What is a bond?
Bonds are essentially a loan from the investor to the bond issuer, to help raise capital for a company or government. They fall into the ‘fixed interest’ category of investments, which includes term deposits, mortgages, corporate bonds and government bonds. It’s an asset class that is usually synonymous with regular, stable returns – but this isn’t always the case. It is important to consider the quality of the bond issuer. Bonds can ‘default’ if the issuer can’t meet its obligations in cases such as bankruptcy.
Like most loans, bonds have a payback date known as the ‘maturity date’. On this date, the bond issuer will return to the investor the principal amount the issuer borrowed. However, as well as receiving their principal on the maturity date, an investor also receives regular payments during the life of the bond called ‘coupon payments’. These are based on an interest rate that can be fixed or floating, depending on the individual bond.
What’s less well known is that bonds also offer opportunities for capital gain or loss during the life of the bond. While they can be purchased directly from the issuer, bonds can also be traded on the secondary ‘over-the-counter’ market. This means that their market value can fluctuate, either up or down, as market interest rates change.
How do they work?
If in 2014, you purchased a new bond with a face value of $20,000, a coupon rate of 5% per annum and a maturity date of 2024, each year you will receive interest income of $1,000 (being 5% of 20,000). That means in 2024, the issuer will pay you back the initial $20,000 it borrowed, plus you will have also earned an income of $10,000 over the 10-year term.
Using the same example to consider capital gains (or losses), if market interest rates rise to 6%, the value of your bond will fall (all else being equal). This is simply because it pays 5% and investors can earn a higher return elsewhere, so it’s worth less. On the flipside, if market interest rates fall to, say 3%, your bond will become more attractive as it is paying a higher return so its price will increase.
What is a share?
A share is a unit of ownership in a company. While owning shares in a business doesn’t mean that the shareholder has direct control over the business’s day-to-day operations, shareholders are entitled to a distribution of any profits by the business. Investors can profit from owning shares in two ways – capital gains and dividends.
How do they work?
Imagine an owner decides to sell 40% of their company. Joe Smith buys 20 shares at $10 each – a total of $200 spent. The company expands, as do its profits. Therefore the demand for shares in the company rises, meaning people are willing to pay, say, $18 per share. Joe then sells his 20 shares for $18 each, making $360 and a gain of $160. The opposite can however also be true, whereby the company’s profits fall and the demand for shares in the company fall, as does its share price. It is therefore important for an investor to understand the quality and the profit outlook of the companies in which the investor purchases shares.
If you want to know more about diversifying your portfolio, or would like to discuss your personal finances, please get in touch with your Westpac Financial Adviser.