This article is written as part of a DollarsAndSense Bonds Investing Education Series with Azalea Asset Management.
Many investors automatically assume that bonds are safe investments, especially when compared to stocks, properties or private businesses. Investors also commonly associate it with generating stable and recurring returns with a high degree of predictability.
While this may generally be the case, it does not mean that bonds investment are without risk. In fact, assuming that they are without risk is a major misconception. For example, the challenges in the oil and gas sector over the past two years have seen some companies being heavily impacted, and thus defaulting on the bonds that they had issued.
Understanding Different Bond Investments
The first step towards evaluating how safe or risky your bond investments are would be to understand them as much as you possibly can.
There are many different types of bonds that you can invest in, including government bonds, corporate bonds, bond funds and even private equity-backed bonds. Each of these types of bonds have unique characteristics, and the risks they carry can vary quite drastically.
To better understand your investments and the kinds of risks you may be exposed to as a bond investor, we detail five common areas of risks you should be paying a close attention to.
# 1 Default Risk/Credit Risk
Default risk is one of the most important risks that investors should be concerned about when investing into bonds.
Default risk refers to the risk that the bond issuer may be unable to keep up with coupon payments, or may even default on the repayment of your principal investment upon maturity. If this happens, investors may not receive the money they have invested into the bond, or may be forced to take a reduced return.
Bonds that are issued by organisation with a greater chance of defaulting usually have to pay a higher coupon rate – otherwise investors would just put their money in safer bonds offering the same coupon rate.
International credit ratings agencies, such as Standard & Poor’s, Moody’s and Fitch, may assign credit ratings on government bonds and highly rated corporate bonds, which represents its ability to meet its financial obligations. Do note that these ratings can change during the lifespan of the bond until its maturity, depending on market conditions and the performance of the organisation that issues it. Smaller companies that issue bonds may not have credit ratings.
To give you an idea of how this works, consider bonds issued by the Singapore government, with a AAA credit rating, the Malaysia government, with an A- credit rating, and the Vietnam government, with a BB- credit rating. All these ratings are based on Standard & Poor’s assessments.
Based on the current credit ratings, you would expect the bonds issued by the Singapore government to pay the lowest coupons, the Malaysia government to pay a higher coupon rate and the Vietnamese government to pay the highest coupons. Intuitively, this makes sense, since the bonds issued by the Singapore Government are considered the safest among the trio based on their ratings. The same approach is used for companies that issue bonds.
Another key consideration is how stable the issuers remain over time. In the event that the Singapore or Malaysia government are downgraded by credit ratings agencies for whatever reasons, it’s likely that future bonds issued would require a higher coupon rate in order for investors to be willing to invest into it.
Concurrently, this also means that with higher interest rate, existing bond prices will also decline. This brings us to point 2.
# 2 Interest Rate Risk
If you are a bond investor, you need to pay attention to interest rate. This is because interest rates and bond prices have an inverse relationship, which can greatly impact the value of your bonds.
When interest rates rise, bond prices tend to fall; and when interest rates fall, bond prices tend to rise.
Here’s a simple example of why this happens. Imagine you’ve invested $1,000 in a 2-year Singapore government bond that currently pays a coupon rate of 1.5% per annum. You also note that the 1-year government bond is currently paying 1.3% per annum.
If interest rates falls at the end of the first year, and the Singapore government is now issuing 2-year bonds at 1.3% per annum and 1-year bonds paying 1.0% per annum, everyone will flock to buy your initial bond investment on the secondary market because it still has one year left to run but pays 1.5% per annum, as compared to the current market, which only pays 1.0% per annum for 1-year bonds.
To correct this, the market price of your bond investment will rise until it delivers a return of close to 1.0% per annum on the second year. Conversely, if interest rates were to increase, the market price of your bonds would decline.
# 3 Liquidity Risk
Investor interest levels have always been greater in stocks. Bond investors also tend to be long term and hold on to their investment for the yield instead of trading them. This means that bond markets, despite having relatively liquid secondary markets, trade at thinner volumes and/or greater bid/ask spread to stocks.
If you want to offload your bond investments quick or in a volatile market, it could mean being forced to accept a price that’s lower than expected.
# 4 Reinvestment Risk
When you invest in bonds, you typically receive cash returns. This means that you have to choose how you want to use or invest this money once it comes in.
The problem is that not only will you be more susceptible to spending that cash, you may not be able to achieve the same returns if interest rates are declining.
For example, if you are receiving an annual 5% coupon payment for a bond that you previously invested into, but interest rates have since declined, you will not be able to reinvest your coupon payment at the same 5% rate that you used to get.
Another form of reinvestment risk presents itself when you put your money into callable bonds. Callable bonds give issuers the flexibility, but not the obligation, to pay back bonds earlier than its maturity date. Again, in a declining interest rate environment, organisations would pay back these callable bonds and either issue new bonds or take new loans at a lower interest rate.
While this may be good for the organisation, it leaves investors with a pile of cash and a big dilemma of having to reinvest in a business landscape that’s offering lower interest rates.
# 5 Inflation Risk
A common reason for investing in bonds is that you want to have greater visibility into your future returns. Knowing exactly how much you’ll be receiving in coupons, when you’ll be receiving it and when the bond matures can be beneficial for financial planning when you’re nearing retirement.
However, if you’re expecting to use cash flows from your bond investments for your daily expenses, inflation risk becomes material.
If inflation increases, and continues to do so at a rate greater than your coupons, but you’re committed to receiving fixed returns for the long-term, you may end up achieving negative real returns. This means your spending power will be stunted – and you cannot buy the same basket of goods you used to be able to.
To highlight this point, imagine you’ve invested in a bond that pays a coupon rate of 5% to supplement your retirement income. You reason this can tide you through inflation, which has been hovering below this level in Singapore.
However, should inflation spike to over 10% per annum in the next decade, your returns may not be able to cope with increasing prices.
Knowledge Is Key To Understanding Risks And Investing Prudently
When it comes to bonds, the risks that investors face are typically lower compared to if they have invested in the stocks issued by the same company.
However, this doesn’t equate into taking on no risk. Like all investments, there are always some risks involved that investors bear. The key thing is to be aware and to understand the various risks that you are taking on when investing in bonds, and to ensure that you are comfortable with the risk-return trade-off before you invest your monies.