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Grasping the Basics of Bonds: An Essential Guide

A detailed phone open on a table displaying charts on bonds, their risks, and benefits.

Last Updated on by Tree of Wealth

When one ventures into the realm of bonds, it can be understood as providing a loan to the bond issuer. This loan comes with a predetermined interest rate and is set for a distinct period. It is expected that, barring any default from the bond issuer, an investor will receive back their initial investment or principal once the bond reaches maturity. It’s crucial to keep in mind the relationship between interest rates and bond prices: as interest rates rise, bond prices generally fall, and conversely, when interest rates decrease, bond prices tend to go up.

Deciphering Bonds

At its core, a bond is a kind of debt security – think of it as an IOU. Both governmental organizations and businesses issue bonds as a means to secure capital, which are essentially borrowed funds. When you choose to invest in bonds, you’re effectively lending money to the issuer for a specified period.

The Mechanics of Bonds: Most bonds provide a steady income throughout their life, termed as a coupon. The coupon rates are often given as a percentage of the bond’s primary amount, known as its “face” or “par” value. When these bonds reach their set maturity date, they are redeemed, granting you the return of the face or par value.

Your potential earnings from bonds typically come from two sources:

  1. Interest income: Represented by the coupon payments you receive as the bondholder.
  2. Capital gains: Should you sell the bonds at a price higher than what you initially paid for them, you stand to gain capital.

It’s crucial to remember that even though the coupon rate generally stays constant over the life of the bond, the bond’s market price might vary.

When determining the yield of a bond, factor in:

  • The coupons you’ll collect over the life of the bond.
  • Any possible capital gains or losses stemming from price changes relative to your original investment.

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Is Investing in Bonds Right for You?

Bonds can be attractive to those investors looking for regular income or those aiming to bring diversity to their portfolio.

Yet, deciding if bonds fit into your investment approach should hinge on your individual circumstances. It’s essential to consider if you:

  • Understand the bond’s terms thoroughly.
  • Can gauge how the bond might sway the overall balance of your investment portfolio.
  • Possess the financial bandwidth and liquidity to withstand the inherent risks of bond investment, including potentially losing a considerable chunk, or even the entirety, of your principal.
  • Have the capacity, whether on your own or through a financial adviser, to keep track of and interpret the various economic and other dynamics that might influence either the bond issuer or the bond’s standing in the market.

Decoding Coupon Rates in Bonds

The coupon rates across various bonds fluctuate depending on the creditworthiness of the issuer and the assigned credit rating.

Issuer’s Credit Quality

Issuers that present lower credit quality usually offer higher coupon rates on their bonds. This is attributed to the fact that issuers with less creditworthiness pose a higher risk of default. To incentivize investors and balance out the elevated risk, these issuers often issue bonds with greater coupon rates. It is imperative that you meticulously evaluate the issuer’s credit risk to determine if it aligns with your risk tolerance before investing in its bonds. Credit ratings and credit metrics can serve as useful tools in assessing the issuer’s credit risk.

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Understanding Credit Ratings

Both borrowers and the bonds they issue are typically allocated a credit rating. Note, the company or country issuing bonds may have a distinct rating from the bonds themselves, so the issuer rating and the bond rating might differ. Credit ratings act as a gauge of a bond issuer’s creditworthiness in relation to its bond obligations. The table below outlines the various bond rating scales from the prominent rating agencies – Moody’s, Standard & Poor’s (S&P), and Fitch:

Moody’s Rating S&P / Fitch Rating Rating Category Creditworthiness
Aaa – Aa AAA – AA Investment Grade High
A – Baa A – BBB Investment Grade Medium
Ba – B BB – B Non-investment Grade Low
Caa/Ca/C CCC/CC/C Non-investment Grade Highly Speculative
C D Non-investment Grade In Default

Ratings broadly fall into two categories: investment and non-investment grade.

Non-investment Grade Bonds

Often referred to as junk bonds or high-yield bonds, non-investment grade bonds offer considerably higher yields to offset the heightened risk of default. Therefore, it’s critical to remember that bonds aren’t universally low-risk; some can indeed harbor risks higher than stocks.

The Case of Unrated Bonds

Not every bond gets a rating by global or major rating agencies. Some issuers might opt not to seek a credit rating, especially if they believe their target investor markets are adequately familiar with them, possibly even considering them more creditworthy than a potential credit rating might suggest. Similarly, smaller and infrequent issuers may choose not to bear the costs of rating fees if their bonds are intended for a domestic market already familiar with them. For such unrated issuers and bonds, other indicators of creditworthiness and bond characteristics should be taken into account when deciding to invest.

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Key Considerations Before Investing in Bonds

Credit ratings, though beneficial, shouldn’t be your only guiding factor while deciding the suitability of a bond for your investment portfolio. They simply represent the opinion of the respective credit rating agency and aren’t investment recommendations. Ratings are based on available data at the time of assignment and are prone to revisions or withdrawal. As an issuer’s creditworthiness can fluctuate rapidly, it’s important to research the issuer’s profitability, prior bond issues, and their ability to meet debt obligations – including any bond you’re considering.

