3 Things You Should Know About Bonds

Most investors know little about bonds and therefore investors typically alternate between investing in equities and cash (savings or fixed deposits). One investment instrument that is often left out from the radar screen would be fixed income instruments. We aim to close this gap by introducing to investors what are bonds and how to get exposure via bond funds in a series of articles.

In the first of a three part series on bonds & bond funds, we identified three important characteristics of bonds and bond funds for investors to bring back.

Number 1: What Are Bonds?

Simply put, bonds are the building blocks of bond funds. Bond funds typically invest their portfolio into bonds and we shall explain a bit more about the practicalities of investing in bonds.

First and foremost, there are several avenues for companies to raise money. They can raise money by selling equity (initial public offering if the first time or rights issue if the company is already listed), go to the bank for loans or raise money through the issue of bonds. The bond is a loan that the bondholder makes to the bond issuer. The bond issuer owes holders a debt and is obliged to repay the principal at a specific date and interest periodically. Because of this interest component that does not change throughout the bond’s life (we refer to fixed-rate bonds); bonds are also known as fixed income securities.

Investors might be familiar with the more popular Malaysian Government Securities (MGS) but corporate bonds might be more distant. The table below shows a comparison of equities and a bond issue of YTL Power International Bhd (YTL Power), a Malaysian-based independent power producer.

Table 1 Comparing an Actual Corporate Bond and the Company’s Share

*As at 14 November 2008, Source: iFAST Compilations

Number 2: Three Essential Bond Features of Bonds

The quintessential things an investor should know about bonds would be features such as: the maturity date, par value and coupon rate of a bond.

Firstly, like all loans, there is a time for repayment of loan principal. The maturity date of the loan determines when the bondholder receives the loan principal. From our example above, the maturity date is 18 April 2013.

The second essential thing you should know would be what the price of the bond means. The loan principal is also known as par value or face value of the bond. When a bond is issued and traded on the secondary market, the value of the bond can fluctuate. If you bought the bond at a discount to par value, you will receive the par value upon maturity and gain from the price appreciation.

It is also possible that a bondholder pays a price higher than the par value and experiences price depreciation when the bond matures. From Table 1, we know that the YTL Power bond trades at a discount as at 14 November. This is because you can buy the bond at $919,300 when its par value is $1,000,000. Investors buying into the bond would experience capital appreciation of the bond upon maturity (when he gets back the par value at maturity), provided that YTL Power does not default on payment.

The third thing that investor should know would be the coupon rate which is the interest that bondholder receives on the loan made to the company. Our example of YTL Power bond issue pays out 3.0% per annum interest on the par value. Coupons are paid on a semi-annual basis. As this is a fixed rate loan, the amount does not change every year for the term of the loan.

The return components for bonds are thus the interest income and price appreciation/depreciation. If the bondholder holds the bond to maturity, the interest income and price appreciation/depreciation upon maturity can be calculated as yield to maturity (YTM). Assuming that the company does not default on payments and the coupons are reinvested at a similar rate, YTM gives bondholder an accurate estimation of returns from now till maturity of the bond.

An accurate estimation of future returns on investment into equities is not possible based on the information at hand today. Both the dividends and price of equities can never be estimated with much certainty. On the other hand, for bonds, the price goes back to the par value of the bond.

There is a relationship between the YTM and price of the bond and the YTM is an important gauge of how attractive the bond fund is. Quite a lot needs to be explained - that is why we will look into the complexities of YTM in a separate article.

What are some of the advantages that bonds offer?

Bonds offer diversification to an investor’s portfolio. Government bonds from developed nations are often regarded as a safe haven, providing shelter when the equities markets are volatile. For corporate bonds, debt holders are ahead of shareholders to get paid in case of liquidation of the company during bankruptcy. Holding a portfolio of bonds can offer stability to an investor’s portfolio. Moreover, the predictability of cash flow from bonds provides investors with a steady inflow of income. The interest rates of bond are generally higher than bank deposit rates, albeit with a higher risk.

Number 3: Bond funds – A more practical approach

When investors decide to diversify their portfolio by investing in fixed income assets, they need to choose between investing into individual bonds or through bond funds. Both methods provide investors with income and offer diversification to their traditionally equity-heavy portfolios. We believe bond funds can offer wider range of benefits for investors in terms of minimum investment amounts, diversification, liquidity and maturity.

Bond funds invest in many securities with different coupon payments and maturities. It is regarded as a more easy and affordable way to invest in a diversified portfolio of bonds. Most bond funds on our platform have an RM1000 minimum investment amount. This is much lower than the typical RM100,000 you need to invest in a corporate bond.

It is more convenient for investors to purchase and redeem their investments in the bond funds. Units in a bond fund can be redeemed at any time at net asset value (NAV) and in any quantity.  On the other hand, individual bonds can be sold prior to maturity in secondary or over-the-counter market. However, the bonds might be thinly traded and this lack of liquidity can potentially result in higher price volatility. In addition, individual bond investors may face the higher bid/ask spread experience higher expenses associated with trading the bonds as compared with bond fund manager.

Table 2 Comparing features of a bond fund and an individual bond

Source: iFAST Compilations

If an investor has only RM100,000 to buy a bond providing an annual coupon of 5%, this means that he will receive RM5,000 annually. This sum would be too little for him to reinvest into another bond and he would have to reinvest into safer assets like savings or fixed deposits with lower yields. However, the problem would not crop up in the case of a bond fund. As bond funds are larger in size, the absolute coupon income that they collect will be large as well. Imagine a RM100 million bond fund receiving 5% coupon on their investments. This would result in RM5 million worth of coupon income and the fund manager would be able to buy into other corporate bonds to reinvest this coupon income (if the bond fund does not pay all or part of these bonds to their investors).

Start Thinking About Bonds

In previous months, a portfolio that has allocated to bond funds would probably have held up better than a portfolio that is all into equities. Unfamiliarity with bonds and therefore bond funds might have restricted investors in considering bond funds for their assets allocation decision. However, unfamiliarity should not be a deterrent for investors to avoid an asset class that can help the diversification of the portfolio. We have made use of a concrete example of bond that bond funds might invest into in an attempt to illustrate clearly what goes inside bond funds for investors. We have also shared with investors why investing through a bond fund is more practical than investing into bonds.

Do look out for a series of our articles and new web features which we hope will help investors understand more about bond funds and provide confidence to investors to make investment decisions.

This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any fund. No investment decision should be taken without first viewing a fund's prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Past performance and any forecast is not necessarily indicative of the future or likely performance of the fund. The value of units and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.