A primer on bond investing

BONDS have surged in popularity over the past couple of years following the steep rise in interest rates. Now that newly issued bonds are paying much higher coupons than before, retail interest in bonds has never been higher.

We believe bonds will remain popular; the asset class provides not only portfolio benefits but also much higher income.

For those who are less familiar, bonds can be simply understood as loans from the investor who is the lender to an entity (the borrower). In return, the entity will typically pay the investor a fixed interest or coupon over a predetermined period.

At the end of the period, the investor gets back the borrowed amount or principal. Entities are issuers of bonds, which may be governments (sovereign bonds) or companies (corporate bonds).

With this understanding, investors can already see the benefits of bonds in a portfolio. The asset class provides a stable and consistent fixed income over a period. It also boasts lower volatility compared to riskier asset classes like equities.

Lastly, bonds also serve as an instrument of capital preservation, as there is the return of the principal at the maturity date.

Investors might have also wondered about the potential return from bonds. To break it down, bondholders benefit from two aspects – regular coupon payments and potential capital appreciation.

The coupon represents the fixed income portion of bonds, usually expressed as a percentage of the bond’s principal amount. For example, a bond with a principal amount of S$1,000 and a coupon of 5 per cent will pay S$50 per annum at a stated interval until maturity.

Potential capital appreciation arises when investors purchase the bond in the secondary market. For a bond with a face value of S$1,000, the investor may have purchased it at S$950. This translates to a S$50 upside at maturity, when the bondholder receives S$1,000 in principal amount.

More importantly, this is on top of the coupons which bondholders will regularly receive, adding to the total return from the bond. On the other hand, if investors purchased at a higher price in the secondary market – for example, S$1,050 – there will be a capital loss of S$50 to account for in the overall returns.

These aspects of the bond’s earnings give rise to ‘yield to maturity’ (YTM) – a bondholder’s annualised return based on the purchase price. This term is commonly used and is a relatively simple way to express the expected return.

There are some important things to note when using YTM. Firstly, the figure assumes that bondholders reinvest the coupons at the same yield level which might be difficult in practice. Secondly, it does not take fees into account. Still, YTM remains meaningful in making comparisons among bond options.

The potential returns from the bonds are determined by a myriad of factors, with the most important being credit risk. Credit risk can be understood as the issuer’s ability to fulfil the payment of coupons and the principal amount.

Different issuers price their bonds at varying coupon levels that correspond to their credit risk. As it can be difficult to have a complete understanding of the issuer’s financial profile, this task is made simpler by the use of credit ratings.

Rating agencies, such as S&P Global Ratings and Fitch Ratings, assign credit ratings to companies based on their financial profile.

The higher the credit rating, the stronger the creditworthiness and the lower the default probability. With that in mind, higher credit ratings tend to correlate with lower returns, as yields are generally lower.

Besides the issuer’s credit risk, certain features may affect the potential earnings for bondholders. Some features increase the risk exposure but also compensate bondholders with higher coupons.

A key example is the issuer call option, where the issuer may redeem the bond at an earlier date before maturity. For bonds with this feature, issuers typically provide higher coupons to compensate for the possibility of redeeming such bonds earlier.

On the other hand, some features enhance the credibility of the bond, which in turn might lower the coupons offered.

Some bonds have a guarantor, which steps in to make coupon payments and repayment of the principal amount in the event of an issuer default.

Investors should also mind the interest rate environment when investing in bonds. Interest rates will also affect the potential return of bonds as prices are influenced by the shift in yields.

When interest rates increase, existing bond prices tend to fall. The extent of the drop depends on the duration and tenor of the bonds, with longer-tenor bonds being more affected.

On the other hand, investors who plan to hold the bond to maturity instead of selling on the secondary market may ignore the interest rate risk, as the issuer is obliged to return the full principal amount on maturity.

For investors considering investing in bonds, corporate bonds and retail bonds are available in Singapore. Retail bonds are more easily accessible at S$1,000 per lot, compared to corporate bonds at S$250,000 per lot.

Singapore Treasury Bills remain one of the best retail options in the market, especially considering the inverted yield curve where shorter-tenor bonds are giving higher yields than longer-tenor bonds. For investors willing to take some risk, the Astrea series retail bonds are an option, offering attractive yields at good credit ratings.

The writer is a fixed income analyst of the Bondsupermart team at iFast Financial, the Singapore subsidiary of mainboard-listed iFast Corporation