One method of assessment is examining the company’s solvency ratios like interest coverage ratios and other credit metrics.

Credit Metrics to Keep in Mind

Here are some helpful financial credit metrics you might want to consider:

  • Debt to Equity Ratio: It reveals the proportion of debt an issuer employs to finance its assets and operations, compared to its equity. Higher debt indicates greater risk.
  • Debt to Operating Income Ratio: This ratio indicates a company’s ability to service its debt using operating income. A higher ratio might suggest difficulties in servicing debt.
  • Interest Coverage Ratio: It reflects the issuer’s ability to pay interest on debt obligations from its operating income. A lower ratio indicates less ability to cover interest payments.
  • Operating Profit Margin: This represents operating profit as a percentage of revenue. The lower the margin, the higher the risk of the issuer being unable to meet its fixed costs.
  • Free Cash Flow: The surplus cash a company retains after spending on maintaining or expanding its assets. A profitable and well-managed company should consistently show positive free cash flows.

You should compare these metrics across similar entities as they may vary across industries.

Bond Tenure

Bonds with longer tenures tend to offer higher coupon rates to compensate investors for the increased risk of default over a longer period.

Callable bonds give the issuer the option to buy back the bond before its maturity, exposing you to reinvestment risks if the bond is called when prevailing interest rates are lower than when you bought it.

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Government Bonds vs Corporate Bonds

In any given country, government bonds are typically the safest and highest credit quality bonds, followed by quasi-government entities, banks, and companies. If you prioritize safety, consider government or investment-grade corporate bonds. Those willing to accept higher risk could consider lower credit-quality or non-rated bonds.

Diversification is a recommended strategy to mitigate risk. Avoid concentrated exposure to any one security as individual investments can fluctuate in value.

Risk of Loss

You may lose a portion of your investment if you sell your bonds before maturity, as bond prices can fluctuate based on the issuer’s perceived credit quality and market conditions. In cases of issuer default or liquidation, you risk losing your entire investment.

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Potential Risks of Bonds

Risks associated with bonds primarily include:

Default Risk

The bond’s price can be influenced by the perceived credit quality or likelihood of default by the issuer. Default risk can be altered by broader economic changes or changes in the issuer’s financial situation.

Interest Rate Risk

Bond prices and interest rates are inversely related. An increase in interest rates often results in a decrease in bond prices, and vice versa. Longer-term bonds are more sensitive to changes in interest rates compared to shorter maturity bonds.

Liquidity and Market Risk in Bonds

When contemplating the sale of a bond before its maturity, various factors can come into play. The volatility of changing market conditions can result in bond prices either escalating or diminishing. Furthermore, a bond’s liquidity is contingent upon the presence of potential buyers. If only a few buyers express interest, it indicates that the bond lacks substantial liquidity. This scenario can pose challenges for an investor wishing to offload the bond, potentially compelling them to sell it at a depreciated value, or even at a loss.

Call Risk or Early Redemption Risk

Bonds, by their very nature, come with a host of risks and conditions, one of which is the call risk, also known as the early redemption risk. Some bonds are designed to grant the issuer the right to redeem or buy back the bond before it reaches its predetermined maturity date. This particular feature can be a double-edged sword for investors. On the one hand, an early redemption might provide liquidity sooner than anticipated. On the other, it could potentially curtail an investor’s capacity to reinvest the funds in another product offering a similar yield. It underscores the importance of fully understanding the unique intricacies each bond brings with it.

Note: Bonds, like many financial products, are not one-size-fits-all. They can have an array of terms and conditions that vary widely from one to the next. As an investor, it’s paramount to ensure that you fully grasp these terms before committing your capital. The onus is on the individual to be well-informed to make prudent investment decisions.

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In Case of a Bond Default

When discussing bonds, the possibility of default looms as a significant concern for many investors. A bond is said to default under several circumstances. The most straightforward scenario is when the issuer fails to make the requisite payments, be it interest or principal, on the due date. However, defaults aren’t limited to missed payments. They can also occur if the issuer breaches certain financial covenants. An example might be when specific financial ratios, such as the ratio of net borrowings to total equity, exceed the limits set out in the bond’s terms. These stipulations, termed “events of default”, are meticulously outlined in the bond’s terms and conditions. Typically, these are disclosed in the bond’s offer document. The ramifications of a default can be severe, with investors potentially losing all or a significant portion of their invested capital.

Purchasing a Bond

You can acquire a bond at issuance through a public offer, where you’ll pay the bond’s face value. Alternatively, you can purchase a bond on the secondary market (post-issuance) if there is a seller. This can be done via the Singapore Exchange (SGX).

If you buy on the secondary market, the price you pay depends on the prevailing market price, and transaction fees such as brokerage fees are applicable.

