There's been much commentary lately about bonds and what purpose they serve for investors, with even Warren Buffet weighing in on the conversation. But what exactly is a bond? And why do they play such an important role in diversified portfolios?

What is a bond?

Bonds operate like an IOU, whereby you lend your money to the bond issuer for a set period of time, in return for interest paid over the term of your investment. Your investment, or capital, is then paid back to you in full at the end of the investment term.

Bonds can be issued by the Federal government, state governments, semi-government authorities, banks and other corporations, both locally and overseas, to raise capital for projects.

Bonds usually have longer investment terms than cash investments. Australian bond maturities usually range from one to 10 years while US bonds can extend up to 30 years.

Bonds can be traded on the secondary market before their maturity. For example, the Australian government issues a bond which is then bought and sold in a secondary market by fund managers. Retail investors then purchase bonds through these managers, who profit off price fluctuations.

Risk/return characteristics

Bonds are a low– to medium– risk investment suitable for investors with a timeframe of three years or more.

In addition to providing a regular income stream – an important feature for many investors – bonds may provide a stabilising effect during periods of sharemarket volatility.

Total bond returns can include income from interest payments and growth from price fluctuations. Bond yields are inversely related to bond prices. When bond yields rise, bond prices will fall and vice versa.

Bond yields and prices may fluctuate regularly based on the economic outlook. Bonds can provide capital growth (and loss) when sold prior to the maturity date for a higher (or lower) price.

Credit risk refers to the risk of an issuer defaulting on repayment of capital. Credit ratings provide a good indication of the risk level associated with the issuer. Bond issues are rated by independent rating agencies like Standard & Poor's. The higher the rating the less likelihood of the issuer defaulting on repaying your capital. Usually, the higher the risk, the higher the yield.

Bonds provide a buffer in volatile markets

Bonds can provide a buffer against volatile share markets when held in a diversified portfolio.

Bond returns tend to move in the opposite direction to shares and play a valuable role in protecting near-term downside risk when the share market performs worse than expected over short periods.

In other words, they provide asset class diversification to help smooth out total investment returns over time.

Accessing bond markets

You can invest in bonds directly or through an ETF or managed fund. ETFs and managed funds provide a cost-effective way of accessing a diversified portfolio of bonds, which can include a mix of Australian or international government and corporate bonds, or a combination of both.

Smart Investing, Vanguard

Note: If in doubt, speak to your Financial Advisor/Planner, or call Westmount Financial/Rick Maggi (Perth)