What Are Bonds and How Do They Work?
A bond is a loan made by an investor to a borrower - typically a government or corporation. In return, the borrower promises to pay regular interest (the coupon) and repay the principal at maturity. Bonds are a fundamental building block of diversified investment portfolios, providing income, capital stability, and (in some market conditions) a counterbalance to equity market volatility.
- Face value (par value): The amount the bond will repay at maturity - typically $1,000 or $100 per unit. If you buy a bond at par, you receive the face value back at maturity regardless of what happens to market prices in between.
- Coupon rate: The annual interest rate stated on the bond, expressed as a percentage of face value. A $1,000 bond with a 4% coupon pays $40/year, typically in semi-annual instalments of $20. The coupon rate is fixed for the life of a standard fixed-rate bond.
- Yield to Maturity (YTM): The total annualised return you receive if you buy the bond at the current market price and hold it to maturity - taking into account both coupon payments and any capital gain or loss from the purchase price to face value. YTM is the most useful single measure for comparing bonds.
- The inverse relationship between bond prices and interest rates: When market interest rates rise, existing bond prices fall (because the fixed coupon becomes less attractive relative to new bonds issued at higher rates). When rates fall, existing bond prices rise. This is the fundamental mechanic that causes bond portfolio volatility and is the source of duration risk.
- Maturity: Short-term bonds (under 3 years) have low sensitivity to rate changes. Long-term bonds (10–30 years) have high sensitivity - a 1% rise in interest rates can cause a 10%+ fall in the price of a 20-year bond. For capital-stable fixed income, shorter maturities are safer.
Australian Government Bonds (AGBs)
The Australian Government issues bonds through the Australian Office of Financial Management (AOFM). AGBs are backed by the full faith and credit of the Commonwealth - Australia is one of the few nations to maintain a AAA credit rating from all three major rating agencies (Moody's, S&P, Fitch). They are the lowest-risk Australian dollar fixed income investment available.
- Treasury Bonds: Fixed semi-annual coupon payments with maturities ranging from 2 to 30 years. Liquid and actively traded. Available in the secondary market through brokers or directly via the AOFM's bond tender process (primarily for institutional investors). Retail investors typically access AGBs through the ASX bond market or via bond ETFs.
- Treasury Indexed Bonds (TIBs): Capital value is indexed to CPI - providing inflation protection. The coupon is paid on the growing principal. TIBs are appropriate for investors who want real (inflation-adjusted) returns rather than nominal returns.
- Retail access via ASX: The ASX lists Australian Government bond ETFs that provide retail investors with low-cost, liquid exposure to the AGB market without needing to participate in AOFM tenders or the institutional OTC market.
- Current yield context (2025): AGB yields in 2025 are materially higher than the near-zero rates of 2020-21. The 10-year AGB yield has fluctuated between approximately 4.0–4.6% in 2024-25 - providing meaningful income for the first time in years. This changes the portfolio role of bonds: at 1% yields, bonds provided diversification but little income; at 4%+, they provide both.
Bond ETFs: IAF, VAF, AGVT and Others
For most Australian retail investors, bond ETFs are the most practical way to access fixed income - providing instant diversification, daily liquidity, low cost, and professional management of the underlying bond portfolios.
- IAF - iShares Core Composite Bond ETF: Tracks the Bloomberg AusBond Composite 0+ Index. Holds a broad mix of Australian government, semi-government (state government) and investment-grade corporate bonds. MER: 0.20%/year. Duration: approximately 5–6 years. The most widely held Australian bond ETF - a solid core fixed income holding.
- VAF - Vanguard Australian Fixed Interest Index ETF: Tracks the Bloomberg AusBond Composite 0+ Index (same index as IAF). MER: 0.20%/year. Duration: similar to IAF. Essentially equivalent to IAF - choose based on brokerage platform preference or liquidity.
- AGVT - Vanguard Australian Government Bond Index ETF: Holds only Commonwealth and state government bonds - excludes corporate credit. MER: 0.20%/year. Lower credit risk than IAF/VAF (no corporate bonds), but similar interest rate/duration risk. Appropriate for investors who want maximum credit quality in their bond allocation.
- VBND - Vanguard Global Aggregate Bond Index (Hedged) ETF: Provides exposure to global government and investment-grade corporate bonds, currency-hedged to AUD. MER: 0.20%/year. Adds geographic diversification to the bond portfolio. Hedging cost is approximately equal to the interest rate differential between Australia and global markets.
- QPON - BetaShares Australian Bank Senior Floating Rate Bond ETF: Floating-rate bonds - coupon adjusts with the bank bill rate (BBSW). Duration near zero - minimal interest rate risk. Yield tracks the cash rate closely. Appropriate in rising rate environments or for capital-stable income. MER: 0.22%/year.
- Corporate bonds - higher yield, higher risk: Investment-grade corporate bonds (rated BBB- or above) offer higher yields than government bonds to compensate for credit risk. High-yield (sub-investment grade, 'junk') bonds offer higher yields still but correlate more strongly with equities in downturns - reducing diversification benefit. IAF includes investment-grade corporates; a separate high-yield allocation requires dedicated ETFs.
Duration Risk, Laddering and Portfolio Role
Understanding duration - the sensitivity of a bond's price to interest rate changes - is essential before investing. Managing duration through laddering or ETF selection prevents unwanted capital volatility.
- Duration explained: A bond (or bond portfolio) with a duration of 5 years will fall approximately 5% in price for every 1% rise in interest rates. IAF and VAF have duration of approximately 5–6 years - meaning a 1% rate rise causes roughly a 5–6% capital loss in the short term. This loss is temporary if you hold to maturity (or near it), but real if you need to sell.
- Bond laddering: A ladder holds individual bonds maturing at regular intervals - e.g. bonds maturing in 1, 2, 3, 4 and 5 years. When each bond matures, the proceeds are reinvested at the prevailing rate. A ladder provides predictable income, reduces reinvestment risk, and smooths the impact of rate changes. Practical for wholesale/direct bond investors; retail investors typically replicate the concept using a mix of short, medium and long ETFs.
- Short-term vs long-term ETFs: SGOV/short-duration ETFs (1–3 year) have lower interest rate sensitivity but lower yield. Long-duration ETFs (10+ years) have higher yield but significant capital volatility. Match duration to your investment horizon and tolerance for short-term capital fluctuations.
- Portfolio role - defensive allocation: Bonds in a diversified portfolio serve to: (a) provide income uncorrelated with dividends, (b) preserve capital during equity market downturns (government bonds typically rise when equities fall sharply, as investors seek safety), and (c) reduce overall portfolio volatility. A traditional 60/40 portfolio (60% equities, 40% bonds) has historically provided returns close to 100% equity portfolios with materially lower drawdowns. At higher bond yields (4%+), the 40% allocation provides meaningful income as well as diversification.
- Tax treatment of bond income: Interest income from bonds (coupon payments) is assessable at your marginal tax rate in the year received - unlike dividends, there are no franking credits. Capital gains on bond ETF sales are subject to CGT - 50% discount applies if held 12+ months. Bond ETFs may also distribute capital gains embedded in the fund's annual portfolio turnover.
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