Just as it took the AIDS epidemic to deliver the safe-sex message, it's taken the global financial crisis to remind investors that long-term financial survival depends on capital protection. And there's nothing safer than an Australian Government capital guarantee.

The banks have been the main beneficiaries of the safe-investment message as Australians pull money out of shares, property and high-risk fixed-income investments and park it in government-guaranteed term deposits and savings accounts.

For investors who want the certainty of a regular fixed income with the safety of an iron-clad capital guarantee, there is another option - dowdy old government bonds.

Along with growing your own vegetables and shopping at Aldi, government bonds are back in vogue.

Australian bonds were the best-performing asset class last year with a total return of 14.9 per cent. By comparison, short-term cash investments returned 7.9 per cent.

Returns from individual bond issues are unlikely to send pulses racing but the fixed income flows into your account as regular as clockwork and you can sell your bonds before maturity if you need to.

You can currently buy a yield of about 3.3 per cent on a three-year Commonwealth Government bond and 4.3 per cent on a 10-year bond.

Semi-government bonds (issued by state governments) have slightly higher returns, up to 5.7 per cent on a 10-year Queensland Treasury Corporation bond and 4.4 per cent on its three-year bonds.

By comparison, you can earn up to 4.55 per cent on a bank term deposit if you lock your money away for three years, although most banks pay closer to 3 per cent.

If you don't want to lock your money away, you can earn up to 5 per cent with an online savings account at AMP or Bankwest - the average online rate is 4.33 per cent - but those rates are variable and likely to fall as soon as this month if the Reserve Bank cuts interest rates again.

In addition, the higher rates of online savings accounts generally come with strings attached; some are honeymoon rates and others require you to deposit a certain amount each month and make no withdrawals.

Tony Lewis, a fixed-interest specialist at Cameron Stockbrokers, says although bank deposits are government guaranteed, the details of how and when depositors get their cash back in the event of a bank failure have not been revealed.

"Payment may not be immediate, whereas government bonds have an explicit guarantee and payment date," Lewis says.

While government bonds are a byword for safety and security, they are more complex than term deposits or savings accounts so investors seduced by their charms should check them out thoroughly before putting money on the table.

How bonds work

A bond is a form of debt. You lend the Government (or a company in the case of corporate bonds) a sum of money and they pay interest, typically twice a year, for the life of the bond.

Government bonds are issued with a maturity date of anywhere from one to 30 years, when you are guaranteed your money back.

The interest rate on a bond is called the coupon; it's fixed at the time of issue and remains fixed for the life of the bond. Take the example of a September 2009 Commonwealth bond, with a 7.5 per cent coupon and an issue price of $100. You receive $7.50 a year in two payments of $3.75 for each unit you hold until maturity. The coupon rate should not be confused with the bond yield and this is where things get tricky.

Because you can buy and sell bonds before maturity, the price fluctuates over time, depending on interest rate movements, supply and demand. The yield depends on the coupon, the market price and the time left to maturity.

As you can see from the table, yields fall as the bond gets closer to maturity.

The September 2009 bond is currently trading at about $102.45. If you bought the bond at that price, you would still receive only annual interest of $7.50 but the yield on your investment, or your true rate of return, would have fallen to 2.59 per cent.

One of the hardest things for beginners to get their heads around is the fact that bond prices rise as interest rates fall and vice versa.

When interest rates fall, as they did around the globe last year, investors flock to bond issues with higher interest rates and this increased demand pushes up prices.

While Australian bonds returned close to 15 per cent last year, only 5 per cent came from interest; 10 per cent came from capital gains due to rising bond prices.

Types of bonds

Bonds are issued by federal, state and local government authorities as well as government-guaranteed authorities such as Telstra or Pacific Power.

Commonwealth bonds are guaranteed by the Federal Government while semi-government bonds are issued by state governments and, as of last week, temporarily guaranteed by the Federal Government.

On announcing the extension of the Federal Government guarantee to state borrowings, federal Treasurer Wayne Swan said the measure would make it easier for cash-strapped state governments to finance critical infrastructure investment during the global recession.

The market had expected the move for some time. Lewis says state governments had been disadvantaged by the Federal Government's guarantee of bank deposits and had been struggling to raise funds. "Joe Blog would rather put his money in a term deposit," Lewis says.

All government and semi-government bonds are AAA rated, except Queensland, which Standard & Poor's recently downgraded to AA+ due to a blowout in the state budget deficit.

Most government bonds have a fixed coupon but the Federal Government also has three issues of inflation-linked bonds whose returns are adjusted for inflation over the life of the bond. There have been no new issues since 2003, when they were jettisoned in a period of low inflation and budget surpluses.

Companies also issue bonds and other forms of fixed-interest securities, some of which are highly rated, but they don't have a capital guarantee.

Despite a low awareness of government bonds in the general community, demand is picking up, says FIIG Securities associate director David Moore. "Even though yields are low people are focusing on return of capital," he says.

Or, as Lewis puts it, "You don't buy bonds to get rich, you buy bonds for guaranteed income and protection of your capital."

Buying and selling bonds

You can buy government bonds when they're issued and hold them until maturity just like a term deposit, or you can buy and sell on the secondary market through a broker, fixed-interest specialist, financial planner or, in the case of some semi-government bonds, a bank.

If you want to bypass the middle man you can buy bonds direct from the Reserve Bank for a minimum investment of $1000.

You can download a form from the bank's website (rba.gov.au) and lodge your application in person at the bank's Sydney or Canberra offices or via the post.

There is an administration charge of $2.50 for every $1000 of face value bought or sold and no other fees or charges. This works out slightly cheaper than a broker's commission but investors are yet to catch on.

