A guide to bonds

A guide to bonds

Investing in equities or stocks is not only the most popular but among the easiest ways for people to get started on their investment journey. Here’s why.

Financial news and street talk tend to give more airplay to stocks (compared with bonds) and when share prices jump or dive, it usually gets the most headline attention. Stock prices tend to move aggressively too, giving a sense of excitement that profits can be made in a pretty short amount of time.

It doesn’t help that some retail investors have the misperception that bonds are an inaccessible asset class. They also believe the market to be complex due to the wide-ranging terminology used to describe components of the bond.

These are some of the common factors that have often left “boring” bonds in the shadows. That said, bonds are an essential component of an investment portfolio. Moreover, they play an essential role in diversification as they help to lower risks by a concentration of similar asset types.

A comprehensive investment portfolio should include both stocks and bonds. Stocks give investors the opportunity to capitalise in bull markets, which could result in better-than-average capital appreciation of their overall portfolio. On the other hand, bonds are viewed as more stable assets, which can cushion blows taken by an investor during bear markets while providing a regular stream of interest payments.

You are free to decide on the allocation of your funds between stocks and bonds as much of this is down to your personal investment philosophy and objectives. With your preferred allocation for these two asset classes, you can enjoy the best of both worlds.

A guide to bonds

If you are new to or interested in investing in bonds, here’s a quick rundown.

Unlike stocks, which give you ownership in a company, bonds represent a debt obligation to investors. So, by investing in a bond, you are making a loan (instead of taking one). In addition, bonds are issued by organisations, which means issuers are not only companies but governments too.

Broadly speaking, when you purchase a bond, the issuer is obliged to pay an interest coupon - a predetermined annual interest rate on the bond. This is expressed as a percentage of the face value of the bond. Think of face value as similar to the Initial Public Offering (IPO) price for a stock.

A guide to bonds

Bearing in mind that a bond is essentially a loan, the issuer is required to make these regular interest payments — usually annually or semi-annually — to the investor until the end of the period of the bond. Only then will the issuer return the principal to the investor.

A guide to bonds

Bonds provide a regular recurring payment; this becomes a source of regular income for the investor. As such, bonds are also known as fixed income instruments.

If a company intends to issue a bond with a face value of $1.00 at a coupon rate of 4.5% to be paid yearly, after 10 years the investor is expected to receive a total of $1.45 per bond if it has been held for the full duration.

This is illustrated below:

Bond

Value

Principal $1
Interest coupon x duration $0.045x10
Total Return upon maturity $1.45

If you have familiarity with investing in stocks you might see some parallels.

There is some truth to this. Afterall, bonds are traded in public markets and their prices can fluctuate, just like stocks. Moreover, the interest coupon component is similar to dividends paid out to investors in that there is a regularity to receiving payments from stock issuers.

However, these similarities are just on the surface.

Bonds are less volatile in nature to stocks, which should limit the variance in the price of bonds in public markets. Moreover, coupon interest is fixed and should not be confused with dividends, which can vary according to the performance of a company. Dividends are also not obligatory as companies can choose to reinvest their profits.

If investors are looking for a hybrid of bonds and shares, they can choose to invest in perpetuals or “perps”. They provide investors with regular fixed income but do not have a maturity date.

A guide to bonds

A key drawback to these types of bond is that they are not redeemable. That said, issuers do pay a regular stream of interest payments in perpetuity, in other words, forever. An exception to this is when the issuer opts to “call back” or redeems the bond.

If investors want to get back initial the investment, they can choose to sell these bonds in public markets.

Given that money loses value over time due to inflation, the annual interest payment to investors carries less value over time. As such, even though perpetuals pay interest forever it is a of a finite value, which in turn represents their price.

Making sense of bond terminology

For an investor with limited experience investing in bonds, the barrage of terminology that comes across might throw off interest in gaining an understanding of the asset class.

However, you should still take the time to learn the terms associated with bond investing. A simple breakdown is listed below:

Term

Meaning

Face Value The face value or par value of a bond is the amount that the bond issuer has borrowed from the investor.
Coupon The fixed rate of interest to be paid by the bond issuer to the investor multiplied by the face value of the bond.

For example:

A guide to bonds

Fixed Income This is also known as an annual interest payment or the amount received in coupons at regular intervals is the investor’s fixed income per year.
Current yield Bonds are typically tradable. As market prices vary from the face value, the current yield of a bond is the annual coupon interest payment of the bond divided by the bond’s current price.

