexed bonds to earn a return that increases with inflation (which can reduce the your returns) and diversify a portfolio.

Risk of selling before maturity

If you buy a bond and hold it to maturity, you'll get back the face value. But if you sell a bond before maturity, you'll get market value. This can be more or less than the face value.

The market value (price) of a bond depends on supply and demand. Market interest rates have the biggest impact on the price of bonds. The credit risk of the issuer and how long the bond is issued for (duration) can also have a big impact on the price of a bond.

The price of fixed rate bonds and indexed bonds moves in the opposite direction to market interest rates:

• If market interest rates rise, the price of these bonds falls.
• If market interest rates fall, the price of these bonds rises.

The price of floating rate bonds doesn't move very much when interest rates change because their coupon payment rate adjusts.

Working out the value of a bond

Yield to maturity (YTM) is the best measure of the value of a bond. It is also a good way to compare what you'll get by investing in different bonds.

YTM calculates the average annual return of a bond from when you buy it (at market value) until maturity. It assumes that you reinvest coupon payments in the bond at the same interest rate the bond is earning.

Bear in mind that YTM doesn't assess the risks of particular bonds (such as credit risk). Balance the return you can get against any risks before you make an investment decision.