What is a bond?
Bonds are basically loans issued by the government or a corporation, of which the investor is the lender. In return, the bond issuer will usually pay the bondholder a fixed interest over a predetermined period, agreed on at the time of purchase. This interest rate is known as a coupon. The investor will get back the borrowed amount, also known as face value, par value or principal amount, on the maturity date.
For example, John purchases a bond of $1 million that matures on 1st January 2040 from a corporation at a coupon rate of 2.8% per annum. John is now the bondholder, and receives 2.8% of the face value from the corporation every year until maturity. At maturity, the corporation will pay John back the face value.
Why invest in bonds?
1. Fixed Income
Bondholders enjoy fixed payments regularly until the bond matures, which is a form of passive income. This is especially important for retirees or the unemployed.
Furthermore, having a fixed income stream and the timing certainty of cash inflows enables investors to manage their finances and investments better.
2. Preservation of Capital
Unlike stocks, there is certainty in the amount to be received upon maturity. An ideal capital preservation portfolio should have at least some allocation to bonds.
3. Less Risky
As opposed to stock investors, bondholders are paid first in the event that a corporation encounters bankruptcy. Also, bond prices are less volatile compared to stocks, which means you can use bonds to diversify portfolios and manage investment risk.
How do you earn from investing in bonds?
Receive Coupons
Investors receive coupon payments when they hold onto a bond. These represent the fixed amount of interest to be paid out for the bond, expressed as a percentage of the bond’s face value, say $5 per year on par value of $100, or a 5% p.a. coupon rate.
Potential capital appreciation
Instead of holding a bond to maturity, investors may also choose to sell their bonds to other investors in the secondary market. This is similar to the stock market, where stocks change hands at prices agreed upon by both the buyer and the seller. An investor who does so can benefit from potential capital appreciation if the yield on the bond declines, resulting in a corresponding increase in the bond price. As such, the bond investor may not have to wait for a bond to mature to profit from the investment.
Conversely, if bond yields rise, there could be mark-to-market losses – an investor who wishes to sell the bond in the secondary market prior to maturity could face losses on the bond. However, bond investors also have the option of waiting for the bond to mature to avoid realising mark-to-market losses.
Yield to Maturity
The yield to maturity is possibly one of the most critical figures to look at when assessing a bond for investment, since that represents a good approximation of the rate of return that an investor can receive from holding a bond to maturity. In calculating this, investors need to consider two components – the bond’s coupon rate and price of the bond.
As a rule of thumb, if an investor buys a bond above par value (e.g. at a price of $105 versus $100 face value), the actual yield on the bond will be lower than the coupon rate. Conversely, if an investor buys a bond at a discount to par value (e.g. $95 versus $100 face value), the yield on the bond to the investor would be higher than the stated coupon rate. Thus, the only time a coupon rate equals the bond’s yield is when the investor purchases the bond at par value (i.e. paying $100 for $100 of face value). As such, investors seeking out bonds may wish to focus more on the bond’s yield to maturity rather than paying too much attention to the bond’s coupon rate.
A few examples of the types of bonds available
- Developed Sovereign Bonds
- Quasi-sovereign Bonds
- Investment-grade Corporate Bonds
- Non-investment grade Corporate Bonds
Developed Sovereign Bonds
Usually refer to government-issued bonds from countries that have high levels of economic stability.
These bonds are usually accorded high credit ratings from the three main credit ratings agencies (S&P, Moody’s and Fitch Ratings).
Examples include US Treasuries, Singapore Government Securities, and Hong Kong Government Bonds.
Their bond yields form the basis for risk-free rates for investors in their respective countries.
(i) What kind of returns can I expect?
- Lowest yields, compared to other bond segments
(ii) What risks should I be mindful of?
- Generally free from default/credit risk, but interest rate risk is an issue for longer-maturity securities
- Suitable for investors who want lowest risk bonds as fixed deposit alternatives that can provide a source of stable income
Quasi-sovereign Bonds
“Quasi-sovereign” entities are companies with full or government ownership or control, or established under specific legal statutes. They usually enjoy support from the government. Examples of these include government agencies.
The different levels of implied government support can result in differing yields for quasi-sovereign bonds, even for those of similar maturities; credit ratings agencies tend to take this into account when assigning credit ratings to quasi-sovereign entities.
Examples of quasi-sovereign issuers would include Singapore’s Housing Development Board (HDB), one of the country’s sovereign wealth funds (Temasek Holdings), or Hong Kong’s Kowloon Canton Railway Corp.
(i) What kind of returns can I expect?
- The segment is generally characterised by low yields, similar to their sovereign counterparts
(ii) What risks should I be mindful of?
