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Bonds and Fixed Income

What are bonds – an introduction

 

This is a first of two parts in trying to educate and to share the knowledge in investing not just for the present but also for the long term. I think the first idea most of us will associate with when we think about investing is equities or simply stocks. Right? Yes. We just couldn’t helped it since most of us were exposed to this in our growing up years when our parents dabble with the controls, flipping through pages of stock price on the Teletext screen. Boy, did they actually know what they were buying? But, have we ever heard them talk about bonds? Not in my case for sure.

There may be an abundance of financial instruments out there but not all are available to retail investors. Stock and Bonds being the core of financial assets, fortunately are. In this article, we are going to go deeper into Bonds, which serves as a prelude to our next article. Check out our article on different investment products, which has a portion on bonds.

Singapore Bond Market

To better align our investment goals, one has to understand the nature of the Singapore Bond market. Traditionally, bond market is a source of financing for governments. US and Japan being the biggest bond player in the global markets issue bonds to finance their spending. This explains the dynamism of their bond market. Singapore, on the other hand does not need to finance it’s spending due to it’s prudent fiscal nature whereby it’s tax revenue is able to cover spending. This also explains the nature of Singapore’s bond market. It isn’t as dynamic compared to the big players but it serves a purpose. It was only after the 1997 Asian Financial Crisis where countries in the APAC region realized they are too dependent on short-term financing. Creating a bond market thus ensures that long-term financing needs are available to companies.

Singapore’s bond market currently stands at SGD$357B in market capitalization as at 2011 and it was awarded the highest credit rating. This means that bonds issued are fully backed by the Singapore Government and are deemed to be a safe investment by the market.

Why invest in Bonds?

Before we answer the question of why bonds, let me link this to the concept of stocks. There are various reasons why we are vested in a particular company. Be it performing sufficient due diligence of the company, ensuring valuations are cheap or determining the trend-lines are favorable, the same goes for Bonds. So, why bonds?

Capital Preservation

As a fixed income instrument, the principal amount invested in bonds is guaranteed. This form of investing might be ideal for individuals who have a liability to meet in the future because it not only ensures the principal amount is repaid but interest income can be gained in the interim periods. Additionally, it is also a wiser choice than leaving funds in a savings deposit account given the near 0% interest rate on these accounts.

To offer a perspective on the value of capital preservation, you can read this article. Capital preservation will be an investment strategy adopted by fund managers in the next few years. Why?

In recent years, interest rates have been depressed to very low levels due to the monetary expansion by central banks around the world. This is partly to stimulate the economy by offering low interest rates on loans and also, to prevent people from saving; consumption forms the equation for growth, not savings. Low interest rates also boost the stock market and this is evident in the last few weeks when the stock market in the US hits new highs. What do all these mean for bond investing?

With interest rates being so low and given that the US and world economy will recover at some point, will interest rate not rise? It will, and when it does, prices of bond will plummet. Recall: bond prices and interest rate move in opposite directions. Thus, it makes sense for fund managers to adopt a more conservative approach rather than actively trading bonds.

Capital Appreciation

Bonds can also appreciate in value when it is traded on an exchange as a secondary market. In the market, the law of demand and supply is in effect and when there is increased demand for the bond, the price will increase. Why would the demand of a bond increase? For example, a company with credit rating BBB+ issues bond which is then traded in the market. It then continues to expand and do well in both profit and cash flow terms. This resulted in an upgrade of the company’s rating to A-. Overall, this is good news both for the company and it’s creditors as an upgrade is synonymous with increased capability to repay its debt. Demand for its bond will then increase and since the law of demand and supply implies higher demand equates to higher price, the price of the bond will then increased.

It is important to know that Capital preservation and Capital appreciation are two separate forms of investing. When the bond is held to maturity (capital preservation), any price gains in the bond will be forfeited, as the value of the bond will revert back to its par value. For example, a particular bond is currently trading at 1005 with 1000 par and it is to the benefit of the investor to take advantage of the capital appreciation but if he/she chooses not to, the gains from the appreciation will be unrealized. He/she will receive back 1000 at maturity date. On the other hand, if the investor chooses to sell the bond at the higher price, he/she will forfeit the future interest income but it may be offset by the higher price of the bond.

In reality, it depends on whether you are an investor looking for higher yields or simply to preserve your capital.

Diversification

Traditionally, bonds as an asset class serve as a rebalancing instrument in portfolios. Let me illustrate:

Credits: www.stockcharts.com

Credits: www.andrewhallam.com

In the first graph, we can spot the pattern right away. When stocks fall, the value of bonds rises and vice versa. Similarly, in the second graph, both the green trend-line (S&P 500 stock ETF) and the blue trend-line (iShares bond index) exhibit an inverse relationship. Why is that so?

There are various reasons why stock market crashes. The most recent crash being the 2007 subprime crisis which was followed by the Eurozone debt crisis. When such crashes occurred, the economy will go down with it leading to recessions and a fall in aggregate demand. Since the world of finance is a zero-sum game, money flowing around the world must go somewhere. It is usually in bonds where all the money will end up in. Investors and institutional investors will play the capital preservation game. Having my principal guarantee is better than losing everything. And, so we see it, in the two graphs above, the price of bonds shot up as there was demand for them while stock market crashed.

Thus, having bonds in a portfolio helps in a downturn where the re-balancing effect kick in.

There you have it, hope it does add on to your knowledge! In the next series, we will touch on active and passive investing which is a follow-up from this series.