Wednesday, October 23, 2013

4 things you should know before investing into bonds

I'm sure all of us have heard of bonds one way or another before. Either from the financial advisors who recommend you to buy a balanced bond fund or the bank personnel who told you that bonds are safe and give you a higher return than a savings deposit.

Before you invest into bonds, you must know the answers to these 4 questions:
1) What is a bond?
2) How does it work?
3) What are the types of bonds and their risk?
4) When is the right time for buying bonds?

What is a bond?
A bond is essentially a debt instrument. Government issue bonds so that they can borrow money from the public. The government is taking a loan from the bond investors. If you invest in that government bond, it means the government owes you money. You are lending money to the government.

How does a bond work?
Some terms that you must know before you invest in bonds.

1) Term to maturity/tenure: This is the number of years before the bond matures.

There are different term to maturity of bonds. They can come in 2 years, 5 years, 10 years 20 years etc. One important thing to know is bond price and yields move in the opposite direction. The yield here represents the market yield which is the current market interest rates. If market interest rates increase, bond prices decrease and vice versa.

Another thing to note is the longer the tenure of the bond, the more volatile it is to interest rates movement. Let me explain this further. Let’s say you buy a 2 year bond at $100 and market interest rate moves up by 1%, your bond price will go down to $90. However, if you buy a 20 year bond at $100 and market interest rate moves up by the same 1% also, your bond price will go down even lower to $70. This calculation is just an example and does not reflect the actual valuation of bonds. This volatility can be proven mathematically and is taught in finance courses in the university. Remember, the longer term the bond, the more volatile it is in response to interest rates.

2) Face Value: This is the money you will get back when the bond reaches maturity

Bonds face value can be priced at $100 and $1000. This is the exact amount you will receive when the bond matures regardless of what price you bought it at. If you bought the bond at $102, you will still receive $100 at maturity. If you bought the bond at $98, you will also receive $100 at maturity. If the current bond price is below the face value, it is selling at a discount. If it is above the face value, it is selling at a premium.

3) Coupons: This is the payment you will receive every year. Coupons are mostly paid semi-annually.

This is similar to dividends from stocks. Coupons are in percentages. They are fixed payments paid to bond holders. The coupon rate will be fixed throughout the bond tenure.

Types of bonds and their risk
We’ve discussed on government bonds which is one of the types of bonds. Another popular bond is corporate bonds. These are bonds issued by companies who want to raise capital. For example if Capitamall wants to build a new shopping centre, it can raise capital through issuing of bonds.

So what are the risk involved for bonds? There are many types of risk. The first one is default risk. This means the government or company which issued the bond goes bankrupt and cannot repay its loan. Therefore, when they default, bond holders will not be able to get back their money. Government bonds are known to be default free meaning that the likelihood of a government going bankrupt is non-existent. However, through the European crisis, we know that Greece almost went bankrupt along with other big countries. Countries defaulting on their debt may happen in the near future. For corporate bonds, there is certainly default risks. A company can go bankrupt any time so do take note of this risk when investing in corporate bonds.

Another risk is exchange rate risk. This applies when you invest in a bond denominated in a foreign currency. For example if you’re living in Singapore and invest in US government bonds, then you are subjected to exchange rate risk. If the US dollar goes down, the money you get back when you sell the bond will be considerably lower.

Finally, there is price risk. Bonds are traded in the market just like stocks. They can be bought and sold in the bond market. In Singapore, you can buy bonds from SGX itself. If you decide to sell the bond before maturity, you may lose money. The bond price may have already dropped in price. If the price has gone up, then it'll be good for you.

When is the right time for buying bonds?
This is an answer we all want to know. Is it a good time to buy bonds now? When should we invest in it? The right way to approach this question is by asking yourself how long are you going to hold the bond for? If you intend to hold it all the way till maturity, then you will get back the guaranteed face value. If not, you'll have to take into consideration the price movement of the bond.

As discussed earlier, bond prices will move down when interest rates rises. If you expect interest rates to rise now, then you should not be investing into bonds. News like the federal reserve will end the QE stimulus soon will cause bond prices to fall significantly due to interest rates rising. This is why i don't recommend investing into bonds at the current moment. Interest rates are at record low and the only way for it to go is up. There is limited downside left for interest rates. When that happens, bond prices will start to fall. This is also applicable if you buy a fund or unit trust that has bonds as one of it components. The fund price will be affected by the bond price.

