Exchange-traded Government Bonds
Exchange-traded Australian Government Bonds (AGBs) launched on the Australian Securities Exchange in May 2013. The following educational information should assist you in your understanding of these instruments and bonds more generally:
What is a government bond?
It is a debt obligation of the issuing government. When you invest in a government bond you are effectively lending money to the issuing government. A debt obligation requires that the issuer make all contracted payments. Bonds are wholesale debt securities traded by institutional investors and are not subject to a prospectus.
Why are bonds issued?
Bonds are issued by the government as a means of funding long-term infrastructure and other commitments.
Notwithstanding that the Australian Government ran budget surpluses for an extended period and could have repaid its debt, it maintained an issuance program to ensure the continued orderly operation of Australian wholesale debt markets. This now means that the current issuance programs are easier to implement.
What are exchange-traded government bonds?
Exchange-traded AGB holders gain beneficial ownership of an Australian Government Bond in the form of a CHESS Depositary Interest (CDI). Holders obtain all the economic benefits, including payments, attached to legal ownership of the Australian Government Bond over which the CDI has been issued.
What are the types of exchange traded AGBs?
There are two different types of exchange-traded AGBs:
- Exchange-traded Treasury Bonds (TBs) are medium- to long-term debt securities with a fixed face value. They carry an annual rate of interest fixed over the life of the security, payable every six months. For further information on TBs please view this ASX publication (PDF).
- Exchange-traded Treasury Indexed Bonds (TIBs) are medium- to long-term debt securities. They differ from Exchange-traded Treasury Bonds because their face value is adjusted for movements in the Consumer Price Index (CPI). Interest is paid quarterly, at a fixed rate, on the adjusted capital value. At maturity, investors receive the adjusted face value of the security adjusted for CPI movement over the life of the bond. To learn more, view this ASX publication on TIBs (PDF).
Why are bond yields often lower than bank deposit rates?
In simple terms, because governments of developed economies have the ability to raise taxes to repay their debts, they can borrow more cheaply than any borrower including banks. This differential still exists despite the existence of a Government Guarantee on ADI deposits.
How often do I receive interest payments?
Interest payments are known as coupons and are paid half yearly in two equal amounts for TBs, while they are paid quarterly for TIBs.
What is interest rate risk?
Given that government bonds are guaranteed by the issuer there is virtually no credit risk. However there is interest rate risk. This is where the value of the security will fall if interest rates rise, conversely its value will rise if interest rates fall. Simply explained, if you lock in an interest rate on an investment and rates subsequently fall, your investment at that higher rate becomes more attractive and therefore more valuable. This is reflected in the price of the security.
Conversely, if you make an investment at a fixed interest rate and rates subsequently rise, your investment will become less attractive. This too will be reflected in the value of your bond and if you choose to sell it you may realise a loss. The longer the term to maturity, the more sensitive the bond's price to a change in interest rates. This means that longer dated bonds expose investors to a potentially higher level of price volatility. Some investors use this volatility to trade bonds based on their expectation of future movements in interest rates.
Price and yield relationship
Why invest in government bonds?
There are three primary reasons for investing in bonds; they can form part of a diversified investment portfolio so as to reduce the overall level of risk in the portfolio. Secondly, in times of uncertainty and heightened risk in financial markets, they can be held as a "safe haven" asset. Lastly, notwithstanding lower yields they can be used as a low risk source of income.
Government bond performance tends to have a low or negative correlation with the performance of other asset classes such as shares and property. In times of economic uncertainty these asset classes tend to perform poorly. However, this uncertainty tends to push investors into safe haven assets such as Government bonds. As demand for bonds increases, the price will rise, which will be reflected in a fall in bond yields.
Post the GFC we saw a period when risk assets performed poorly, however bonds delivered strong returns to investors.
How do I invest?
You can buy or sell exchange-traded AGBs on ASX the same way you buy or sell shares, but with both prices and yields quoted. You cannot sell a security which you do not already own. Settlement of the trade takes place two business days after the transaction (T+2) and you will receive a CHESS statement recording your holding, just as you do when you buy shares on-market. Exchange-traded AGBs cannot be taken out of the CHESS registry system.
Can I sell my bond prior to maturity?
Yes, but you need to be aware that the value of your investment may have changed resulting in you receiving more or less than you initially invested. To sell, you will need to contact your Morgans adviser who will obtain a price for the sale and execute on the ASX on your behalf.
Are bond yields linked to the RBA Official Cash Rate?
Not directly. Bond yields more generally reflect the outlook for inflation over the longer term, that is, investors generally expect to earn a return equal to the inflation rate plus a real margin over inflation. The actual yield for each bond is determined through the trading of these securities by institutional investors and traders.
How can I assess whether bond yields are likely to rise or fall?
There are numerous factors that impact on the direction of both short and long term interest rates and you should consider their potential impact on the value of your investment should you need to realise your investment before maturity. You should consider asking your Morgans adviser for more information.
Why is the quoted yield to maturity different to the coupon rate?
The coupon is the percentage interest rate paid each year; it is divided into two equal half yearly payments. The yield is the return if the security is held to maturity and takes into account the difference between the purchase (capital) price and the face value repayable at maturity as well as future coupons. The yield is calculated using the RBA bond formula which is available on the RBA website.
Summary
Exchange traded bonds provide investors with an opportunity to diversify their investment portfolio into an asset class that perform counter cyclically with property and shares. In periods of declining interest rates there may be opportunities for capital gains.
However, remember that when rates rise, the capital value of bonds will fall. TIBs provide a mechanism through which to protect against future increases in inflation. You should ensure you understand both the advantages and risks before investing.
More information
For more details, please contact your Morgans adviser or nearest Morgans office.
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