For example:

A guide to bonds

Bond price In contrast with face value, a bond’s price is what investors are willing to pay a bond that has already been listed in public markets.

If a bond’s face value is S$100,000 but it is trading at S$105,000 then a bond is said to be quoted at 105%. This means that the said bond is trading at a 5% premium.
Callable This means the issuer can buy back the bonds at an earlier date than the maturity date, paying the investors the principal.
Step-up This means the coupon payable rises on a set date. For example, a particular 10-year bond might have a coupon rate of 4.5% in the first 5 years before it increases to 5% for the last 5 years of the years of the duration.

Three factors that drive bond prices

1. Interest rates

Bond prices have an inverse relationship with interest rates. This means bond prices usually rise when interest rates fall. The interest rate is the amount a lender like a Central Bank or an agent bank like DBS charges individuals or organisations for borrowing money.

For example, if an investor owns a bond paying a coupon rate of 4.5%, when interest rates are low at 1% - similar to what they are now - bonds appear attractive as the bond’s coupon rate is higher than the going interest. This changes if interest rates rise to 4.6% or higher as the bond’s coupon rate will now give the investors less return for the same amount invested.

As a further illustration, if an investor purchases a 10-year government bond with a coupon of 3% at face value of $10,000.

If within the first year of holding the bond, interest rates increase to 5.5% and new government bonds are issued at a coupon rate of 5.5%, the investor would not be able to sell the 3% coupon bonds at the face value of $10,000.

Since the coupon of the bond is fixed the only thing which can adjust to make the 3% bond appealing to a potential purchaser of the 5.5% bond is price. The price will have to be adjusted downward to give the 3% bond a higher yield. This means the 3% coupon bonds the investor bought will need to be sold in the market for a discount (less than the face value).

2. Inflation

Like interest rates, bonds have an inverse relationship with inflation. In general, when inflation is on the rise, bond prices fall.  Inflation can be defined as the sustained increase in the general price of goods and services in an economy. The result of this is a decrease in the purchasing power of each unit of currency. Simply put, you would have been able to buy more with $1,000 in 2020 than you would a decade later.

The inverse relationship exists because rising inflation erodes the purchasing power of your principal when subscribing to a bond. When your bond matures, the return you’ve earned on your investment will be worth less in today’s dollars.

Inflation also affects the purchasing power of the regular interest payments you receive from holding a bond. Put simply, the higher the current rate of inflation and the higher investors expect the bond coupon rate to be as investors will demand this higher yield to compensate for inflation risk.

For example, if the forecasted inflation rate for 2020 is 1.5%, holding a bond that pays a coupon rate of 2.5% would be worthwhile for an investor but if inflation is forecasted to increase to 3% in 2021, the investor could be better off moving to a higher yielding bond in the future.

A guide to bonds

3. Creditworthiness of an issuer

Understanding credit ratings are essential in an investor’s decision-making process when investing in bonds. Afterall, bonds are debt instruments and investors need a sense of how safe or unsafe it is to lend money.

A credit rating can provide information about an issuer’s ability to make interest payments and repay the principal on a bond. The higher the credit rating, the stronger the financial standing of the bond issuer in the eyes of the ratings agency.

Along with credit quality, investors also face default risk. This happens when the issuer of the bond fails to satisfy the terms of the obligation with respect to the timely payment of interest and/or repayment of principal.

If the issuer’s credit rating goes up, the price of its bonds will rise. If the rating goes down, it will drive its bond prices lower.

Different credit ratings agencies use different ratings system. Standard & Poor (S&P) – one of three main rating agencies – uses the following system to provide bond investors with a reliable gauge of credit quality.

A guide to bonds

Investment grade bonds have a lower risk of default and issuers of such bonds range from being those with moderate to minimal credit risk. As investment grade bonds are viewed as safer, they are usually issued at lower yields than less creditworthy bonds.

However, an unrated bond does not mean that the issuer is of poor financial standing. In some cases, the issuing company is so confident that its bonds will sell on the company’s brand name or reputation and does not want to put resources towards getting a credit rating.

In such an instance, unless you are able to assess the non-rated issuer’s balance sheet, earnings, cash flow situation and outlook yourself, you are taking on the risk of lending only on the basis of reputation, which may or may not be indicative of actual credit quality.

