If you are interested in investing, you should definitely understand what bonds are. Bonds are a very important way for governments corporations to finance their operations, and form the biggest part of the global financial market. Here, we have prepared a guide to bonds for investors in Singapore. You can read about what bonds are, why they are important, and how you could think about investing in them.
- What Are Bonds?
- Why Invest in Bonds?
- Pricing Of Bonds
- How Bond Investments Make Money
- Risks of Bond Investing
Bonds are essentially a way for corporations and governments to borrow money. By selling debt securities to the financial market, these entities can raise money to fund their operations or other activities like mergers and acquisitions. Just like loans, bonds pay a pre-determined interest to its holders (or lenders). Because of this, bonds are also often referred to as fixed income securities, as they tend to pay a steady stream of interest called “coupons” at regular time periods until maturity when full repayment of the bond is due.
- Face or Par Value: the total owed to bondholders at maturity, principal amount of the bond
- Coupon: interest rate of the bond, expressed as a percentage of the principal or par value
- Maturity: the date that the full repayment of the bond is due
Some bonds called “zero-coupon bonds”, however, do not pay any coupons at all. Instead, they are priced at a discount to their face value, so that bond investors can buy the bond at a discount to the amount they will be paid in the future. At maturity, bondholders receive the full-face value of the loan, and earn a return of a predetermined “coupon” rate.
Investors who want a source of regular and steady income without taking too much risk may find bonds to be an attractive investment. Unlike stocks, bond holders could get their money back even if the issuer defaults. Therefore, bond holders have a more limited downside in their investments, while still being able to earn steady income through coupons. Typically, older generation of people like retirees tend to gravitate towards fixed income investments.
Bonds could also be a great way to diversify an investment portfolio if you already own meaningful amount of equities. Some assets correlate heavily in price fluctuations, and this correlation increases for same types of assets. Therefore, owning both bonds and equities could provide some defense against a stock market crash, for example, as bonds and stocks do not always move in the same direction or by the same degree.
The yield on a bond depends on a few factors, including credit quality of the borrower, maturity of the bond, and fixed or floating nature of the coupon. This is quite similar to any other loans. We’ll explain how each one factor impacts a bond’s interest rate.
First, borrowers with higher credit quality are deemed safer and thus get lower interest rates. In most markets including Singapore, government bonds are usually regarded as the safest bonds in the market. They are then followed by corporate bonds from healthy and reputable companies. Then there are bonds called “junk bonds,” which are debt securities issued by companies with less healthy balance sheet, and thus are less safe than other bonds. In return, junk bonds promise higher coupons to make up for the higher probability of bankruptcy. Bonds always come with a credit rating attached to them, which signals the credit quality of the bond issuer. Before making an investment, make sure you know what kind of entity is asking for your money, and how easily they can pay the money back.
Secondly, longer maturities tend to command higher coupons. Because investors do not know how the market interest rates will behave in the future, they ask for a premium on their coupons to adjust for such uncertainty. For instance, if you are getting paid 5% per year on your bond for next 10 years, it might sound like a great deal. However, what if interest rates rise to 10% in 2 years? Then you will have lost an opportunity to earn a much higher rate just because you committed your money to a 10-year long bond already. In contrast, short term bonds provide the flexibility to adjust to market changes, so offer lower rates than longer term bonds.
Lastly, the option of having a fixed or floating coupon rate can impact the bond’s price. While fixed coupon provides a constant interest rate throughout a bond’s maturity, a floating rate fluctuates along with the market rates influenced by central banks around the world. Therefore, it might be better to remain flexible with a floating rate security when the market rates are low, while it might be more beneficial to secure a high fixed rate bond when market rates are high. To put it differently, in a high rate environment, investors appreciate the ability to fix their coupon rate. Therefore, bond issuers are able to get a lower than market rate with a fixed coupon (vice versa for floating rate). On the other hand, if market rates are already low, then investors do not like fixed rates, so fixed rate bonds will price in higher coupon than market rate to attract investors.
Easiest way for investors to earn money with bonds is to receive the coupons as promised. If you buy a bond at 100% of face value, and hold it until maturity, your return will be equal to the coupon rate you receive.
However, there’s another way of making money bonds: by trading them at higher prices than what you paid initially. Because market interest rates fluctuate constantly, it affects opportunity cost of holding a bond, and thus impacts the market price of all fixed income securities. If you buy a bond at more or less than the face value and hold the bond until maturity, your return is based on the coupon you receive plus any gain or loss from holding the bond.
For instance, let’s say a 5-year bond with 2% coupon was trading at $100. All of a sudden, interest rates in the market declined, and new 5-year bonds in the market were now promising only 1%. This means that your bond is earning twice as much as the prevailing bonds in the market. Therefore, any new buyers of 5-year bonds would be happy to take your bond at 1% coupon by offering $200, meaning the value of your bond will double. It could also work the other way. If market rates increased to 3%, then the market value of your bond will decline to $67 (from earning 2$ on $100 at 2% to earning $2 on $67 at 3%).
It’s important to note, however, the face value at maturity will not change. The market price of your bonds change only to “new buyers” to adjust to new interest rates. However, if you hold on to your bond until maturity, you will get all of you’re the promised money back, unless there are some other complications like bankruptcy.
Although bond investments are regarded to be safer than equity investments, fixed income securities have their own set of risks. Below, we summarize each of them in a nicely organized table.
|Risks of Investing in Bonds|
|Default (or credit risk)||If perceived credit quality of probability of default worsens for the bond issuer, you may lose some or all or your investment.|
|Call risks||Sometimes, the issuer can buy back (or redeem) the bond before its maturity date, and you may not be able to reinvest your money at good interest rates.|
|Price/interest rate risk||Bond prices and interest rates are inversely related.|
|Reinvestment risk||If market rates are falling, you may have to reinvest your money at increasingly lower rates.|
|Exchange rate risk||Investing in bonds denominated in foreign currencies may be impacted by fluctuations in exchange rates.|
|Liquidity risk||If your bond does not have much liquidity in the market, it may be hard to buy or sell it even when you want to.|
|Inflation risk||If inflation rate is higher than the bond's coupon rate, your bond's value will be eroding because purchasing power of the bond's coupons and principal is falling.|
|Event risk||Some events might unexpectedly erode an issuer’s credit strength and ability to make good on its debt payments, for example, natural disasters, takeovers, and restructurings.|
|Market risk||A bond’s price will fluctuate with changing market conditions, including the forces of supply and demand and interest rate changes.|