WHAT IS A BOND?
A bond is an interest-bearing or a discounted government
or corporate security that obligates the issuer to pay the bondholder
a specified sum of money, usually at specific intervals, and to
repay the principal amount of the loan at maturity. Simply put,
a bond is an IOU from the issuer. It is also known as a fixed-income
instrument.
*Example: a 4.375%, 6/7/04, AA+ bond issued by
John Hancock
The bond issued by John Hancock is a corporate bond.
The 4.375% is the coupon, which determines the interest payment
that John Hancock must make to the bondholder at specific intervals
(in this case semi-annually). 6 July 2004 is the maturity date when
John Hancock agrees to repay the principal or the face value of
the loan. AA+ is the credit rating accorded by S&P's debt rating
agency. According to the latter, an AA+ rating means the issuer
has a very strong capacity to pay interest and repay principal.
WHAT DO I NEED TO KNOW BEFORE I INVEST IN BONDS?
First of all, you need to know that a bond's price
movement is influenced by three main factors - interest rate outlook,
credit quality and maturity. In general, if the interest rate is
expected to go lower, or the bond's credit quality is likely to
get better, the price of the bond, hence its market value should
be higher. The nearer it is to its maturity, the closer is its price
to its par or face value.
Secondly, you need to understand that like stocks,
not all bond prices move by the same magnitude. How volatile the
bond price will be, as measured by what is known as 'duration',
depends on its coupon, credit rating and maturity. As a rule, the
lower the coupon, the lower the quality or the longer the maturity,
the more volatile will the bond be, in respect to interest rate
changes.
Thirdly, you need to appreciate the fact that bonds,
like any investment, are exposed to certain investment risks. Specifically,
these are - interest rate risk, re-investment risk, inflation risk,
credit risk, call risk, liquidity risk and event risk. Foreign bonds
are additionally exposed to currency risks.
Interest
rate risk - is the risk of the bond's market value falling if
interest rate rises. It also affects the reinvestment rate. This
risk, also known as the 'systematic risk', cannot be reduced by
diversification. It can only be 'controlled' by buying bonds that
are less volatile to interest rate changes.
Reinvestment
risk - is the risk that rates will decline, causing the interest
payments to earn less than the original investment's rate.
Inflation risk - is the risk of inflation eroding the value of the interest income, since they are usually not indexed to inflation (except for inflation-indexed bonds).
Credit risk - is the risk of the issuer defaulting on the obligations. This risk can be reduced by diversification i.e., investing in government bonds, quasi-government bonds and high quality bonds.
Call risk - is the risk of the bond being redeemed before its maturity. That said, not all bonds are callable. Callable bonds risk being redeemed earlier when interest rate falls, as it would be in the issuer's interest to redeem them and re-finance their debt obligations at lower interest rates.
Liquidity risk - is the risk that the bond has to be sold at below its market value, due to thin trading volume. It can be reduced by buying bonds which are actively traded.
Event risk - is the risk of the bond's market value falling as a result of a specific event, be it a market event (e.g. Russian default crisis), acquisition made, a merger, leveraged buyout, or other corporate restructuring.
Currency risk - is the risk that the bond's overall returns are reduced because the investor's home currency appreciates against the bond's native currency.
WHAT IS A BOND FUND?
A bond fund is a unit trust holding bonds. Depending on the fund's mandate, they could invest in bonds of all sorts - domestic, foreign bonds, which could be sub-divided into government, municipal, corporate, convertible, high-yielding bonds etc. Depending on the investment objective, a bond fund could be managed to achieve current income or total returns (i.e. returns from a combination of capital appreciation and interest income). One major difference to note is that unlike the bonds in a bond fund, the fund itself does not mature.
Like an equity fund, a bond fund can be open-ended or closed-ended. An open-ended fund would allow new units to be created continually to accommodate new inflows of money. A close-ended fund issues a limited number of shares and do not accept fresh inflows of money once the fund is closed. Most of the normal bond funds listed in Singapore (except for principal guaranteed funds) are open-ended.
*Example: DBS Shenton Income, OCBC Savers Global
Bond are bond funds.
SHOULD I BUY DIRECT BONDS OR BOND FUNDS?
Your decision would very much depend on your investment objectives. If you prefer to adopt a buy-and-hold strategy i.e., putting your money set aside to earn some interest income, you could have it invested in some high quality, liquid bonds. Of course, it would be crucial that you select the bond carefully, analysing its key investment characteristics. In addition, you should be aware of any special features such as call options (callable bond) or covenants that may affect the bondholder's right on the debt obligation. You should select the bond based on your investment horizon and income objective. You also need to bear in mind that buying individual bonds might limit your ability to seek optimal diversification, given the constraints of your investment size. Direct bonds trade in minimum size of S$10,000. In some cases, it could be as high as S$250,000.
On the other hand, investing in bond funds will suit you if you want to have the flexibility to withdraw some of your principal at any time. They would also make sense if you prefer to make smaller investments. In addition, bond funds are advantageous if you want to have your bonds actively managed, to take advantage of interest rate changes. Fourthly, investing directly in high yielding bonds or more complex instruments such as foreign bonds, junk bonds, callable bonds, bond futures, bond options can be quite challenging. These instruments would be best left to the expertise of the bond fund specialists.
NI offers both direct bonds and bond funds. We make specific recommendations to our clients, depending on their financial needs, objectives and personal circumstances.
*All examples cited and views expressed
herein are not intended as offers or solicitations for the purchase
or sale; nor do they take into account the investment objectives
or financial situation of any particular person. Investors should
seek independent advice based on their individual circumstances
before making investment decisions.