A guide to bonds

"Democratization” of Bond investing

For many years, bonds were viewed as out of reach for retail investors. To recap, the larger part of the bond market is only for accredited investors who are individuals who might be broadly regarded as having “high net worth”. In contrast, retail investors refer to those with personal assets of less than S$2 million and annual income below S$300,000.

In the past, many corporate bonds are only available to investors with at least S$250,000 to fork out per trade. However, there are avenues now open to small investors. Even from as little as a few hundred dollars, investors can start investing in some bonds in Singapore.

Now that you understand the different types of bonds available in Singapore, you can consider investing in one or more.

Here are the options for investing in bonds for Singapore retail investors:

1. Retail bonds traded on the Singapore Exchange (SGX). They can be bought and sold in “board lots” or minimum trade sizes of 1,000 units. There are about a dozen such bonds which are traded on the SGX. Buy/Sell prices are publicly available on the SGX website.

2. If investors want diversification of their bond investments for a relatively small amount, an alternative is a bond exchange traded fund (ETF). Banks can offer a range of such ETFs. There are four bond ETFs traded on the SGX in minimum board lots of 100 units or 5 units, depending on the specific ETF. 

These ETFs offer diversified investment in Asian corporate and Singapore government bonds. For example, the ABF Singapore Bond ETF trades in board lots of 100 units. And they are priced at time of writing around S$1.11-S$1.12. So, each board lot would require an investment of S$111 to S$112 only, excluding brokerage fees and taxes. Note you can also invest in a Singapore bond ETF via a regular savings plan through local banks like DBS.

3. Another option is the Singapore Savings Bond (SSB), which provides a higher return alternative to fixed deposit accounts. You can invest in SSBs from as little as $500.

They are issued and backed by the Government of Singapore, which enjoys the highest credit ratings from the world’s top three credit rating agencies.

They are issued with 10-year maturities, but SSB holders may redeem their bonds at any time, with no penalties. Unlike corporate bonds, SSBs cannot be sold to another party. They can only be redeemed through the Singapore Government.

The interest rate is based on the average yields for benchmark Singapore Government Securities (SGS) recorded the month before the SSB issue. The return starts lower and steps up over time. If you hold your SSBs for the full 10-years, your return will match the 10-year SGS in the month before the bond was issued. If you redeem early, you will receive a lower return – a figure similar to that for an SGS of an equivalent tenure.

4. Finally, there are unit trusts which investors may invest in through banks and stockbrokers. Investors in Singapore can access a wide variety of unit trusts which invest in different segments of the bond markets – government bonds, investment grade corporate bonds, high yield bonds, etc.

Unit trusts pool investors’ funds to buy a large portfolio of securities. Investors can buy into UTs for as little as S$1,000 as a lump sum or S$100 a month under a regular savings plan. Yet, as a result of the pooling of investors’ monies, these funds often hold portfolios of 40-50 stocks or bonds, thus reducing the risks associated with any of those securities.

A guide to bonds

Options to invest in non-local bond issues

As previously mentioned, the introduction of Bond ETFs has democratised the asset class. This gives most retail investors ample opportunities to gain exposure to both government and corporate bonds. The options are not limited to local bond issues and cover sector and countries all over.

Investors in Singapore also have the option to purchase Bond ETFs of non-Singapore issuers on the Singapore Exchange (SGX).

In the second half of 2020, two China-focused bond ETFs were launched on the SGX. For exposure to bonds issued by the Chinese government and three policy banks, investors can select NikkoAM-ICBCSG China Bond ETF for “board lot” or minimum trade sizes of 10 units.

If you prefer exposure to just Chinese government bonds, you might prefer the ICBC CSOP FTSE Chinese Government Bond Index ETF. You will have to purchase a minimum of 10 units to invest in this ETF.

For diversified exposure to the region’s bond markets, the iShares Barclays Capital USD Asia High Yield Bond Index ETF allows you to invest in high yield bonds issued by governments and corporates in Asia excluding Japan. The minimum trade size to invest is 100 units.

The most diversified of bond ETFs listed in Singapore with a regional focus is the iShares J.P. Morgan USD Asia Credit Bond Index ETF. The ETF has holdings of debt instruments issued by governments, government-linked entities and corporates in Asia excluding Japan. The minimum trade size to invest is 100 units.

Considerations before taking the plunge

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.

Bonds, in general, are less risky and more conservative than stocks. But, contrary to popular belief, fixed income investing involves a great deal of research and analysis. Just like investing in stocks, those who don't do their homework run the risk of suffering low or negative returns.

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Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.

All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.

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