Introduction to bond investing

The Business Times
Cai Haoxiang
9/9/2013

ONE month ago, as Singapore celebrated its National Day, Japan celebrated a dubious national milestone.

On Aug 9, 2013, the Japanese finance ministry announced that total Japanese government debt as at end-June was over 1,000 trillion yen, or 1,000,000,000,000,000 yen.

One quadrillion yen translates to $12.8 trillion in Singapore dollar terms, or $12,800 billion. The size of Singapore's economy was just $350 billion last year. Japan's government thus owes money to the tune of 37 Singapores. This astronomical sum was more than twice the size of Japan's own economy, which was already the third largest in the world.

Add in total corporate and private debt, and total Japanese debt is 500 per cent of its gross domestic product (GDP), or more than 2,000 trillion yen.

By contrast, the total market capitalisation of the Tokyo Stock Exchange was just 400 trillion yen at end-August.

Debt is obviously a big deal, and this is also reflected in global financial markets.

The news might tend to be dominated by stock market movements, but the movements in the bond markets have a potentially weightier impact.

According to a 2011 report by consultancy McKinsey, the world's stock of equity and debt amounted to US$212 trillion in 2010. Stock market capitalisation amounted to just a little over a quarter, or US$54 trillion. The remainder consisted of debt: bonds issued by corporations, financial institutions, governments; asset-backed securities; and bank loans held on balance sheets. Government debt amounted to 69 per cent of world GDP.

Since the global financial crisis, money has flowed into debt markets as governments borrowed to fund stimulus programmes or to boost confidence in the economy, and investors fled to the relative safety of high-quality debt securities.

Among the very rich, a popular way to mint money in a low interest rate environment was to borrow from banks at a lower rate, say 3 per cent, and buy bonds yielding a higher rate, say 6 per cent. Assuming the bonds did not go into default, which would seldom happen if they bought investment-grade bonds, and assuming the lengths of both the bank loans and bonds were matched, the trades were extremely profitable at a very low risk.

But what exactly are bonds? And how do you go about bond investing?

This article gives the briefest glimpse of the world of bonds, otherwise known as debt or fixed income securities. I will focus on the simplest type of bonds, and leave the discussion of perpetuals, callable or putable bonds, convertible bonds, preference shares, mortgage-backed securities and asset-backed securities for another day.

The gist is this: Bonds are a way for companies and governments to borrow money from investors for a fixed period of time over the long term.

From the investor's point of view, bonds are generally regarded as less risky. However, they usually have to settle for lower returns. And in an environment of potentially rising interest rates as the US Federal Reserve gradually stops pumping so much liquidity into the financial system, bonds are not a recommended investment for investors who intend to sell their bonds before they are due.

How to buy bonds

I will tackle the investing question first before going into detail on the nature of bonds.

There are two ways of investing in bonds: buying the individual bond, and buying units in a bond fund.

Buying individual bonds is typically not done by the retail investor due to the large commitment required per bond, which can be $250,000 a lot. But there are a couple of options.

Singapore government bonds, for example, can be bought through an ATM machine or Internet banking platform. The minimum investment is $1,000, and people buy in multiples of $1,000.

Some bonds are also traded on the Singapore Exchange. These are known as retail bonds. There are 10 retail bonds out on the market, issued by companies such as Singapore Airlines (SIA), Olam, Genting, CapitaMalls Asia, United Engineers, and Tiger Airways.

The minimum investment required for retail bonds is typically relatively low. In 2010, SIA was the first listed company to set aside a portion of its corporate bonds for retail investors, with a minimum subscription of $10,000.

The largest amount of debt sold to investors here happened last year, when casino operator Genting made a $1.8 billion perpetual bond issue, with another $500 million of perpetuals targeted at retail investors with a minimum subscription of $5,000.

But the main portion of the bond market is traded by institutions and high net worth individuals in the over-the-counter (OTC) market, that is, not publicly in any formal exchange. To buy them, investors go through banks or through a broker. Bond professionals, however, recommend that retail investors invest in bond funds instead. These funds invest money in a variety of bonds. This is to spread out the risk, in case the company you lent money to goes belly-up. Bond funds are typically more liquid. This means they are traded more frequently, so it is easier to buy and sell at a fairer price.

There are numerous bond funds catering to bonds across different countries, geographical regions, and companies. They can be bought through the Central Provident Fund (CPF) Investment Scheme, through fund providers such as Fidelity, Vanguard and BlackRock, and offered indirectly or directly in products by insurance companies and banks.

