Introduction : Bonds
Australian bond issuance trends in the recent past and now As per the Reserve Bank of Australia, bonds account for around 10% of Australian banks' funding, and bonds issued by banks account for about half of the non-government bond market. The Australian bank bond market is mainly dominated by the prominent banks in Australia, which issue most of the banks' bonds. Australian banks' senior unsecured bond issuance since the COVID-19 pandemic, and the policies implemented in response, significantly influenced bank bond issuance. In particular, banks' bond issuance declined as they accessed funds through the Reserve Bank's Term Funding Facility; however, issuance has increased recently as the economy has recovered from the initial phase of the pandemic.
Who issues bonds?
A bond can be defined as a long-term contract under which a borrower agrees to make payments of interest and principal on a particular date to the holder of the bond. Investors have different options while investing in bonds. Bonds have been categorized into four main types: Corporate, Treasury, Municipal, and Foreign.
Key characteristics of bonds
Generally, bonds do not always have the same contractual features. For instance, corporate bonds have provisions for early repayment that are called features, but these provisions can vary for different bonds. Differences in contractual provisions and in the underlying strength of the companies backing the bonds lead to major differences in the bonds’ risks, prices, and expected returns. To understand bonds, it is important to understand the following terms:
Par Value
The par value is the stated face value of the bond; for illustrative purposes, let us generally assume a par value of $1000. The par value can be defined as representing the principal value that the firm borrows and promises to repay on the maturity date, already determined during the time of bond issuance.
Coupon interest rate
The bond issuer needs to pay a fixed amount of interest each year. When the coupon payment, as it is called, is divided by the par value, the result is the coupon interest rate. For example:- Assume that the par value of a company is $1000 and the interest rate is $100 each year, so the coupon interest rate is $100/$1000 = 10%.
Maturity date
Bonds generally have a particular maturity date on which the par value must be redeemed. Most bonds have original maturities ranging from 10 to 40 years, but any maturity is legally permissible. Of course, the effective maturity of a bond declines each year after it has been issued; thus, the company bonds had a 15-year original maturity.
Bond Ratings
Since a couple of decades ago, bonds have been assigned quality ratings that reflect their probability of going into default. The three major rating agencies are Moody’s Investor Services (Moody’s), Standard and Poor’s Corporation (S&P), and Fitch Investors Service. These agencies use rating terms accordingly, such as Moody’s and S&P, which use “modifiers” for bonds rated below triple-A. S&P uses a plus and minus system; thus, A+ designates the strongest A-rated bonds and A- the weakest. Moody’s normally practices using a 1, 2, or 3 designation, with 1 denoting the strongest and 3 the weakest; thus, within the double-A category, Aa1 is the best, Aa2 is average, and there is a significant probability of going into default.
Bond markets
Corporate bond markets are traded mainly in the over-the-counter (OTC) market. Most bonds are owned and traded among the large financial institutions, and it is relatively easy for the over-the-counter (OTC) bond dealers to arrange the transfer of large blocks of bonds among the few holders of the bonds. It would be much more difficult to conduct similar operations in the stock market, where there are literally millions of large and small stockholders, so a higher percentage of stock trades occur on the exchanges.
Frequently Asked Questions (F.A.Q)
What is a bond?
A commitment is derived after a mutual understanding from both the party that is the bond issuer and the bond holder. A bond can be defined as a long-term contract under which a borrower agrees to make payments of interest and principal on a particular date to the holder of the bond.
How do Australian Government bonds work?
Government bonds are a low-risk financial instrument where the holders lend money to the government at a fixed interest rate. In return, bond holders receive regular interest payments called ‘coupon payments’. In this case, the bond holder holds the bond until maturity and is authorized to receive the face value of the bond back.
What are the types of bonds available in Australia?
There are two categories of government bonds issued by the Australian Government: one is Treasury Bonds, which are fixed-rate bonds, and the other is Treasury Indexed Bonds, which are indexed bonds linked to the CPI.
How do I buy bonds in Australia?
Interested investor in investment in bonds can invest directly in bonds either over the counter (OTC) or via the Australian Securities Exchange (ASX). In both cases, investors will be needed to have a broker.
How are bond returns taxed in Australia?
Returns from investments in bonds are taxed at the corporate tax rate of 30% in Australia. If bond holder holds it for more than ten years, then there is no tax to pay.
What role does the Reserve Bank of Australia (RBA) play in the bond market?
The critical role of the Reserve Bank of Australia (RBA) is to govern and regulate the financial markets in Australia. During the pandemic, it has sought to address the disruption in financial markets, particularly in the government bond market, given the central role that the market plays in underpinning the interest rate structure in the Australian financial system. At the November 2020 Board meeting, the Reserve Bank announced that it would undertake a $100 billion bond purchase programme, purchasing $80 billion of Australian Government Securities (AGS) and $20 billion of bonds issued by the state and territory borrowing authorities over the following 6 months. The intention of the bond purchase programme was to lower government bond yields.
How are bond prices affected by changes in interest rates?
The general relationship between bond prices and the interest rate is inversely proportional. A rising interest rate would reduce bond prices, and vice versa. When the central bank increases the interest rate, the new bonds become much more attractive than the old bonds due to the high bond yield at lower bond prices.
What are zero-coupon bonds?
A zero-coupon bond can be defined as a debt instrument that does not pay any interest but is available at a highly discounted rate, which generally renders profit at maturity when it is redeemed.
Are there bond exchange-traded funds (ETFs) available in Australia?
Yes, the iShares Core Composite Bond ETF (ASX: IAF) is a bond ETF, which is a low-risk underlying asset, and funds generally invest in the investment-grade fixed-income securities issued by corporate entities that form the index.
How does inflation affect the value of bonds?
To tackle inflation, the central government increases the interest rate, leading to a decrease in the value of existing bonds, which seems to be less attractive during the inflation phase.
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