We've discussed about the 4 things you should know before investing into bonds. I hope it has been beneficial for you and you will be able to make wise decisions on when is a good time to invest in it. With this knowledge, we can certainly avoid unnecessary loses due to our own ignorance. In this case, knowledge is power and ignorance is definitely not bliss.

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  1. Hi SG YI

    Does bond comprises a portion into your portfolio? If not do you have any plans toinclude them in the future?

    1. Hi B,

      I do not have bonds in my portfolio at the moment. In the future maybe if stocks get really too risky and I have to diversify part of it into bonds. How about you?

    2. They say a good allocation of bond is to take the number of years old you are right now. So for me, it would be aroun 28-30% allocation. I still think its too high though. But I am willing to take in about 10% allocation sometime when I get older.

    3. Hi B,

      For me, how much to allocate into it will depend on market conditions. I believe asset allocation is still better. I can have 50% into bonds when stocks are deemed too risky. I may also keep cash if all else fails. Don't have to be fully invested at all times.

  2. Hi,

    Maybe you can look into preference shares (from banks only, pls) as they work about the same as bonds, except that it can be traded like shares on the stock exchange like any other stock counters.

    When is the best time to buy bonds? When it's below par value, imo :) Then don't look at the ups and downs of it already.

    The worst kind is to buy a bond fund. You lose the capital guarantee upon maturity part in exchange for potentially greater security (due to greater diversification for the same buck).

    1. Hi LP,

      Thanks for your recommendation on preference shares. I've heard of it before but have never really looked into it before. I shall check it out.

      Buying bond below face value id one way of reducing your risk but the returns will only be guaranteed if you will hold till maturity. If not, undervalued can go even lower too :)

      I agree with you on the bond fund part. It doesn't make sense to buy a bond fund when buying bonds directly will have far greater benefits.

  3. Hi SGYI,

    ".. but the returns will only be guaranteed if you will hold till maturity".

    I think you mean the capital will only be guaranteed upon maturity, not the returns right? By returns, I mean the coupon or the 'dividend' part of the bond, not the capital. Basically, I think a bond is as guaranteed as the underlying that supports the bond. If you buy below par, there is also a guaranteed capital gain since the bond will be bought back at par value. This is the margin of safety, I believe, for bonds.

    I can point you to some of the posts that I've made regarding pref shares:


    Really very similar to bonds, you'll see.

    1. Hi LP,

      Yes, I mean the capital. Sorry for my english. :p

      Thanks for the post on pref shares. I'll definitely check it out. By the way, I've been reading your blog too. You're an experienced financial blogger. Lots to learn from you :)

  4. Hi SGYI,

    Nah, don't say that...we share share information and knowledge :) Do blog about your findings :)

  5. "If the current bond price is below the face value, it is undervalued. If it is priced over the face value, it is overvalued."

    This statement is certainly incorrect.

    1. Hi Anonymous,

      I've rephrased the sentence: "If the current bond price is below the face value, it is selling at a discount. If it is above the face value, it is selling at a premium."

      This should be the proper way to phrase it. Thanks for pointing out :)

  6. Hi SG YI,

    When interest rate rises by 1%, the price for a 2-year and 20-year bond will drop by about 2% and 14% respectively. It is related to the concept of bond duration.

    Fully agree with you that now is not the time to buy bonds. I have a chart that keeps track of S'pore Govt Securities bond yields at

    (The) Boring Investor

    1. Hi Chin Wai,

      You're right. This is how its proven mathematically. Thanks for the info.

      I shall check out your chart on SGS bond yields. Thanks

  7. Liked*
    This is a really comprehensive post about bonds! Good job outta you!

    Best Regards
    Pok Chow

    1. Hi Pok Chow,

      Thanks for "Liking" my post. Hope its good information for you. :)

  8. Why does the longer tenure to maturity of a bond bring about an increase volatility of the price of the bond in relation to the market interest rate?

    1. Hi Mark,

      Longer term bonds have a longer time before the bond matures so it has more time to adjust its rates. When market interest rates change, the bond will adjust itself to suit the current economic conditions.

  9. Hi Thanks for the detailed writeup.

    does it mean the latest Singapore government bond is not recommended?

    1. Hi,

      The latest Singapore savings bond is actually not really a bond since they guarantee the capital and we can sell every month without any risk. It is like a fixed deposit but with no lock in period.