Risk increases as the length of time funds are invested increases. what is this known as?

Understand how bonds work and the things to look out for if you are thinking of investing in them.

Key takeaways

• When you invest in bonds, you are lending money to the bond issuer at an agreed interest rate for a set period of time.
• You can expect to be repaid the principal amount when the bond matures, provided that the bond issuer does not default.
• When interest rates rise, you will likely see a fall in bond prices, and vice versa.

What it is

A bond is a debt security. It is a form of borrowing. Governments and companies issue bonds to raise funds (borrow money). When you invest in bonds, you are lending money to the issuer for a fixed period of time.

How it works

Most bonds pay a regular stream of income throughout their life, also known as a coupon. Coupon rates are typically expressed as a percentage of the principal amount, which is also known as the “face” or “par” value. Upon maturity, the bonds are redeemed and you are paid back the face or par value.

Typically, you can earn returns through:

• Interest income. These are the coupon payments you receive as an investor.
• Capital gains. You can earn capital gains if you sell the bonds at a higher price than the price you bought them at.

It is important to note that while the coupon rate is generally fixed through the life of the bond, the price of the bond may vary.

Hence, in deriving a bond’s return, you will have to consider:

• The coupon that you will receive over the life of the bond
• The potential capital gains or losses if the price of the bond becomes higher or lower than the price you initially paid

Are bonds suitable for you?

Bonds may be attractive for investors who desire a source of regular income, or are looking to diversify their portfolio of investment assets.

You should consider the suitability of an investment in bonds in light of your own circumstances. In particular, you should consider whether you:

• Understand thoroughly the terms and conditions of the bonds
• Are able to evaluate the investment in the bonds and how such investment will impact your overall investment portfolio
• Have sufficient financial resources and liquidity to bear all the risks of investing in the bonds or holding the bonds to maturity, including losing all or a substantial amount of the capital invested
• Are able to monitor or evaluate (either by yourself or with the help of a financial adviser) changes in economic or other factors that may affect the issuer or the bonds

Why bonds have different coupon rates

The coupon rates for different bonds will vary based on the credit quality of the issuer and the credit rating.

Credit quality of the issuer

Issuers with lower credit quality generally pay higher coupon rates on their bonds. This is because when an issuer has a lower credit quality, there is a greater probability of default. Such issuers typically issue bonds with higher coupon rates in order to compensate investors for the higher risks.

Study carefully the credit risk of the issuer to see whether you have the risk appetite to invest in its bonds. You can assess the credit risk of the issuer through its credit ratings or by using credit metrics.

Credit ratings

Borrowers and the bonds they issue are often assigned a credit rating. There could be a separate rating for the company or country issuing bonds and another rating for the bonds themselves.

So, the issuer rating and the bond rating are not necessarily the same.

Credit ratings are an indication of the credit worthiness of a bond issuer with respect to its bond obligations. The table below illustrates the different bond rating scales from the major rating agencies, Moody's, Standard & Poor's (S&P) and Fitch.

All ratings fall into two large categories known as investment and non-investment grade.

Non-investment grade bonds

Non-investment grade bonds are also commonly known as junk bonds or high yield bonds. They offer a much higher yield to compensate for the higher probability of default. In effect, bonds are not always low risk; some may be riskier than stocks.

Unrated bonds

Not all bonds are rated by international or major rating agencies. Some bond issuers may not seek a credit rating. For example, if the issuer feels that their target investor markets are sufficiently familiar with them and may even regard them as being more creditworthy than a credit rating may have suggested.

For the same reason, smaller and less frequent issuers may also not want to bear the cost of rating fees if the bonds are meant for a domestic market that already knows them.

For such unrated issuers and bonds, you should consider other measures of the issuer’s creditworthiness and the characteristics of the bonds when deciding whether to invest in the issuer’s bonds.

What to consider before investing

Credit ratings have their limitations and should not be your sole consideration when deciding whether a bond should be included in your investment portfolio.

They are only statements of opinion by the relevant credit rating agency and are not recommendations to invest. Furthermore, as the ratings are based on information available at the time the rating is assigned, they are subject to revision or withdrawal.

As an issuers’ credit worthiness can change quickly, there is no assurance that any revisions to the ratings will be made in a timely manner. You should find out more about the issuer, profitability of the business and track record of prior bond issues, if any. This will help you to examine if the company is able to meet its debt obligations, including the bond you may be considering.

One way is to look at the company’s solvency ratios such as interest coverage ratios and other credit metrics.

Credit metrics

Some useful financial credit metrics that you could look out for are:

• Debt to equity ratio – Measures how much debt an issuer is using to finance its assets and operations, as compared with the issuer’s equity. A high level of debt suggests higher risk. If debt to equity ratio is more than 2, it means that to finance its operations, the issuer has more than twice the amount of debt compared with equity.
• Debt to operating income ratio – Indicates the ability of a company to pay its debt using operating income. A higher ratio suggests that the company may have more difficulty servicing its debt. A declining ratio is better than an increasing one because it implies the company is paying off its debt and/or growing earnings.
• Interest coverage ratio – Reflects how many times the issuer can pay interest on debt obligations, using its operating income (or earnings). A lower interest coverage ratio means a weaker ability to cover interest obligations using its operating income. If the ratio is less than 1, it means that the issuer does not earn enough to cover its interest expense.
• Operating profit margin – Measures operating profit (or operating income) as a percentage of revenue. This shows the proportion of revenue left, after the issuer pays for operating expenses (such as wages), which can be used to pay for fixed costs (such as interest). The lower the operating profit margin, the higher the risk of the issuer not being able to pay its fixed costs.
• Free cash flow – The cash that a company has after spending money to maintain or expand its assets. An issuer with a profitable and well-managed business should exhibit positive free cash flows consistently.

