8 essentials for the bond investor

8 essentials for the bond investor

“My word is my bond.” We’ve all probably heard that expression. Hence, the idea behind this asset class called “bonds”. It is a promise to repay a loan – a legally sophisticated IOU.

Let’s start by understanding the fundamentals of this product. What are bonds? Are there different types of bonds? How do bonds work? How can you evaluate their quality? What are the risks associated with bonds?

A bond is a debt instrument

When you buy a bond, you are lending money to the company that is issuing the bond. Investors usually buy bonds for three main reasons – for the regular income (“coupon”) offered, the promise that they will get their principal back on maturity of the bond, and the diversification that bonds offer to stock portfolios.

The coupon is the fixed income you get for your investment

Think of it as the interest you receive for lending your money, until the bond matures. The amount of coupon you receive generally corresponds to the level of risk involved. A bigger coupon typically means there is a higher risk involved. Coupons are generally also higher for longer-dated bonds, to compensate you for the risks of lending to the company for a longer period of time.

While the fixed income of bonds may be a pull factor, you are locked into a fixed compensation for lending your money

This fixed compensation is beneficial if interest rates are falling, but will not be so attractive when interest rates are rising.

The returns for bonds vary according to the credit risk

There are different grades of risk even within the “bonds” asset class. Not all bonds are created equal. There are government bonds, which generally tend to be safer than corporate bonds. Why? Because governments’ finances are backed by taxation powers over an economy. But note that some of the biggest companies in the world have a higher credit rating than some governments.

So, governments’ credit worthiness differs greatly. For example, Singapore government securities (bonds) enjoy the highest credit rating of AAA. The credit rating of the Government of Greece on the other hand ranges from CC to B, depending on the ratings agency. To cut through the jargon, Greek government securities are “junk bonds”, which means they carry significant risk of default. So, you get much higher payoffs from Greek government bonds compared to Singapore government securities. That’s the risk-reward trade-off.

The higher the credit rating, the stronger the financial standing of the bond issuer is in the eyes of the ratings agency. Different credit rating agencies use different rating systems.

A widely followed agency, S&P Global Ratings, adopts the following system:

  • AAA to BBB- for investment grade bonds, AAA being the highest quality.
  • BB+ to B indicate non-investment grade or speculative bonds.
  • CCC and below are applied to high-risk to potential default bonds.

However, just because a bond is unrated does not necessarily mean that the issuer is of poor financial standing. In some cases, the issuing company could be very confident of its bonds selling on the back of the company’s brand name and reputation that it deems it unnecessary to spend money and management time to obtain a credit rating.

A “perpetual” (or a “perp”) is a hybrid between a bond and a stock

Perpetuals offer fixed income but has no maturity date. The issuer has no obligation to pay the investor the principal at a specific date either. Investors usually need to sell them on the market at the prevailing price to get their funds back. In some instances, issuers may redeem their perpetuals (known as “called” back), but this is at the discretion of the issuer and is not an obligation.

Be thorough about the features of each bond

Be familiar with all the features, and terms and conditions of the bond. Some bonds are “callable”, which means the issuer can buy back the bonds and pay investors the principal earlier than the maturity date. Some bonds have a “step-up” feature, where the coupon amount rises on pre-set dates.

Always remember that while bonds are regarded as “safer” than stocks and shares, safety depends on the credit quality of its issuer

You know the saying “my word is my bond”? There are rare occasions when investors lose money investing in bonds when the issuer defaults on the payment, which means they become financially unable to pay either the coupon, or the principal on maturity.

In an event of corporate bankruptcy, secured creditors will get paid first. Bond investors (who typically hold unsecured corporate bonds) rank lower – but they will still get paid before shareholders do in such a situation.

Some bonds have lower liquidity than publicly traded stocks and shares

Liquidity refers to the extent that assets – in this case, bonds – can be bought and sold at stable prices. Bond prices can be affected by investor perceptions of inflation and interest rates, credit quality and if the gap between what buyers are prepared to pay and what sellers are asking for (bid-ask spread) becomes significantly large. Low liquidity happens when there are few buyers and sellers in the market.

For investors who intend to hold the bonds to maturity, liquidity is not an issue. But for investors who may need the funds before the bond matures, liquidity concerns are real.

The liquidity concern applies whether the bonds are traded centrally on the Singapore Exchange (SGX), or to non-retail bonds that bought and sold via over-the-counter (OTC) dealer networks.

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