There are a few bond funds tradeable on SGX. The ABF Singapore Bond Index Fund is one such investment. It is an exchange-traded fund (ETF) run by Nikko Asset Management, and gives investors exposure to Singapore government bonds. Its last traded price was $1.1320 a unit, and the lot size is 1,000 units a lot. The fund distributes dividends once a year. Its last distribution was announced at end-September 2012, of $0.0128 per unit, giving a yield of 1.1 per cent.

What are bonds?

Bonds are essentially a contract between a borrower and a lender.

The lender agrees to lend a sum of money to the borrower for a fixed period of time for a year or more.

In return, the borrower typically promises to pay the lender interest payments every six months, to compensate the lender for parting with the money. These payments are known as coupons.

Coupons are called thus because bonds used to be issued to investors in the form of engraved certificates. The bonds would come with multiple coupons that represented the interest payments. When they become due, say on June 30 or Dec 31, the owner would clip the relevant coupon and bring it to a bank to exchange for money. At the end of the borrowing period, the borrower will give the entire sum borrowed back to the lender, together with the final coupon payment.

This process is automated now, but the old name stuck.

If the borrower cannot pay interest payments or pay back the original sum it borrowed, it will be in default. This is a technical term that means the borrower has not met its legal obligations according to its debt contract.

The lower the credit rating of the borrower, known as the bond issuer, the higher the chance of default.

Credit rating agencies such as Moody's, S&P and Fitch are companies that help investors assess the likelihood of failure. They classify bonds into various grades, akin to the grades you get in school.

The top four grades, AAA, AA, A, and BBB (Baa for Moody's), are known as investment grade bonds. Typically, these are bonds that banks and financial institutions invest in, because these borrowers are judged to have a low enough risk.

Issuers with strong balance sheets and mature businesses tend to get rated higher. By having a higher rating, they do not need to pay investors as much interest. The yield of investment grade bonds tend to be low, say 2-3 per cent a year.

Bonds below investment grade, such as BB, B, or C-rated bonds, are considered speculative grade. These bonds are also known as junk bonds, or high-yield bonds. These companies are assessed to be riskier to invest in and lend money to, and often have to pay investors a higher interest rate, say 7 per cent or more. There is an advantage to buying the bonds of a risky company compared to buying its stock, however.

In the event of default, bondholders get paid first as a company's assets get liquidated. Stockholders are often left with nothing after that.

The bond investor also seldom loses everything even if the company defaults. A study by Moody's on 1,100 defaulting North American bond issuers from 1983 to 2003 found the average recovery rate to be 39.5 per cent, and the median, 36.6 per cent.

Bond jargon

The bond world, unfortunately, is rife with jargon. This can make it difficult for the layman investor to understand how bonds work.

The exact mechanics of bond pricing will be explained in a future piece.

But the most important thing investors should be careful of is the percentages bandied around by bond professionals.

A bond typically pays a fixed coupon rate on its face value, the amount that the issuer has to pay back upon the end of the borrowing period.

For example, an issuer might borrow $1,000 from investors with a coupon rate of 5 per cent, for a period of 10 years. This means coupon payments are $50 a year, or $25 every half-year.

There will be a total of 20 half-year payments of $25, before the investor gets back $1,000 at the end of 10 years.

But the price of the bond, or the cost to investors who buy when the bond is first issued, might not be $1,000.

It will only be $1,000 when market interest rates equal the coupon rate. If interest rates are at 5 per cent and the bond offers a coupon of 5 per cent, the market is indifferent to investing $1,000 to get $25 a half-year either in the bond, or elsewhere. Thus it is willing to pay $1,000 for this 5 per cent coupon, 10 year bond.

But if one year later, general interest rates rise to, say, 6 per cent, the market can now get more money by investing in another instrument. Demand for this bond will fall.

The price of this bond will also fall to $931.23 - even though it will continue to pay out $25 every half-year for the next nine years, and will pay $1,000 when it matures.

If investors need to sell the bond instead of holding it till maturity, they will suffer a loss.

The coupon yield, current yield and yield to maturity of a bond can all be different. Investors need to pay the greatest attention to the bond's yield to maturity, which is the bond's total return at the moment when the investor is looking at it.

Yield to maturity is the common understanding of what a bond's yield is.