Outside equities: bonds and how to get exposure

STOCKS or equities are what most people think of when it comes to investing.

But as highlighted in earlier weeks, diversifying and allocating a portion of your portfolio to other asset classes can help you meet your investment goals.

Bonds are another major asset class to consider as they have unique characteristics that can provide diversification benefits.

What are bonds?

When you buy bonds, you are lending money to the issuing companies or countries to fund their activities. This stands in contrast to stocks, which give you partial ownership of a company.

Bonds have a face value, typically $1,000, representing the sum that a bond investor would receive at maturity. Investors typically buy these bonds from the issuers at their face value or par.

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The bond issuer would subsequently pay a fixed amount of interest on a regular basis through the life of the bond - also known as the coupon.

A bond with a $50 annual coupon and a face value of $1,000 works out to a 5 per cent yield. Investors who buy bonds receive fixed returns in the form of interest paid, which is why bonds are also called fixed income instruments.

Bonds would usually also have a set lifespan. When they reach maturity, the issuer would redeem the bonds and repay the loan to investors.

Bonds versus stocks

Bonds can be suitable for investors who prioritise capital preservation over capital accumulation.

Assuming you buy a bond from a strong issuer, the chances of getting back your capital are high.

Several other characteristics of bonds also make them attractive for some investors when compared to stocks.

This does not mean that bonds are without risk, though.

What to look out for

• Coupons

You may have noticed that some bonds have very high coupons, while others yield very little.

The 10-year sovereign bonds issued by the US government, for instance, have a yield of around 1 per cent. A 10-year bond issued by a small company, meanwhile, may pay 8 per cent.

While a higher yield may seem like a tempting proposition, it is important to bear in mind that a higher yield always means higher risk.

If an issuer is unable to pay the coupon or the principal sum, and goes into default, you would lose all your capital.

Market pressures require the lower quality issuers to pay higher coupons in order to compensate for the greater risk of default.

Credit ratings agencies - such as S&P Global, Moody's and Fitch - rate the issuers. Their ratings then affect borrowing costs for the issuers.

Top quality bonds are known as investment-grade bonds, while those with lower ratings are called high-yield or junk bonds.

The United States, which has a gold-standard triple-A rating, does not pay a large coupon on its bonds. The same is true for the Singapore government.

• Inflation and interest rates

Although bond prices are relatively less volatile, they do still fluctuate. Besides issuer stability, they are also affected by market conditions.

Changes in bond prices affect how much you will get for your bonds if you sell them before maturity. They also affect the yield to maturity for investors buying the bonds on the secondary market.

The rate of inflation can affect bond prices, because when inflation is higher, investors want a higher yield that beats inflation. Bond prices would then fall to match those expectations.

Central banks also impact bond prices when they set benchmark interest rates. Again, their interest rates guide expectations of yields from bonds.

If interest rates rise, investors would demand returns from bonds that are high enough to compensate them for not keeping their money in the bank.

Other bond types

There are also bonds with no maturity date. These are known as perpetual securities. Issuers can choose to redeem or call these bonds at various dates, which they are more likely to do when they have cheaper financing options.

Perps often pay higher coupons than regular bonds because there is a risk that you would have to hold these forever, in the absence of a liquid secondary market.

Another type of bond is a zero coupon bond. As the name suggests, this bond does not pay regular interest, but you purchase it at a discount to its face value. When the bond matures, the issuer will redeem it at its face value, providing you with returns.

As these bonds do not pay interest, their price can see greater volatility in the secondary market, when compared with regular bonds, as the full payout only comes at maturity.

How to invest

Generally speaking, the corporate bond market for retail investors is not as popular or developed as the equities market.

But there are still ways for retail investors to get exposure to bonds

For those who value stability, buying Singapore Government Securities, which are backed by the Singapore Government and traded on the Singapore Exchange, is one option.

Another popular instrument for retail investors is the Astrea series of private equity bonds from Temasek-backed Azalea Investment Management.

Coupons for these bonds come from the cash flows of private equity funds, and the retail tranches of these bonds have coupons of between 3 per cent and 4.35 per cent.

You can also gain exposure to bonds indirectly.

Buying into bond funds is one option. There are exchange-traded bond funds that invest in both high-yield and investment grade debt, as well as mutual funds with mandates to invest only in fixed income instruments.

This may work out well for beginner investors as you can access a more diversified portfolio of bond instruments.

Just be sure to pick a fund with a mandate that matches your investment objective.

• This is the eighth instalment of Invest & Grow, a weekly 10-part series that aims to help new investors get started on their investment journey.