Investing

There are fixed-interest assets that can pay higher returns than others, but they also come with a higher risk of loss.

Australian government bonds are viewed as risk-free and offer the lowest return to investors. Hybrid securities are riskier than most other types of fixed income, so the expected return should be higher.

Below are the chief categories of fixed-interest assets to consider when setting up a portfolio.

Cash at call

Returns you can receive from cash parked in an account at a bank, building society or credit union will depend on the institution and account type.

According to research house Canstar, the best rates are paid by high-interest online savings accounts.

Interest rates tend to drop as the official cash rate drops. However, financial institutions are keen to get deposits, so they may keep rates relatively high.

Term deposits

Banks, credit unions and building societies offer term deposits that lock away money for a fixed period in return for a fixed rate of interest.

The interest rate will vary depending on the amount and term. Term deposits run from one month to five years, and sometimes longer.

The withdrawal of any funds before the maturity date will generally incur a fee.

Government bonds

If you invest in a government bond, effectively it is a loan to the government for which it pays an annual rate of interest and promises to return your capital at maturity.

It might be the federal government (via the Reserve Bank of Australia), a state government or a territory that issues the bonds. Every bond has a face value, which is the amount you will get back at the end of a fixed term, and a coupon, which is the interest paid each year. Commonwealth government bonds carry the highest credit rating (AAA/Aaa) and are considered a risk-free investment as the Commonwealth theoretically has unlimited ability to tax or produce currency to repay investors their capital at maturity.

Minimum investments in government bonds are generally $500,000. The yield on the 10-year Commonwealth government bonds is about 3.5 per cent (as at January 2012).

However, the most common way for retail investors to get access to a diversified portfolio of government bonds remains through a managed bond fund.

Inflation-linked bonds

Generally issued by governments and operators of infrastructure projects, these bonds pay a lower interest rate because the capital value of an investment will increase with inflation. The minimum investment in most inflation-linked bonds is $500,000 so most retail investors get access to them through a managed fund.

Due to the small number of dedicated inflation-linked bond funds, diversified bond funds that invest in a mix of assets are often the best bet.

Fixed-interest brokers can organise a direct investment for people with larger sums. FIIG Securities sells minimum $50,000 investments in two inflation-linked bonds, offered by Envestra and Sydney Airports. The Envestra inflation-linked bond matures in 2025 and has a yield of 8.15 per cent. The Sydney Airport inflation-linked bond matures in 2020 and has a yield of 7.8 per cent.

Corporate bonds

By investing in a corporate bond, you are lending money to a business in return for interest payments. All going well, the company will repay the capital at a predetermined date.

The main risk of corporate bonds is that the company might not be able to pay the interest or repay the capital when it is due or if the business collapses.

But corporate bonds rank above equity in the capital structure of a company. So if a company becomes insolvent, the proceeds of any liquidated assets will be paid to bond holders ahead of shareholders.

Corporate bonds should be judged on the likelihood that they will meet their obligations to pay interest and repay capital.

Only a handful of corporate bonds are listed on the Australian Stock Exchange but brokers may be able to offer smaller parcels of corporate bonds, generally at a minimum investment of $50,000.

Hybrids

Hybrid securities are a combination of different financial instruments.

For example, a security might perform like a bond by paying a regular income but its capital value may be affected by the share price movements of the ordinary shares into which it will eventually convert.

Hybrids are usually higher risk than other fixed-interest assets as investors rank below holders of ordinary bonds in the event of a company collapse and the repayment of debt.

A company might issue subordinated debt in the form of bonds which generally ranks below unsubordinated debt.

Investors should expect higher returns from subordinated investments. Common hybrids include preference shares and convertible notes.

Reset preference shares act like traditional bonds to begin with – paying investors a fixed or floating interest rate (often franked) – but at maturity, or a specified date, can be converted to ordinary shares, cashed in, or rolled over into a new security.

Convertible notes pay a fixed coupon rate and can be converted into ordinary shares at a particular date or period of time in the future.

“Investors need to understand that there is still a risk that the capital value of these fixed-interest assets can fall – particularly if investors sell out to move into higher interest generating alternatives,” says Prescott Securities financial adviser Helen Dundon.

Strategies to get the most out of fixed interest