5 reasons to buy bonds. 5 not to
Get a simple overview of bonds, which are an important asset class to include in an investor’s portfolio.
Personal investors are often confused by the different investment options available to them. It can be difficult to understand the financial jargon that describes each product.
Buying a bond essentially means you are loaning money to the government or a corporate borrower. For a certain number of years, you will receive regular interest payments and at the end of the agree upon term or ‘maturity’, you get your principal back.
That’s the theory. However, the reality can be more complicated.
Here are the pros and cons of bond investments to help you decide if you should deploy your money in this instrument.
For some investors, the regularity with which they receive a return is of prime importance. This could be true for retired people or for those who supplement their monthly earnings with income from their savings.
An investment in bonds will give you a consistent stream of returns. You know exactly how much you will receive and the dates on which you will receive it. If it’s stability that you are looking for, it is hard to beat bonds.
The success of your investment strategy will depend to a significant extent on your asset allocation. Don’t make the mistake of investing only in one asset class.
The stock market may promise attractive returns, but remember that it is volatile. It is quite normal to see your principal being depleted by 10% or even more during times when the market is falling. An investment in bonds can potentially help you to stabilise your portfolio. They provide a regular stream of income, an essential requirement for many older investors.
There are times when keeping your principal amount intact is your prime focus. You could be approaching retirement in a few years or you could have suffered losses in your investment portfolio.
Some bonds like Government bonds can help you to protect your capital. Knowing that your funds are safe can be very reassuring in times of market volatility.
For many investors, liquidity is of prime concern. The ability to access your funds at short notice can be a deciding factor in selecting an investment. While it is true that you can sell your stocks and receive the sale proceeds in a matter of days, share investments have one inherent disadvantage. The market may be depressed when you need your money. Selling your shares at a loss may not be a good idea.
Singapore Savings Bonds can be redeemed early if you need your money back. There is no penalty for early redemption. All that you have to pay is a S$2 transaction fee.
Some investors make the mistake of maintaining large sums in term deposits in the bank. Why do they do this? In most instances, these individuals are looking for:
- Safety – they don’t want to take on any risk at all.
- Liquidity – they want to be able to access their money at short notice.
A bank deposit with DBS is absolutely safe and you can get your money back whenever you need it. But the deposit will provide an interest rate of only 1.2% per year. An investment in Singapore Savings Bonds offers an interest rate of between 2% and 3%.
Not all bonds are created equal.
Corporate bonds can carry a high level of risk and investors should conduct a thorough due diligence before committing their funds.
Remember that a bond pays you interest that is at a fixed rate. Over the years, the value of your return may fall because of inflation. According to the Monetary Authority of Singapore, the yearly inflation rate is about 2%. Consequently, your returns will be diluted to this extent.
It can be very difficult to judge whether a company will have the ability to meet its repayment commitments. Take the example of a firm that is involved in the oil industry. A few years ago, oil prices were more than US$100 per barrel. Subsequently, they fell to the US$30 – US$40 range. A company that would have been highly profitable when oil prices were high could quickly start losing money.
It is difficult to predict if a firm will continue to do well for years into the future. Subscribing to a bond issue that matures after five or ten years therefore carries substantial risk and should be carefully considered.
Purchasing bonds, especially capital guaranteed bonds issued by the government, means settling for low returns.
If you assume a 10-year time horizon and a bond investment that yields 2.4%, a sum of S$10,000 will grow to S$12,677. An investment in the stock market that yields an assumed 8% per year return will give you S$21,589. (Returns in both instances have been compounded yearly.)
You could consider looking for alternative asset classes to invest in that present opportunities for higher returns within a level of risk you are able to tolerate.
Many young investors put all their savings into bonds in the mistaken belief that safety is their greatest concern. Over an extended period, other investments can potentially give higher returns.
If you are in your 20s or 30s and are investing for your retirement, bonds should be a low priority for you and should not constitute the majority of your investment holdings as they generally provide low returns, which may not even keep up with inflation.