- Generally free from default/credit risk, but implied government assistance is rarely tested; interest rate risk is still an issue for longer-dated securities
- Suitable for investors who want lower risk bonds which can offer marginally higher yields compared to government bonds
Investment-grade Corporate Bonds
These are bonds issued by companies that have superior financial standing and a better ability to service debt.
They are rated from AAA to BBB- (S&P and Fitch rating scale), or Aaa to Baa3 (Moody’s).
(i) What kind of returns can I expect?
- Differing levels of yields, depending on whether the corporate bond is closer to AAA (highest possible rating) or BBB- (just one notch away from “junk”, or “non-investment grade”)
(ii) What risks should I be mindful of?
- As opposed to sovereign bonds (or even quasi-sovereign bonds), credit risk is an issue – there is the risk that an issuer could default, leading to an impairment on the bond investment.
- Investors have to be mindful of interest rate risk, which can affect the performance of longer-maturity securities.
- Investors can usually find a good mix of lower and higher yielding names in the investment-grade corporate space, which can offer differing risk-reward profiles.
- Suitable for investors who want to take on some credit risk in exchange for higher yields.
Non-Investment Grade Corporate Bonds
These are issued by corporations that have lower creditworthiness, usually by smaller or highly leveraged companies.
These bonds are accorded credit ratings of BB+ or lower (S&P and Fitch), or Ba1 or lower (Moody’s)
Sometimes known as “high-yield bonds” or “junk bonds”
(i) What kind of returns can I expect?
- Highest yields compared to other bond segments; returns may sometimes be described as “equity-like”.
(ii) What risks should I be mindful of?
- Default/credit risk is the main issue, given the lower quality nature of the issuers. For troubled companies, default may be avoided via a restructuring, which may see bond investors take a write-down on their investment.
- Bond price volatility can be high.
- Interest rate risk is less of an issue, since non-investment grade corporate issuance is usually of a shorter maturity.
- USD-denominated bonds make up the biggest part of the non-investment grade corporate space; investors who do not use the USD as a functional currency may be exposed to currency risk.
- Suitable for investors who are looking for some of the highest potential returns in the fixed income space, and are willing to accept a higher level of risk in their investments
An important relationship exists between the bond’s yield and maturity
When investing in bonds, there are certain trade-offs involved between credit risk and a bond’s yield. For example, an investor seeking a higher yield on a bond investment may have to look for bonds of companies that are perceived to be financially weaker, smaller in size, or have businesses that are less stable compared to their stronger peers. In addition to the trade-off between credit quality and yield, investors will find that there is usually also a similar relationship between maturity and yield.
Looking at the US Treasury yield curve (a visual representation of the different Treasury yields associated with different bond maturities), investors will find that the yield curve is typically upward sloping. This indicates that the longer the maturity of the bond, the higher the bond’s yield, and is partly due to the interest-rate risk that an investor must take on. We explore more on this subject in the segment below.
General risks when investing in bonds
Interest rate risk
This refers to the risk that a bond’s price could decline if interest rates rise. As compared to shorter maturity bonds, bonds with a longer time to maturity are more susceptible to price declines when interest rates rise, which means investors in longer-dated bonds require additional compensation for taking on this additional interest rate risk (in the form of higher bond yields, which leads to an upward-sloping yield curve). Of course, an investor holding a bond to maturity (and who ignores mark-to-market price fluctuations) would not worry too much about interest rate risk, as long as the bond’s time to maturity matches the investor’s investment horizon.
Credit risk
Bonds are subject to the risk of the issuer defaulting on its obligations. It should also be noted that credit ratings are not a guarantee but simply an opinion of the rating agencies. In situations where an issuer’s credit conditions deteriorate rapidly, rating agencies may not be able to react fast enough in evaluating and updating such ratings.
A corporate event such as a merger or takeover may lower the credit rating of the bond issuer. If a corporate restructuring is financed by the issuance of a large amount of debt, the company's ability to pay off existing bonds will be weakened.
Liquidity Risk
Some bonds may not have active secondary markets. As such, investors may find it difficult to sell the bond at a preferred price, or even impossible to sell it before its maturity. If the bond is very illiquid, this also creates a wider spread between its bid and ask prices.
How do I invest in bonds?
Bonds typically come in minimum sizes such as USD 200,000, SGD 250,000 or HKD 1,000,000.
Bond Express is an initiative that allows you to trade a selected list of wholesale and retail bonds with firm executable pricing and volumes. You can also trade in lot sizes (nominal values) from as little as 1,000 for retail bonds, and 5,000 for wholesale bonds (accredited investors only).
For further information on Bond Express, you can refer to this article .
You will need a trading account to begin investing in bonds. Here are our partners you may wish to explore:
