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A beginner's guide to bonds

A beginner's guide to bonds

  • 02 September 2022
  • By OCBC
  • 3 mins read

Here's a fun fact: The bond market is by far the largest securities market in the world – much larger than the stock market in terms of the total value of securities traded. Heard of the sub-prime mortgage crisis? Yes, bonds were the investment instrument behind the housing bubble collapse that eventually led to the 2008 Global Financial Crisis.

What is a bond

A bond is a fixed-income instrument that works as a loan from an investor to a borrower. Put simply, when you buy a bond, you (the investor) are lending money to the bond issuer (the borrower) with the promise that they will pay you back the full amount with interest at a predetermined rate and schedule. Bonds can be issued by companies (corporate bonds), government entities (treasury bonds) or municipals (municipal bonds) to raise money to do all sorts of things.

Bond maturity date

The date on which the bond issuer agrees to return the principal amount (also known as the "face value" or "par value") back to the investor is known as the bond's maturity. Bonds are often referred to as being short-, medium-, or long-term, which generally represents a maturity of 5, 10 and 30 years respectively.

Bond coupon

The interest paid by the bond issuer to the investor in exchange for the debt is known as a coupon. Although coupons are typically paid on a semi-annual basis, they can also be paid quarterly or annually. The coupon is tied to and quoted as a percentage of the bond's face value.

More bond-related terms

Besides maturity and coupon, the following are some common terms related to bonds that you might find helpful in your understanding:

Duration

A measure of the bond price sensitivity to interest rate changes. If a bond has a duration of 5 years and interest rates increase by 1%, the bond's price will decline by ~5%.

Call features

The terms and conditions of which the bond can be "called" or "retired" early by the issuer.

Yield

Also known as the return, this refers to the coupon amount expressed in percentage terms.

Yield-to-maturity (YTM)

The return of the bond if it is held to its maturity date. In the context of a bond fund, YTM is a weighted measurement of all the bonds held in the fund.

Yield-to-worst (YTW)

The lowest potential yield that can be received on a bond without the issuer defaulting.

How to read a bond

A bond is typically written like this: ASPSP 5.250% 28Aug2020 Corp (SGD). Let's break it down:

ASPSP

This refers to the bond issuer (e.g. Aspial Corporation).

5.250%

This refers to the bond's yield (e.g. 5.250% for every $1,000).

28Aug2020

This refers to the bond's maturity date.

Corp (SGD)

This refers to the type of bond (e.g. corporate) and the currency in which the bond is issued (e.g. SGD).

Where to buy a bond

Like equities, bonds are sold on both primary and secondary capital markets.

  • Primary market: This is where securities are created and sold for the first time, usually via an Initial Public Offering (IPO). Investment bankers are involved in pitching a new bond deal to institutional investors (such as corporates and fund houses) during a roadshow, with the agenda to raise as much volume as possible.
  • Secondary market: This is the market where securities exchange hands and are freely traded by market participants. Retail investors usually purchase and invest in the secondary market via their broker or Relationship Managers in return for a small fee (commonly called "taking a spread").

Types of bonds

The beauty of financial instruments is their versatility. While the fundamentals are usually the same, the creativity to layer on additional features is what makes them different.

  • Plain vanilla bonds
    • As the name suggests, these types of bonds are simple and straightforward. They are your regular coupon-paying bonds that return your principal at maturity.
  • Zero coupon bonds
    • Intuitively, these bonds don't pay coupons at all. So why invest in such bonds and lend money to someone who won't pay you interest? Well, a zero-coupon bond is often issued at a deep discount from its face value (e.g. 5%). You might pay $95,000 to purchase a 30-year zero coupon bond with a face value of $100,000. After 30 years, the bond issuer pays you $100,000.
  • Perpetual bonds
    • More commonly dubbed as "Perps", these are bonds with no maturity date. While they aren't redeemable, they pay a steady stream of interest indefinitely.
  • Callable bonds
    • These types of bonds can be redeemed by the issuer prior to maturity. Callable bonds generally offer investors a higher yield than bonds without call provisions. This higher yield on the bond entices investors to accept the callable feature (risk where issuer chooses to call back the bond prior to maturity). During a falling interest rate environment, most callable bond issuers would recall the bond as it's "cheaper" for them to pay investors back and re-issue a new set of bonds at a lower yield.
  • Convertible bonds
    • These types of bonds allow the holder to convert the bond into a specified number of common stock shares of the issuing company or cash of equal value.
  • Contingent convertible bonds (CoCos)
    • Unlike regular convertible bonds that allow the bonds to be converted into shares at the discretion of the bondholder, CoCos get converted into shares upon the occurrence of a trigger event – usually when the company is under capital distress as CoCos are designed to be loss-absorbing instruments. They are primarily issued by banks as such institutions have to fulfil mandatory regulatory capital requirements. Notably, these bonds do not have a maturity and are therefore perpetual by nature. In other words, all CoCos are perpetual bonds, but not all perpetual bonds are CoCos.

Bond pricing – the inverse interest rates relationship

In the market, bond prices are quoted as a percentage of the bond's face value. The easiest way to understand bond prices is to add a zero to the price quoted in the market. For example, if a bond is quoted at 99, the price is $990 for every $1,000 of face value and the bond is said to be trading at a discount. If the bond is trading at 101, the price is $1,010 for every $1,000 of face value and the bond is said to be trading at a premium. If the bond is trading at 100, it costs $1,000 for every $1,000 of face value and is said to be trading at par.

