Bonds vs Term Deposits

Types of bonds 

1. Fixed Rate Bonds – pay a consistent rate of interest, known as the coupon rate, over the life of the bond. This can provide a stable income stream for investors as the coupon amount will not change. Coupons are usually paid semi-annually from date of issuance. In the Australian market, fixed rate bonds for corporate issuers range typically from 5 to 10 years in term, while fixed rate bonds for state and federal government can be issued for much longer terms (10 years and beyond).
2. Floating Rate Notes – pay a variable rate of interest that is calculated as a fixed margin over a variable interest rate benchmark, typically the Bank Bill Swap Rate for Australian dollar issues. Coupons are usually paid quarterly from date of issuance, and the coupon will be calculated each quarter as the sum of the Bank Bill Swap Rate plus the fixed issue margin. In the Australian market, Floating Rate Notes are typically issued for terms of 3 to 7 years. Financial institutions such as banks tend to dominate Floating Rate Note issuance in Australia.
3. Inflation linked bonds – pay a fixed coupon on a principal amount that is indexed to inflation, so in a rising inflationary environment, the coupon will increase on each indexation period. This protects investors from inflation risk. These types of bonds are typically issued for longer terms of 20 years or more.

Risks of bonds

1. Credit Risk – that the bond issuer will not be able to repay interest and/or principal due on the bond. In Australia, only 3 investment grade bond issuers have defaulted – Pasminco, HIH and Babcock & Brown. Statistically speaking, there is an extremely low probability of an investment grade issuer defaulting. At the other end of the spectrum, sub-investment grade bonds carry higher credit risk and therefore higher default probabilities.
2. Interest Rate Risk – where market interest rates change and cause the capital price of a fixed rate bond to change. Fixed rate bonds are issued with a coupon that does not change, so when markets move, what does tend to change is the capital price of the bond (above or below the issue price of $100). If a bond is purchased as a hold to maturity investment, price changes won’t impact the economic impact for the investor as the bond will repay at $100 at maturity.  However, if an investor needs to sell a fixed rate bond prior to maturity, and if the prevailing market price is below the purchase price, a capital loss will be incurred. Conversely, if the market price is above the purchase price, a capital gain will be received. However, as Floating Rate Notes have a coupon that resets each quarter to the previous 90 days, they carry almost no interest rate risk and as a result, the capital price of Floating Rate Notes tend to be much more stable compared to fixed rate bonds.

Portfolio considerations

From a diversification perspective, bonds may offer significant advantages, including:

• Protection during economic uncertainty
• Potential capital appreciation when high-quality fixed-rate bonds are held during economic downturns
• Broader issuer and risk profile selection
• When bonds are issued by banks, they rank below term deposits on the capital structure and therefore often offer a higher relative return

Conclusion

While term deposits offer simplicity and government guarantees, bonds typically provide greater diversification of benefits and potential for capital growth. Historically, term deposits have struggled to match the long-term performance of quality fixed-rate bonds. For comprehensive portfolio construction, bonds should be seriously considered to achieve optimal diversification and income objectives.

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