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Sunday, February 26, 2017

Be mindful of these risks when investing in bonds

Lorna Tan
Feb 26, 2017

As with most forms of investment, you can lose part or even all of your capital when investing in bonds.

For instance, when an issuer defaults, it is unable to provide regular interest payments or return the original investment amount to the bondholder upon maturity. You as a bondholder may then lose all or a substantial part of your investment. Not all bonds are created equal, so do your own due diligence before applying to buy them.

In a nutshell, the higher interest rates offered by corporates are to compensate the investor for taking on higher risks, which include the credit risk of the issuer (risk of not being repaid if the issuer defaults), liquidity risk (risk of not being able to readily sell the bond and get back your investment proceeds at any time), and market risk (risk that interest-rate movements cause the bond to decrease in value).

Hence, it is prudent when investing to ask what could cause you to lose money and what is the maximum you could lose.

Here are five risk factors that can impact your bond investments.

Default risk can change due to broader economic changes or changes in the financial situation of the company or country.

A firm with poor credit fundamentals may go bust or default on its debt and coupon payments, and it is best for investors to be cautious of such companies.

Mr Vasu Menon, OCBC Bank's senior investment strategist, suggests checking out financials such as the firm's debt-to-equity ratio. This measures how much debt an issuer is using to finance its assets and operations.

"It is important to assess if a company is too heavily indebted. A company with too much debt may run into difficulties servicing its debt and may be forced to sell off assets or declare bankruptcy," he added.

"A ratio of less than 0.5 times would be ideal. However, there may be times when a company has a significant cash hoard, strong and positive operating cash flow and good business prospects, in which case, a ratio of more than 0.5 times would still be acceptable.

"However, even for such companies, ideally, the debt-to-equity ratio should not exceed one.

"It may also be advisable to compare the company's debt-to-equity ratio with its peers'. If the ratio is significantly higher, this would be a worrisome sign."

Another way of assessing the firm's financial health is to look at the balance sheet. If the company is suffering from a negative operating cash flow - it is spending more cash than it is generating - or has a low interest coverage ratio of less than 2.5 times, be wary.

Note that bond prices are affected by the perceived credit quality or probability of default of the issuer.

This explains why there are advantages to bond issues that have attained credit ratings as they provide a quick, independent and comparable assessment of an issuer's creditworthiness.

Ms Chung Shaw Bee, UOB's head of wealth management for the region and Singapore, said: "The rating is indicative of the issuer's ability to keep up with the expected coupon payment and to return investors' capital upon maturity. However, there are currently a number of bonds that are not rated."

Mr Daryl Liew, co-chair of the Advocacy Committee at CFA Singapore, said: "If the bond has a credit rating, then potential credit-rating downgrades would suggest that something is amiss."

This is why the Monetary Authority of Singapore (MAS) is encouraging bond issuers to obtain credit ratings for their bonds, as the rated issuances will improve transparency in the bond market.

Last November, the regulator announced incentives to offset the costs associated with getting a rating.

"Qualifying Asian issuances will be able to offset up to 50 per cent of one-time issuance costs such as credit-rating fees, international legal fees and arranger fees," the MAS told The Sunday Times. "Even as we draw Asian issuers to Singapore, we want to encourage these issuers to be rated... Rated issuers will be eligible for a larger grant quantum under the Asian Bond Grant."

A basic relationship that bond investors must note is that interest rates and bond prices move in opposite directions.

So if prevailing interest rates rise, you will likely see a fall in bond prices, and vice versa. If bond prices fall, you could experience a capital loss if you sell the bonds before maturity.

Mr Liew advises that it is important to have an outlook on interest rates when considering bond investing as this could dictate the kind of bonds you would prefer.

"For instance, in a rising interest-rate environment, investors may prefer to stick to shorter-duration bonds or floating-rate bonds," he said.

Mr Menon notes that interest rates are now at record-low levels and are likely to rise in the future, which could weigh on the price of bonds.

Upon maturity, bonds are redeemed at face or par value, meaning that the bond holder gets his principal back.

But what happens if you sell your bond before it matures?

Be aware that a bond's price will fluctuate with changing market conditions, including the forces of supply and demand in the secondary market.

For instance, if there are not many interested buyers of the particular bond, it means that it is not very liquid and it will be harder for you to sell or that you may have to sell at a loss before maturity.

Mr Menon said: "Poor trading liquidity could be one disadvantage of a bond. Bonds may sometimes not be as actively traded as stocks and this may pose problems for investors who need to sell their bonds urgently.

"If an investor is unable to find a buyer at the price he wants, he may be left with no choice but to sell at the price available, which could result in lower profits or even losses."

A bond is a contractual arrangement between the issuer and the bond holder. The terms and conditions governing each bond can differ significantly, and you should always read and understand the terms carefully before investing in any bond.

In addition, these terms and conditions may change if bond holders agree to alterations proposed by the bond issuer, said MoneySense, the national financial education programme.

One example is the call risk.

Some bonds have a callable feature that gives the issuer the option to buy back or redeem the bond before its maturity date. The issuer may want to do this particularly when opportunities arise for it to refinance at lower interest rates.

However, this may be unfavourable to you as a bond holder because you may not be able to re-invest in a product with equivalent interest payments.

Another example is early redemption risk.

Bonds may come with terms that allow the issuer or the bondholder to redeem the bonds prior to maturity under certain circumstances. You should take note of which party has the right to exercise the option and the circumstances under which it may be exercised.

For instance, the issuer may give itself the right to redeem the bonds before maturity for tax reasons.

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