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What Are the Pros And Cons Of Bonds Versus Bank Term Deposits?

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Contributor:
Mary Holm
Mary Holm

Question:

Can you explain for all inexperienced investors the pros and cons of bonds versus bank term deposits?

Answer:

Mary Holm:  can see why you're confused. With both term deposits and bonds, you deposit your money and - all going well - you receive regular interest payments and your money back at the end of the term.

There are some important differences, though. Pretty much all bonds, except government bonds, are riskier than bank term deposits. That means they wouldn't have any takers if they didn't pay higher returns than term deposits. And generally they do.

This might sound contrary to what you've read lately. Just last Saturday Brent Sheather wrote about several bond issues that have performed really badly.

That's largely because of another difference between bonds and term deposits - you can sell bonds at any time.

The flexibility is, of course, good. But if you sell before maturity and interest rates have risen since you bought the bond, you will probably get less than you paid for it.

Nobody wants a bond that pays below market rates unless they can buy it cheaply.

By the same token, if interest rates have fallen, you'll sell at a gain. But you can't predict which way rates will go.

There's another risk element, too. If the company that issues a bond starts to look financially wobbly - and possibly unable to repay the money - that, too, will affect its price.

However, if you stick with "investment-grade" bonds, which have a credit rating of BBB minus or better, that's unlikely to happen. And if you hold the bonds until maturity, you eliminate the volatility risk.

You might hear that your bonds are worth less in the meantime, but you just ignore it.

Speaking of maturity, some bonds don't have a maturity date, but are perpetual. Opinions vary on these, but I would suggest a beginner sticks with a range of bonds with fixed repayment dates.

Why do I recommend term deposits for short periods and bonds for longer? You have to pay brokerage on bonds, but over longer periods the higher interest generally more than makes up for that. Also, over longer periods the ability to sell matters more.

For a list of bonds and their ratings, see the Moneymarket section of www.interest.co.nz. In its listings, the "coupon" is the interest rate paid when the bonds were issued. And the "buy yield" is the effective interest you will get if you buy the bond now, taking into account the change in its price since it was issued.

A sharebroker can tell you about your options, including new issues.
 
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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