Reserve Bank head of banking Greg Johnston estimates the bank receives about 10 purchase requests a week. "Late last year [at the height of the share market crash and credit freeze] there was a bit of a pick-up," he says.

While Johnston says people with significant investment portfolios and a conservative approach might have bought in that period last year, most people gain exposure to bonds and fixed interest through superannuation or term deposits.

For semi-government bonds you can apply to the relevant state treasury corporation.

The terms of the issues vary from state to state, with a minimum investment of $5000 for Queensland bonds and $20,000 for NSW issues, and there are no fees and charges.

Investors who want to build a portfolio of bonds with different maturities and payment dates may be better off using the services of a broker.

"We can help people design portfolios that satisfy their needs [for income]," Lewis says. Bonds typically pay interest twice a year, so instead of investing $100,000 in one bond issue, he says it makes sense to purchase two lots of $50,000 and get quarterly income.

Fixed-interest brokers typically charge a margin on the current yield and most require an initial investment of at least $20,000.

"Bonds are always held in your name. If someone rings us and wants to invest in bonds, we buy the bonds and transfer them into [the client's] name. They can transfer them to their wife or kids with no stamp duty," Lewis says.

Rates and yields

The strong bond performance last year was in response to aggressive interest rate cuts, which reduced yields and pushed up prices.

Colonial First State's co-head of fixed interest, Tony Adams, says the potential for further rate cuts is limited, so investors shouldn't count on last year's stellar returns being repeated.

The market is also concerned about the prospect of new government bond issues. "The budget situations of the federal and state governments and their fiscal stimulus packages all have to be funded from somewhere and they tend to be funded by bond issuance," Adams says.

Colonial has increased its holdings of semi-government bonds at the expense of government bonds because of the widening yield spread.

Last week, before the announcement of the Federal Government guarantee, the gap between the yields of government and semi-government bonds had widened to 1.25 per cent on three-year bonds and 1.5 per cent on 10-year bonds.

These spreads were back by 0.2 percentage points within an hour of the announcement.

Queensland Treasury Corporation offers the highest yields as a result of its lower credit rating. However, Adams thinks fears of state governments defaulting on their bond guarantees were overstated. "There's not a lot of default risk in semi-government bonds," he says.

Lewis agrees: "One per cent [yield spread] was a hell of a difference, it used to be one-quarter of a per cent. At the moment everyone wants safety. In time they will want more yield. You can get both now with semi-government bonds."

The biggest threat to bond returns is inflation. While many commentators fear the stimulatory measures being used to keep the global economy on life support will fuel inflation, Lewis believes interest rates are unlikely to rise while unemployment is a problem.

"If interest rates rise, the value of government bonds will fall but I think that's some years off," Lewis says.

"My gut feeling is that you're safe investing [in bonds with maturities] up to about five years."

The beauty of pooled funds

Managed funds are a great idea for people who prefer to leave investment decisions to professionals. Unfortunately, there is only one pure Australian government bond fund and it's not easy to get your hands on it.

Last December Vanguard launched an Australian Government Bond Index Fund to an audience of financial planners desperate for a safe haven for clients reeling from investment losses.

The head of fixed interest at Vanguard, Roger McIntosh, says the fund invests in about 50 Australian government and semi-government securities that make up the UBS Australian Government Bond Index it tracks. Because it's an index fund, the fees are a low 0.29 per cent.

The fund has already taken in more than $50 million and although it's a wholesale fund with a minimum investment of $500,000, McIntosh says it's available to retail investors on "one or two" platforms including Macquarie Wrap.

If you don't mind a few supranational bond issuers such as the World Bank, or government-owned corporations such as Australian Postal Corporation, mixed in with your Australian government bonds, the Colonial First State Wholesale Sovereign Australian Bond fund might appeal. In the year to February it returned 14.72 per cent and has returned 6.5 per cent a year since 2004.

The co-head of fixed interest at Colonial First State, Tony Adams, says the fund currently holds 13.5 per cent in Commonwealth Government bonds and 44 per cent in semi-government bonds.

COMMONWEALTH BONDS WHAT YOU GET
Fixed rate or                   Purchase price
Coupon %        Maturity                ($100 face value)       Yield%
7.50            15 Sep 09       102.45          2.64
5.25            15 Aug 10       103.86          2.81
5.75            15 Jun 11       107.39          3.03
5.75            15 Apr 12       109.59          3.31
6.50            15 May 13       113.36          3.61
6.25            15 Jun 14       112.91          3.86
6.25            15 Apr 15       115.00          3.96
6.00            15 Feb 17       113.14          4.13
5.25            15 Mar 19       107.68          4.31
5.75            15 May 21       113.49          4.52
YIELDS AND PRICES AS AT 24/3/09 SOURCE: RESERVE BANK OF AUSTRALIA
SEMI-GOVERNMENT BONDS WHAT YOU GET
                        Fixed rate                              Price           Yield
                        or Coupon %     Maturity                $               %
NSW Treasury Corp               6               1 May 12                104.981                 4.26
                        5.5             1 Aug 14                102.653                 4.9275
                        6               1 Apr 19                103.381                 5.555
Queensland Treasury Corp        6.5             16 Apr 12       106.137                 4.3275
                        6               14 Aug 13       104.843                 4.76
                        6               14 Oct 15       104.301                 5.215
                        6               14 Sep 17       103.633                 5.4575
Treasury Corp of Victoria       6.25            15 Oct 12       106.361                 4.295
                        4.75            15 Oct 14       99.361          4.8825
                        5.5             15 Nov 18       100.438                 5.44
YIELDS AND PRICES AS AT 25/3/09 SOURCE: CAMERON STOCKBROKERS