You should compare the credit metrics of an issuer with that of other similar entities, as financial ratios vary across industries.

Tenure of the bond

Bonds from the same issuer with longer tenures tend to provide higher coupon rates than bonds with lower tenures. This is to compensate the investors for holding the bonds for a longer period of time as the chance of default rises with the duration of the bond.

Callable bonds have a feature which gives the issuer an option to buy back (redeem) the bond before its maturity date. The issuer may specify a price at which it will call (or redeem) the bonds. If a bond is called when prevailing interest rates are lower than at the time you bought it, you will be exposed to reinvestment risks.

Government bonds versus corporate bonds

For any particular country, the safest and highest credit quality bonds are usually its government bonds, followed by quasi-government or government linked entities, banks and then companies.

If you are interested in the safety of your bond investments, you should consider government or investment grade corporate bonds, while investors willing and able to accept a higher level of risk could consider lower credit-quality or non-rated bonds.

It is also advisable to diversify and avoid concentrated exposures to any one security. Individual investments can go up or down in value. Investing in different products is usually a good strategy to diversify and reduce the risks.

What is the most you can lose?

You may lose a part of your invested amount if you sell your bonds before it matures. Bond prices fluctuate depending on the perceived credit quality of the issuer and market conditions. However, you may lose all of your investment if the issuer defaults on its bond or winds up or is liquidated.

What are the risks?

Common risks associated with bonds include the following:

Note: The terms and conditions for different bonds can differ greatly. Always read and understand the terms carefully before investing in any bonds.

When a bond defaults

An “event of default” could happen when an issuer:

• Fails to pay interest or principal on the payment due date
• Fails to observe financial covenants, such as ensuring that the net borrowings to total equity does not exceed a certain ratio

The issuer will define the “events of default” in the terms and conditions of the bond which should be disclosed in the offer document given to you. When a default happens, you may lose all or a substantial part of your investment.

Find out more: What happens when a bond defaults

Buying a bond

You can buy a bond at issuance, through a public offer. You will pay the face value of the bond.

You can also buy a bond on the secondary market (after issuance), as long as there is a seller for it. This can be done through the Singapore Exchange (SGX).

If you buy on the secondary market, the price you pay for the bond depends on the prevailing market price. You will also need to pay transaction fees, such as brokerage fees.

See also: Buying bonds and perps in sizes of $200,000 or more

Selling a bond

You can hold the bond to maturity. You can expect to be repaid the principal amount of the bond at maturity provided that the bond issuer does not default.

Before the bond matures, you can sell the bond in the secondary market, as long as there is a buyer for it. The price you get depends on the prevailing price at the time of sale.

If you sell the bond at a price higher than what you paid, you can make a capital gain. Likewise, you could also suffer a loss if you sell at a lower price.

Types of bonds

Here are some examples of bond investments available in Singapore.

Singapore Government Securities and Savings Bonds

In Singapore, you can choose from Singapore Government Securities (SGS) and Singapore Savings Bonds (SSBs). These are backed by the Singapore Government and considered risk-free investments.

Savings Bonds are designed specifically for retail investors as a flexible, low-cost and low-risk savings product.

The key differences are as follows:

Corporate bonds

Corporate bonds are issued by companies. They usually pay out higher interest rates than government bonds because they generally carry more risk.

You can buy corporate bonds listed on SGX in the same way as you would buy shares, paying the normal brokerage fees.

Advantages:

• May offer better returns than fixed deposits or government bonds.

What to look out for:

• You will be exposed to credit and other risks.
• Consider whether you are able and willing to take a higher risk of default and losing part or all of your investment, in return for higher yields.

Perpetual securities

Perpetual securities, otherwise referred to as “perps”, are hybrid securities issued without a maturity date.

Bond funds and ETFs

Investing in bond funds and exchange traded funds (ETFs) is usually more practical than investing directly in all the bonds that the fund holds. Some ETFs are Specified Investment Products (SIPs).

Bond ETFs typically aim to track the performance of bond indices. They may invest in a portfolio of bonds, or replicate that exposure through the use of derivative products like swaps. Different bond ETFs may adopt varying strategies

Advantages:

• Smaller capital outlay needed than to own all the bonds in the fund.
• The fund manager actively manages your bond holdings. In the case of an ETF, the fund usually tracks an index.
• Choice of global, regional, country or sector-specific bond funds and ETFs.

What to look out for:

• Examine the total returns when evaluating a bond fund’s performance. Total returns include income and capital gains or losses over time.
• You will have to pay management fees and other charges. These will reduce the overall returns to you.
• Some ETF are complex and classified as SIPs.

Which type of risk refers to the chance that general interest rates will increase?

Which of the following is the risk that changes in market rates will affect the value of a bond?

Which asset would the risk averse financial manager prefer?

When an organization borrows money that must be paid back over time usually with interest what kind of financing is being used?