The Bonds Evolution
In the realm of Investment, there exist a myriad of asset classes and equally diverse category of investors thrown in the mix. In this hodgepodge, finding one’s footing on solid ground is the key not only to success but surviving the financial investment ‘jungle’.
One area where serious investors, both institutional and individual, alike will often encounter is the Bond market. Given the early heydays after the great world wars where global economies began to recover and flourish with double digit growths, many bonds surfaced to greet unsuspecting and unregulated markets with promises of great returns that never materialised. And with that, the term junk bond was born. So can and should the financial markets continue to put their faith in Bonds as a means of wealth creation for individuals and also as a viable means to raise funding for businesses at large?
Let us explore and see where the Bond market is today and why investors are continuing to rely on it to provide market efficiency in the modern post war financial markets of today.
To began, let’s examine what exactly is a Bond? They are neither shares (or stocks as is often the term used in the US) nor are they bank loans. Bonds as a matter of fact straddle the space between these 2 conventional sources for raising capital funding by corporations so very necessary for the assortment of business projects for achieving corporate goals and objectives. They are commonly issued by large corporations and even resorted to by governments of the day to raise significant amounts of monies in situations where banks would typically ‘shy away’, due to lending risk restrictions and limits imposed by central banks. Also, corporate bond issuers typically have shareholders who are not keen to dilute their positions in the company vis-à-vis fresh equity injections.
As the above business and financial landscape are common and a true reflection of many advanced economies, Bonds will remain a staple and major investment offering that needs to be on every investors’ portfolio.
So how do investors go about navigating the bonds “minefield” successfully?
Let’s began by understanding that in buying bonds, investors are essentially loaning monies to the government or a corporate borrower. Just like banks giving bank loans, investors can expect to receive regular interest payments (typically called coupons) for a certain number of years. And at the end of the agreed term known as ‘maturity’ of the Bonds, they can expect to get their principal back. The interest returns generated for each bond is of course directly correlated to the actual and perceived risk investors are informed of and are expected to assume.
That’s the theory. However, the reality can be more complicated.
To quote, albeit in the financial vernacular, Shakespeare’s Hamlet; “To buy or not to buy …”, let us now embark on the exciting and preferably profitable journey of investment.
The case for “To Buy”:-
Reasons why you SHOULD invest in bonds 1.
Creating portfolio of steady stream of income from interest payments
For some investors, the regularity with which they receive a return is of prime importance. This could be true for retired people or for those who supplement their monthly earnings with income from their savings.
An investment in bonds will give you a consistent stream of returns. You know exactly how much you will receive and the dates on which you will receive it. If investors are looking for stability, then it is hard to beat bonds. The same unfortunately cannot be said of for investments in stocks/shares.
2. Helps to diversify your portfolio
The success of any investment strategy will depend to a significant extent on the asset allocation. Here the golden rule of not making the mistake of investing only in one asset class should be heeded.
The stock market may promise attractive returns, but it is also volatile and often unpredictable. It is quite normal to see the investors’ principal being depleted by 10% or even more during times when the market is falling. An investment in bonds together with stocks/shares can potentially help to stabilise investment portfolios. Bonds provide a regular stream of income, an essential requirement for many older investors who are looking for liquidity and stability.
3. Preservation of capital
There are times when keeping the principal amount intact is the prime focus. Older investors could be approaching retirement in a few years and will be most keen to not suffer losses in their investment portfolios.
Some bonds like Government bonds can help to protect capital. Knowing that once own funds are safe can be very reassuring in times of market volatility. That is why Government do not issue stocks/shares!
4. Access your monies whenever you want or need it
For many investors, liquidity is of prime concern. The ability to access their monies at short notice is an important and sometimes even the deciding factor in selecting an investment. While it is true that you can sell your stocks and receive the sale proceeds in a matter of days, share investments have one inherent disadvantage. The market may be depressed when investors need their money. Selling once shares at a loss may not be a good idea especially when they cannot afford to lose their capital after their retirement or nearing retirement.
5. It’s better than keeping money in the bank
Some investors make the mistake of maintaining large sums in term deposits in the bank. Why do they do this? In most instances, these individuals are looking for:
Safety – they don’t want to take on any risk at all.
