Investing In Bonds

It is of late that investment in bonds are made more accessible to the retail investor. Bond issued by statutory boards like the LTA, HDB were available. They were marketed at a time when interest rates were and are still low. The coupons, i.e. guaranteed pay outs semi-annually, were attractive compared to the bank deposit rates. Should investors consider investing in bonds? What are its implications in the investment portfolio? What is the downside? Are bond funds any different?

What are bonds?

Bonds are basically debt instruments. Government, statutory boards, companies can go to the public to borrow money by issuing bonds. They guarantee a fixed coupon rate (interest) every 6 months to compensate for the use of money. Investing in bonds is different from equities primarily because an investor is lending money whereas in equities, the investor is taking ownership of the investment (shares) and hopes to profit from its dividends or capital growth in time. This accounts for the volatility in the price of each of these types of investments. Bonds, historically, provide more stability in the investment portfolio compared to equities.

What are the risks?

there are basically two types of risk in bond investing. There are interest rate (and thus, reinvestment risk) and default risk.

Interest rate (reinvestment) risk

The price that an investor pays for the bond fluctuates when interest rate changes as time goes by. Thus, if an investor were to sell a bond when interest rates are up, he may not recover his original investment. Interest rate affect bonds because the purchasing power of the money paid out at the end of the maturity of the bond may be eroded because of inflation. For example,  if a bond is a $ 1,000 face amount, the $ 1,000 paid out at maturity, say 5 years later, will be les because of inflation.

Default Risk

The issuer of the bonds may default when the bonds are due at maturity, that is, the issuer is supposed to return the investor the borrowed money at the end of the maturity period. Some companies have defaulted and had to make arrangements to extend the repayment period. Singapore government and statutory board bonds have been rated as of very high quality. Chances of defaulting is almost nil. However, that can not be said of corporate bonds. Usually, to compensate for the risk, the issuer will provide a higher interest rate.

Bonds in the investment portfolio

Bonds tends to be less volatile than stocks. However, to manage a portfolio of bonds can also be tricky business as there are bonds with different quality, yields, maturity periods and so on. This is best left to the professionals like the bonds portfolio manager in a financial institution. However, bonds can provide for an annual income in a way similar to dividends provided by stable blue chips stocks. For the individual investor, a good alternative is the bond fund.

Bund Fund

Investing in a bond fund means that the investor relies on the fund manager to manage the bonds in that fund. Investors can have the opportunity to participate in bonds beyond their reach like the global bond market and are relieved the time and effort to monitor the bonds. Bonds funds are diversified. They tend to fluctuate less and are more stable. Thus, it is usually a good idea that it forms part of an investment portfolio.

Conclusion

Investors are more familiar with investing in equities than in bonds. The risk and return characteristics of bonds and bond fund are different and play an important role in an investment portfolio makeup. Income, return of capital and lower risk factors are just desirable as capital gain.