Bonds are basically an IOU between you (the lender) and corporations or governments (the borrower). They are also known as fixed income securities because interest (coupons) is paid at regular intervals throughout the life (tenure) of the bond.
Types & themes
While government bonds are often seen as being less risky, some companies may have healthier balance sheets than governments
The bonds of a well-run company in a developed market, for example, may be less risky than the bonds of an emerging market government.
Assess the quality of a bond by its credit rating, and not by the type of issuer.
You can gauge the quality of a bond from its credit rating.
An investment grade bond is rated BBB- or higher (Standard & Poor’s) or Baa3 or higher (Moody’s). Bonds rated lower are considered speculative or junk bonds.
If you bought a fixed rate bond, it will pay a fixed interest or coupon rate until the bond reaches maturity.
If you bought a floating rate bond, the interest rate will vary according to market conditions. The floating rate is usually set at a fixed premium above an accepted benchmark rate E.g. 25 basis points + London Interbank Offer Rate (LIBOR).
If interest rates are expected to fall, investors may prefer holding fixed rate bonds. If interest rates are expected to rise, investors may prefer holding floating rate bonds.
Not always. If you own a callable bond, the issuer can buy back the bond at a predetermined price before maturity. This is more likely to happen when interest rates are falling as the issuer will then be able to issue new bonds at a lower interest rate.
A callable bond usually comes with a higher yield to compensate the buyer for this flexibility.
Meanwhile, perpetual bonds have no maturity dates. Issuers pay coupons on perpetuals forever and do not redeem the principal.
While this may sound appealing, note that rising interest rates impact the price of perpetuals more negatively than bonds with shorter maturities.
Green Bonds are bonds where the proceeds are used to finance or refinance, in part or in full, activities, projects or assets that will contribute to environmental sustainability.
They can be issued by development banks e.g. World Bank, corporates, government-backed entities and governments.
Green bonds are becoming popular as more investors seek to make an impact through climate investing.
Pricing & valuations
You can look at the difference between the yield of the bond and the yield of another bond with similar maturity but different credit risk E.g. US Treasury.
If the difference (credit spread) appears large relative to its historical average, it suggests that there is room for the bond price to move higher as the credit spread narrows.
Find out if the bond is cheap for a reason. Are there reasons (macro or company specific) why the bond yield high or credit spread is large relative to its historical average or peers?
The current yield and yield to maturity are two ways to look at bond returns.
| Current yield | Yield to maturity (YTM) |
|---|---|
| Yield of bond now | Total return of bond if held till maturity |
| Does not consider capital gain/loss | Considers capital gain/loss |
| Does not consider reinvestment risks | Assumes all cash flows received are reinvested at the same rate |
| Formula = Annual coupon payment /Bond market price | Best to use a financial calculator! |
If you buy a bond at a discount to its face value, the YTM will be higher than the current yield. If you paid a premium for the bond, the YTM will be less than the current yield.
When interest rates rise, the fixed payments from a bond become less attractive. This in turn lowers the bond price.
However, bond prices can also rise when interest rates move higher. This is especially if rising rates are associated with stronger economic growth. For corporate bonds, stronger economic growth usually improves the ability of companies to pay off their debt. This lowers the credit risk of the bond, which causes the bond price to rise.
Corporate bond prices are determined by both rising interest rates and credit risk.
Yield curves typically slope upwards, reflecting expectations that higher economic growth will bring about higher inflation (and interest rates) in the future.
In the last 50 years, the US economy has entered a recession each time the yield curve inverted, although the recessions took place one to two years after the yield curve inverted.
Some research 1suggests that increased worries about a possible recession may be what causes the curve to invert, not the other way around.
Technological disruptions combined with easy monetary policies by developed market central banks post the Global Financial Crisis have contained inflation, helping to keeping long term yields low.
1Different slopes for different folks. Bank of America Merrill Lynch. 29 August 2018
Bond maturity, which is expressed in years, is the date when the principal amount of a bond becomes due and is repaid.
Bond duration is also expressed in years, but it measures how sensitive the bond price is to changes in interest rates.
A bond’s duration will be lower if the maturity period is shorter and the coupon rate is higher. A bond with lower duration is less sensitive to changes in interest rates.
Returns & quality
An income-only bond strategy aims primarily to provide you with a reliable income stream, but this may limit the type of bonds the strategy is invested in. Conversely a total return strategy seeks to maximise returns from both income and capital gains and hence may tap into a wider range of bonds. The volatility of the strategies would differ depending on the type of bonds invested in.
When investing in an income-only strategy, make sure that the strategy is not paying income out of the principal.
If receiving regular income is your key consideration, a portfolio that has bonds with different maturities is recommended i.e. a laddering strategy. With laddering maturities, bond investors can reduce interest rate and reinvestment risks.
If interest rates rise, shorter term bonds maturing at the bottom of the ladder can be reinvested in higher-yielding bonds. Conversely if rates decline, the longer-dated bonds at the top of the ladder will still pay out the higher coupon rates and may even enjoy price gains due to their increased attractiveness. This smoothens the overall income generated in a laddered bond portfolio. A laddered bond portfolio also provides greater diversification.
To enjoy a more predictable income stream, look for non-callable bonds. When a bond is called prior to maturity, its coupon payments cease and the principal is returned to you, earlier than expected. If you buy a bond at a discount to its face value, the YTM will be higher than the current yield. If you paid a premium for the bond, the YTM will be less than the current yield.
Although the credit rating is an important indicator of an issuer’s ability to pay debt, it may not always reflect the full picture. As history has shown, in some of the past crises such as the Global Financial Crisis, credit agencies have been late in revising down the credit ratings of some companies, causing investors to incur significant losses. At the same time, there are many good as well as poorly managed companies that may not have credit ratings. Some active bond fund managers have proprietary frameworks that come up with internal bond ratings which they use to guide them in their investments.
As a credit rating is a statement of opinion and not a statement of fact from a credit agency, it merely serves as a guide.
Credit spreads reflect the additional yield that corporate bonds offer above risk-free bonds to compensate investors for taking on risk. Movements in credit spreads can happen for many reasons, including the change in the perceived creditworthiness of a bond issuer, the bond demand and supply dynamics and the overall economic outlook. Narrowing spreads typically indicate confidence in the economy and the issuer’s ability to repay while widening spreads reflect the opposite.
In a booming economy, investors are usually more willing to accept lower compensation for taking on risks and therefore lower spreads.
A bond default happens when the issuer fails to make a scheduled payment for a variety of reasons. In the event of a default, bondholders can continue to hold the bonds and wait to receive the monies once the issuer liquidates its assets and distributes the proceeds. But this whole process can take time (months or years) and you are unlikely to recover 100% of the bond’s principal. Alternatively, you may be able to sell the bonds at a discounted price dictated by the secondary market.
If you are risk averse, avoid investing in junk bonds which carry a higher default risk.
Sources:
1 Bloomberg. MSCI Asia Pacific ex Japan. April 2019.
2 Morgan Stanley. Jan 2019.
3 Bloomberg. DM: MSCI World. Asia: MSCI Asia ex Japan. Annual data. December 2018.
4 United Nations, Population Division: World Population Prospects – The 2017 Revision (based on medium variants), as at June 2017 future returns.