Liquidity – they want to be able to access their money at short notice.
While bank deposits are safe, the interest rate is only around 1.2% per year in Singapore. While still being a safe investment, bonds like that of Singapore Savings Bonds offers an interest rate of up to 3.01%, a worthwhile increase of yields against the returns on the risk.
6. Regulatory Supervision of Bond Issuers While history is peppered with many junk bond stories that evoke all sorts of emotions and memories, the bond market today is a very different creature from that of its early days. In many countries, bonds are now under the strict purview of regulators like monetary authorities or securities commissions.
In Singapore and Malaysia, the Monetary Authority of Singapore and Securities Commission of Malaysia respectively play the key role of stabilizing the bond market and most importantly to weed out junk bonds.
The introduction of mandatory requirements for licensed professional corporate trustees (such as Pacific Trustees) further enhances the protection given to bond investors. So generally, most bonds are safe except against extreme market events (eg market crashes, global events affecting specific industries, etc).
The case for “To Not Buy”:-
Reasons why you SHOULDN’T invest in bonds
1. Corporate bonds can be safe, but capital returns are not guaranteed Not all bonds are created equal.
Corporate bonds do carry higher levels of risk and investors are well advised to conduct a thorough due diligence either on their own or through the engagement of the private fund managers before committing their funds.
In Singapore, Monetary Authority of Singapore (“MAS”) imposes the requirements for a licensed Corporate Trustee to be appointed to oversee and ensure the monies for repayment of Bonds are kept up in designated accounts. Also, in cases of secured bonds, the securities that are provided are property ‘ring-fenced’ for the additional protection of the bond investors
2. Inflation eating up your returns
It is common knowledge that bonds will pay investors interest at a fixed prescribed rate. Consequently and over the years, the value of bond returns will naturally fall because of inflation. According to MAS, the yearly inflation rate is about 2%. All bond returns will therefore be diluted to this extent. If there’s any reprieve, the same unfortunate fate also applies to bank deposits, thus bonds are not worst off here.
3. Companies issuing bonds can fail It can be very difficult to judge whether a company will have the ability to meet its repayment commitments. Take the example of bond issuing companies who are involved in the oil industry. When OPEC was at its prime, oil prices were set at a lucrative price of more than US$100 per barrel. Subsequently and with the change of strategies of several superpower countries, oil prices fell significantly to the US$30 – US$40 range. A company that would have been highly profitable when oil prices were high will start losing money very quickly.
Thus, selecting bonds issued by companies that may offer attractive bond returns but are also carrying on business in a risky sector will certainly be challenging. To subscribe to a bond issue that matures after a longer term (like ten or more years) therefore carries substantial risk and should be carefully considered.
4. Losing out on other opportunities Purchasing bonds, especially capital guaranteed bonds issued by the government, means settling for low returns.
If you assume a 10-year time horizon and a bond investment that yields 2.4%, a sum of $10,000 will grow to $12,677. An investment in the stock market that generates a yield of 8% per year return will give you $21,589. (Returns in both instances have been compounded yearly.)
Investors could consider looking for alternative asset classes to invest in that present opportunities for higher returns within a level of risk they are able to tolerate.
5. It may not be suitable for your investment horizon Many young investors put all their savings into bonds in the mistaken belief that safety is their greatest concern. Over an extended period, other investments can potentially give higher returns.
For younger investors in their 20s or 30s investing for their retirement, bonds should be a low priority for them and should not constitute the majority of their investment holdings as they generally provide low returns, which may not even keep up with inflation. If bonds are to be part of the young investors’ investment portfolio, it should be kept to a lower level to be gradually increased overtime if only to ensure reduced risk exposure to their capital.
With that said, it should now be much clearer what and how potential investors, young and old alike should consider bonds as one of their preferred investments.
Summing Up So in conclusion, the decisions and actions of potential bondholders can best be summed up with the closing words and wisdom from a well known iconic character in the form of Master Yoda (a.k.a. Star Wars) where he was quoted saying to a young apprentice; “Do or Do Not, there is no Try”.
Pacific Trustees Singapore - www.pacifictrustees.com