What are Investment Bonds? - Primed For Prosperity

If you Google the topic , it’s difficult to understand the differences between the various bonds. Hence the need to elaborate.

There are four type of bonds. Government bonds, Corporate bonds, Education bonds and Investment bonds .

The Moneysmart website explains the differences between government and corporate bonds. Government bonds are a defensive type of investment. Have a read here –https://moneysmart.gov.au/investments-paying-interest/bonds

Previously, these were called insurance bonds, however there is no insurance component now and they are referred to as investment bonds. They are recognized by subsection 9(1)(f) and (g) of the Life Insurance Act 1995(Cwlth) which allow issuers to pay tax on income and capital gains at 30 per cent depending up on the level of franking credits the investment receives.

What this means in plain language is that the bond is an investment vehicle that is taxed internally and with the benefit of franking credits the tax paid is lower than 30 per cent. The income earned within this investment does not form part of your tax return.

How do investment bonds work?

1.Depending on the underlying investment options you choose ( similar to choosing your investment options in your super fund) the product issuer will let you know what the minimum amount per investment is.

2.You can set up via your preferred payment method your monthly investment amount. This is called the Dollar Cost Averaging method. By investing small amounts over a period of time which usually results in a lower average unit entry price.

3.Suppose you invest $1,000 per month and continue this for 10 years , you will get your proceeds exempt from capital gains tax. Comparatively if you followed the same process and invested in ETF’s ,direct shares or managed funds you would have to pay capital gains tax.

4.If your disposable income increases you can increase your investment amount to $2,250 per month( the 125% rule) . Say you make regular payments for three years but for some reason don’t make any in the fourth year, and then if you make any contributions in the fifth year your 10 year period will be reset. Else you can leave that one to run its 10 year period and start a brand new investment bond to get the tax benefits.

What is the 125% rule?

In order to maintain the preferential tax treatment you cannot invest more than 125% of your initial amount.
You can keep increasing the amount by 125% till the 10th year and beyond if your cash flow allows you to. You can invest $10,000 in year 1, $12,500 in year 2 and $15,625 in year 3 so and so forth.
If you don’t make a payment in a year then the next contribution will restart the 10 year period for the whole invested amount.

Underlying investments

Depending on the issuer you can choose from a menu of investment options depending on your purpose for this investment. Many of the Vanguard options are found in these menus making it easier for some investors who are already familiar with these themes. Some of the established issuers in this space are Australian Unity, IOOF and Generation Life.

Tax treatment

They are internally taxed at a maximum rate of 30 % and if you hold them for 10 years there is no capital gains tax on the proceeds.

Time of Redemption	Tax Treatment
During the first 8 years of investment	100% of the earnings are included in your assessable income and you get a 30% tax offset for the tax already paid by the bond.
During the 9^th year	2/3 of the earnings are included in your assessable income and you get a 30% tax offset for the tax already paid by the bond.
During the 10^th year	2/3 of the earnings are included in your assessable income and you get a 30% tax offset for the tax already paid by the bond.
After 10 years	All earnings are tax free and are not included in your tax return.

Fees

The issuer of the bond will charge an administration fee and the underlying investment will charge a management fee. These fees are similar to what you will pay if you invest via an IDPS platform or a wrap platform provider like Macquarie, Netwealth or Hub 24. This extra layer of administration fees is paid to the issuer for facilitating the investment, providing you a login, reporting etc.

Who is it suitable for?

You are probably thinking, this all sounds quite complicated, and who can it really benefit?

High income earners whose marginal tax rate is above 30% can get the benefit of a reduced tax rate.
If the bond holder dies the amount is paid out tax free irrespective of the holding period. It can be nominated to a beneficiary as well and this has been proven to be an effective estate planning tool for gifting assets to specific beneficiaries.
It can be a good way to earmark funds for a particular goal in 10 years time, say a milestone birthday, wedding anniversary etc.
They can be used to fund children’s education however there is a separate product called an education bond that maybe more suitable.
Good way to build up passive income for the future outside of superannuation and it is not subject to the restrictions of super which are dictated by political parties.

In Summary

Though it seems quite straightforward the implementation of this strategy can be tricky.

You need to be very organised to ensure that you do not miss a payment and your 10 year period is reset.
You need to ensure that you have a sufficient cash buffer to take care of emergencies before investing.
You can choose a defensive option if you dont want to be exposed to the volatility of the share market however the fees charged may not make such a strategy worthwhile.

Disclaimer

Please note the above information is purely for educational purposes. Please consult a registered financial adviser and get personal financial advice based on your goals and objectives.