Investing In Bonds: What You Need To Know

Investing

Investing In Bonds: What You Need To Know

Bonds are an essential component of any diversified, balanced investment portfolio. Here we explain how bonds work, and examine their benefits and risks.

Published on 11 September 2017

Every investor’s portfolio should include fixed-income securities, which are commonly referred to as bonds. A government or a company issues these debt instruments to investors when it wants to borrow money. The bond issuer pays a fixed rate of interest to the lender at periodic intervals. On the maturity date, the principal amount is repaid.

Investors can gain several advantages by deploying their funds in this manner. They get a predictable stream of cash inflows on pre-decided dates, while the amount that they have invested remains safe with the borrower.

While bonds are generally regarded as a secure investment, they do carry certain risks. The issuer may incur losses and lose the ability to repay investors. This type of risk is usually restricted to corporate bonds. But there is another type of risk that is common to both corporate bonds as well as government bonds.

The risk of rising interest rates

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US Federal Reserve Building, Washington DC

That’s right, when interest rates rise, your bond investments may lose value. While this seems to be a contradiction, it is a reality that every investor must understand.

This is how it works: Remember that a bond is a fixed-income instrument. The borrowing company or the government issuer has promised to pay interest at a certain rate until the principal amount is repaid. Now, if market interest rates rise, investors would have the opportunity to purchase new bonds that offer higher rates. If you try and sell the lower interest rate bonds that you own, you will receive less than you had initially invested.

Of course, if you don’t want to sell and you plan to hold the bonds until their maturity date, you will not suffer a loss.

In a falling interest rate environment, bondholders would benefit. They would own instruments that pay a relatively higher rate of interest. Additionally, the market value of their holdings would increase, as new issues of corporations and governments would be at lower rates.

Boring is good

Despite the fact that bonds do have some disadvantages, they are a must-have for every investment portfolio. Why is that? An investment in bonds serves as an important component of a balanced asset allocation, stabilising an investment portfolio against the volatility that is sometimes seen in stocks.

Indeed, the shares of individual companies and even indexes like the Dow Jones Industrial Average or the S&P 500 can behave in a very erratic manner. The Dow Jones index has gained about 18% over the past last year, while the S&P 500 has increased by 13%. But the losses that you can suffer in the stock market can be equally high.

For example, the Dow fell by 778 points on 29 September 2008. That’s a loss of about 7% in a single day. It dropped by 7.1% on 11 September 2001 on the news of the attack on the Twin Towers in New York City.

The Singapore Straits Times Index (STI) has displayed similar fluctuations. Although it is currently about 11.5% higher than it was a year ago, the returns that it has delivered are far from consistent.

An individual who invested in the STI in the beginning of 2016 and liquidated the investment at the end of the year would have likely earned no return at all. At the start of the year, the STI stood at a level of 2,836 and at year-end, it was at 2,880.

Bonds are the perfect foil for stock investments. While the shares that you have invested in could suffer a large loss in value, your bond investments will continue chugging along, paying interest at the stipulated coupon rate.

There is another advantage that bonds offer vis-à-vis the stock market. When the share market falls, bond prices go up. When the dot-com boom fizzled out, US stocks took a beating. The share market fell by 39% in the period from 11 October 2000 to 10 March 2003. But in this period, the yield on the 10-year Treasury note fell from 4.63% to 3.59%. Remember that falling yields indicate rising bond prices.

Similarly, at the time of the global financial crisis in 2008, US stock prices fell by 45%, while yields on the 10-year Treasury note moved downwards from 3.91% to 2.89%.

How much should you invest in bonds?

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It can be difficult to decide on the proportion of your portfolio that should go into bonds. The “100 minus your age” rule can be used as a starting point, but it is rather simplistic. According to this maxim, an investor should gradually move away from equities and deploy a greater percentage of investible resources in bonds with increasing age.

The rule implies that three-quarters of a 25-year-old’s portfolio should be in stocks and the remaining amount in bonds. By the time this individual is 50 years old, the ratio of stocks and bonds should be equal.

Obviously, you should not follow this rule blindly. If you need regular income, you may want to deploy a greater percentage of your funds in bonds. Older investors who have an adequate level of income from other sources may want to invest greater amounts in equities.

Consider the risks involved

Many investors mistakenly believe that bond investments guarantee the payment of interest and the return of capital. While this is true of government debt, corporate bonds are another matter altogether.

It is useful to remember that you should not chase yields. Corporate bonds that offer high coupons are bound to carry an increased degree of risk. In fact, if you have the misfortune of holding bonds in a company that becomes bankrupt, you could lose your entire investment.

How can you ensure that you do not fall into this trap? Before purchasing a corporate bond, enquire about the issuing company. How long has it been in existence, what is the nature of its business, and does it have the capability of meeting its financial commitments? While it may not be possible to carry out a detailed review, you can use one simple rule of thumb to ascertain if your investment will be safe.

An inflated yield points to low creditworthiness. While this should not be a deal-breaker, you must ascertain the reason behind the high returns that are available before you invest.

The bottom line

You should invest in bonds only after you have understood the objectives that you are trying to achieve. If your goal is to balance your portfolio and reduce the risks that you face from your equity investments, then government bonds are a good option. On the other hand, if your primary objective is high returns, then you should consider corporate bonds. Whatever your purpose, it is essential that you understand the risks involved before you make an investment decision.

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