Selling a Bond

You can hold the bond until maturity and expect to be repaid the principal amount, assuming the issuer does not default. You can also sell the bond before maturity in the secondary market, provided there is a buyer. The selling price is based on the prevailing market price.

You can make a capital gain if you sell the bond at a higher price than your purchase price, or face a loss if sold at a lower price.

Singapore Government Securities and Savings Bonds

In Singapore, options include Singapore Government Securities (SGS) and Singapore Savings Bonds (SSBs), both backed by the Singapore Government, making them nearly risk-free investments.

Savings Bonds are tailored for retail investors as a flexible, low-cost, and low-risk savings product.

Singapore Savings Bonds vs. Singapore Government Securities: Key Differences

  1. Tradability: One of the fundamental differences between Singapore Savings Bonds and Singapore Government Securities is their tradability. Singapore Savings Bonds are not tradable, meaning they cannot be sold on an exchange. In contrast, Singapore Government Securities are tradable and can be actively bought and sold on the Singapore Exchange.
  2. Redemption: Singapore Savings Bonds offer a flexible redemption feature. Investors can redeem the full principal amount along with the accrued interest in any given month without incurring a penalty. Singapore Government Securities, on the other hand, do not offer early redemption. However, they provide an alternative as they can be sold in the secondary market. It’s crucial for investors to be aware that prices of these securities can either rise or fall before their maturity, which could impact returns.
  3. Investment Amount: There’s a notable difference in the minimum investment amounts between the two. The minimum investment amount and unit size for Singapore Savings Bonds is set at $500. In comparison, Singapore Government Securities have a higher threshold with a minimum investment amount and unit size of $1,000.
  4. Investment Limits: Singapore Savings Bonds come with a cap on the investment amount. An individual can hold up to $200,000 of Savings Bonds at any given time. This is in contrast to Singapore Government Securities, which have no such investment limits, allowing investors to hold a larger amount if they so choose.

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Corporate Bonds

Corporate bonds represent debt obligations issued by various companies. These bonds are known for offering interest rates that are generally higher than those of government bonds. This higher rate compensates investors for the increased risk associated with lending to companies as opposed to stable government entities. For investors in Singapore, corporate bonds that are listed on the SGX can be bought and sold in a manner similar to shares. However, it’s important to remember that purchasing these bonds also involves brokerage fees, just as with stock transactions.

Benefits: One of the key benefits of investing in corporate bonds is the potential for superior returns, especially when compared to instruments like fixed deposits or government bonds.

Considerations: Investing in corporate bonds does come with its own set of challenges. Investors are exposed to credit risks and other associated uncertainties. Before diving into corporate bond investments, it’s crucial for investors to assess both their capacity and willingness to bear a heightened risk of default. This could mean potentially losing all or a significant portion of their investment in the quest for higher yields.

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Perpetual Securities

Perpetual securities, colloquially referred to as “perps”, stand out as hybrid securities in the financial market. Unique in their design, these securities are issued without a predetermined maturity date, setting them apart from traditional bonds.

Bond Funds and ETFs

When considering investments in bonds, many find that opting for bond funds and exchange-traded funds (ETFs) is more pragmatic than directly investing in every bond within a fund. It’s worth noting that some of these ETFs fall under the classification of Specified Investment Products (SIPs). Bond ETFs, in their operational strategy, primarily aim to mirror the performance of established bond indices. Depending on the specific ETF, this might mean direct investments in a range of bonds or employing derivative products like swaps to simulate that exposure. Furthermore, the strategies of different bond ETFs can vary widely.

Benefits

Bond funds and ETFs come with a host of benefits for the discerning investor. For starters, there’s no need for massive capital outlays, as one would require less capital than owning every bond in a specific fund. Moreover, investors can rest easy knowing that their bond holdings receive active management from experienced fund managers. In the case of ETFs, this management typically involves tracking a specific index. Finally, the variety on offer is expansive, allowing investors to select from global, regional, country-specific, or sector-specific bond funds and ETFs.

Considerations

As with any investment, there are considerations to be mindful of. When scrutinizing a bond fund’s performance, it’s imperative to look at total returns, which encompass both the income and capital gains or losses over time. Additionally, management fees and other ancillary charges can have a dampening effect on overall returns. Lastly, some ETFs, especially those tagged as SIPs, can be intricate, demanding careful evaluation before investment.

Bonds offer an intriguing avenue for investment, presenting both opportunities for steady income and diversification. Whether it’s the reliability of government-backed securities or the allure of higher yields from corporate bonds, there’s a bond for every type of investor. While every financial instrument has its own set of risks and rewards, the world of bonds provides an exciting landscape that, when navigated correctly, can pave the way to fulfilling your financial aspirations.

Investing wisely requires knowledge, insight, and strategic planning. Our experienced financial advisors are eager to guide you through financial planning, ensuring your decisions align perfectly with your financial goals. Embarking on your investment journey doesn’t have to be daunting.

Reach out to our financial advisor today and lay the groundwork for a prosperous future.

 

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