Most bonds are issued slightly below par and can then trade in the secondary market above or below par, depending on interest rates, credit ratings and/or other factors. Just remember this: bond prices have an inverse relationship with interest rates:

  • When interest rates rise, bond prices fall.
  • When interest rates fall, bond prices rise.

In a rising interest rate environment (i.e. the cost of borrowing money increases), newly issued bonds will pay investors higher interest rates (yield) than older bonds, so these older bonds tend to drop in price to attract demand.

In a falling interest rate environment (i.e. the cost of borrowing money decreases), the yield of older bonds would suddenly look very attractive and demand for these bonds would push its price up, meaning that they tend to sell at a premium.

Bond ratings – investment grade vs high yield bonds

Credit ratings reflect the quality of a bond and give an indication of the bond's risk level. Ratings are given by external agencies like Moody's, Standard & Poor's (S&P) and Fitch. Bonds can be classified into Investment Grade (IG) and Non-Investment Grade (also known as High Yield (HY)).

Types of bond strategies

To be fair, this is stretching a little beyond bond basics. But learning about bond strategies might help in understanding the reasons why retail investors prefer investing into bond funds instead of executing a bond strategy themselves.

  • Bullet strategy: A bullet bond strategy is a strategy in which an investor buys bonds at different times with the same maturity (the bonds mature at the same time). This is a defensive strategy as it attempts to hedge inflation risk by purchasing bonds at different intervals. Let's put this into an example: you are planning to fund your child's tuition fees in 2035 so between now and then, you want to invest your money to earn some returns. Instead of investing into a single bond that expires in 2035, you can construct a bullet strategy that includes 6 investments across 6 different years: 2022, 2024, 2026, 2028, 2030 and 2032. In each of these years, the bonds all share the same maturity date of 2035, where the returned principals can be used to pay for your child's tuition. As we know by now, interest rates are always changing so by using a bullet strategy, you are bettering your chances of optimising your returns (earning higher coupons) while minimising your risks.
  • Barbell strategy: A bond barbell strategy divides a portfolio into two sections: a low-risk side and a high-risk side. The conservative side of the portfolio is filled with short-term bonds while the risker side of the portfolio is filled with long-term, higher-risk bonds. The risks are higher for longer-term bonds as they are more susceptible to rising inflation. Unlike a physical barbell, the bond barbell strategy doesn't necessarily need to be equally weighted on both sides – the weights are assigned based on an investor's outlook and yield requirements. To construct a barbell bond portfolio, an investor could split their investments into a 90/10 split, where 90% of their investments are short-term, and 10% are long-term. Compared to a bullet bond strategy, this is an active strategy as it requires frequent monitoring and action since the shorter-term bonds will need to be rolled into new issues on a frequent basis. As such, a bond barbell strategy generally offers greater diversification, higher liquidity and higher yield – but at a higher volatility risk in holding a long-term bond.
  • Ladder strategy: A bond ladder is a strategy to invest in a portfolio made up of individual bonds that mature on different dates, essentially investing in multiple bonds with different maturities. This strategy is designed to provide consistent current income while minimising exposure to interest rate fluctuations. Instead of buying bonds that are scheduled to mature during the same year (like a bullet bond strategy), spreading out maturity dates can help prevent investors from trying to time the market and ride out interest rate fluctuations by reinvesting the proceeds from maturing bonds.

Why invest in bond (and bond funds)

While direct investment into a bond has its perks, it does have its own set of constraints such as minimum investment size and liquidity concerns. For most retail investors, purchasing a bond from a bank requires at least $250,000 and a Relationship Manager to help facilitate the transaction. And while bonds are traded on secondary markets, they are generally not as liquid as compared to funds and equities. Self-execution of bond strategies also requires more time and effort. In consideration of this, bond funds offer investors a great alternative to direct investment into a bond.

Here are 3 key reasons why bonds (as well as bond funds) make a sound investment:

  • Income: Earn periodic coupon interest payments that are higher than your fixed deposits rates and where the yield generally beats inflation. For those that are not in need of a consistent income stream, you can choose to earn more income by reinvesting these periodic coupons.
  • Capital appreciation: Capital gain (or loss) when the bond matures is recalled or sold off.
  • Diversification: Bonds are great for diversification. Bond funds especially, allow an investor to be diversified across regions, issuers, strategies and bond types. A bond fund generally invests in over 100 different bonds and has a low barrier to entry, providing investors immediate access to broader diversification without the need to be capital intensive.

Fixed income fund ideas

Ideas Description
LionGlobal Short Duration Bond Fund

This bond fund seeks to provide a total return of capital growth and income by investing in a portfolio of globally diversified shorter-term corporate bonds, issued mainly by Asian corporates. In a rising interest rate environment, it is potentially safer to invest in shorter duration bonds. While the fund can have high yield exposure, most of the holdings are high quality, investment grade bonds. The fund also strives to pay a potential quarterly distribution to investors, though the amount is not guaranteed.

PIMCO GIS Income Fund
[Premier | PPC Only]

This bond fund is a multi-sector solution that has the flexibility to invest in the most attractive opportunities across all sectors of the global fixed income market. The fund aims to provide strong risk-adjusted returns, as well as a consistent and high-income distribution to investors by investing in higher yielding and higher quality assets. With a focus on prudent investment management and risk-factor diversification, the fund also seeks to reduce downside risk and has achieved lower volatility historically as compared to other credit-oriented strategies.

JPMorgan Income Fund
[Premier | PPC Only]

This bond fund invests globally across different debt securities and seeks to provide attractive and predictable monthly income to investors. With a flexible and unconstrained approach, the fund employs active duration management and dynamic sector allocation, allowing it to maximise income within a given prudent risk level.


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