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How Do Bonds Differ From Term Deposits?

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Contributor:
Mary Holm
Mary Holm

Question:

We are a lower income couple in our earlier sixties with a mortgage-free home and modest savings towards our retirement.

We understand the importance of having our assets diversified, but we are still not very clear about the place of bonds.

For example, Kiwi Bonds pay 6 per cent, but $10,000 on term deposit at Kiwibank has a return of 6.95 per cent.

Could you explain what the advantage would be to have some investments in bonds as well as term deposits? (We do have other types of investments besides term deposits!)

Answer:

Mary Holm: There are two main advantages:

* Most bonds pay higher returns than term deposits.

* You can sell bonds if you want to get out early.

Kiwi Bonds are just one type of bond. They are issued by the government, and are therefore regarded as the lowest-risk type of investment around, so they pay very low interest.

For a list of some other types of bonds, see the end of the share listings in the Business Herald each day, under "NZDX Market".

At about the same level of risk as bank term deposits are bonds issued by local authorities, such as Auckland City, or SOEs, such as Transpower.

There are, however, other bonds issued by companies, such as Auckland International Airport and Fletcher Building Finance.

These are riskier and therefore have to pay higher interest to borrow money from you. Still, a company's bonds are less risky than its shares. If its gets into financial trouble, it must repay all bondholders before shareholders get anything.

You can get an idea of how likely it is that a company will get into trouble by its credit rating. One place to see the ratings is on www.interest.co.nz. Click on Money Market.

Ratings of AAA or G1 are best. The website gives you more information about ratings under its Consumer Guide.

It's obviously safest to go with high-rated bonds. And it's also best to spread your money over lots of different companies, just in case.

As I said, one big advantage of bonds over term deposits is that, if you want to get your money out before maturity, you can sell the bond.

And while many bonds have five-year terms, if you want to tie up your money for a shorter period, you can buy one that is already part-way through its term.

If you buy or sell part-way through, you'll find the price will be higher or lower than the original price - depending on whether interest rates have gone up or down in the meantime.

But that's not as complicated as it sounds. It just means that you should get a fair return on your investment for the risk you're taking - given the level of market interest rates at the time you buy or sell.

If you buy part-way through you also need to understand the difference between the coupon rate and the buy yield.

The coupon rate is the interest paid to those who buy when the bond is first issued. The buy yield is the interest you get if you buy later on, which takes into account the fact that you have paid a different price from the original price.

Head spinning? Bonds are simple if you buy at the start and hold to maturity, which most people do.

A good stockbroker or financial adviser can explain bonds to you. They can be an excellent lowish-risk investment for those approaching retirement and in retirement.

 

Mary Holm is the author of bestselling books on KiwiSaver and personal finance. She is also a highly praised seminar presenter. Her written advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following that advice.  

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