Making up a US$135 trillion market globally, bonds are sold by both countries and companies to investors so as to raise money for their financing needs. Investors are effectively lending money to the borrowers and receiving a coupon, or interest, on their lending. 

Bonds are commonly found in most investors’ diversified portfolios and are meant to provide a stream of regular income through these coupons to investors. 

Given the importance of the trillion-dollar global bond marketplace, here’s a primer on bonds and why they should be part of your portfolio. We also explain how bond funds have been impacted by the latest Fed rate cut, and what that means for your portfolio.

What are bonds?

In simple terms, a bond is a financial instrument that represents a loan. 

Governments, corporations, and other entities issue bonds to investors when they need to borrow capital for acquiring assets or investing in their business. A bond consists of three main components:

1. Face value (or par value or principal): The amount of money being borrowed.
2. Coupon rate: The interest rate paid on the bond, typically on a quarterly, semi-annual, or annual basis.
3. Maturity: The time from issue to the bond's expiration date.

For example, let's consider a bond with a US$1,000 par value, a 10% annual coupon, and a maturity year of 2029. The bond pays interest semi-annually, which means the investor will receive $50 every six months for the next five years.

What are bond coupons, bond prices, and yields to maturity?

The coupon rate, bond price, and yield-to-maturity are three core concepts in bond investing. 

First, the three main factors determine the coupon rate on bonds:

1. An issuer’s creditworthiness
2. Bond structure (e.g., loan term or tenor)
3. Current interest rates (e.g., fed funds rate)

Bonds are typically traded, which means bondholders can buy and sell the asset based on the price quoted to interested buyers and sellers. An important thing to note here is that bond prices can and will often differ from the par value.

When bond prices are greater than the par value, a bond is called trading at a premium; at a discount, when bond trades lower than its par. Factors such as demand, prevailing interest rates, and credit ratings influence whether a bond trades at a premium or discount.

Bonds trade at a premium when

• the demand for a bond is greater than the supply;
• the prevailing interest rate declines below the coupon rate. This means new bonds will be issued with lower coupon rates so bonds paying higher interest will be in greater demand, or
• the credit rating of an issuer improves

Bonds trade at a discount when

• the prevailing interest rate moves above the coupon rate. This means new bonds are issued at a higher interest rate;
• the credit rating of an issue declines

Lastly, the yield to maturity (YTM) of a bond is the total return on a bond, assuming that it is held until its maturity. This rate includes the principal payment, as well as regular coupon payments and takes into account the market price of the bond. 

While the coupon rate remains fixed, the YTM changes with the bond’s market price.

Here’s an illustration: Bond A’s principal or face value is $1,000 with an annual fixed coupon rate of 5% and a maturity date set to exactly one year later. 

• When the bond was first issued, the YTM would be equal to the coupon rate. When bond prices move, YTM also changes. 
• If the bond price increases to $1,200, the YTM lowers to 4.17% ($50/$1,200 = 4.17%) from the initial 5%. If the bond price decreases to $800, the YTM increase to 6.25% ($50/$800). 
• All this while, the coupon rate remains at 5%.

Why add bonds to your portfolio?

Investors find bonds attractive for two main reasons:

1. Predictable income stream: Barring a default, regular coupon payments continue until maturity, when the principal is returned.
2. Diversification benefits: Bonds typically have low correlations with equities, helping to mitigate portfolio risks.

Ways to invest in bonds in Singapore

Now that the benefits of having bonds in your portfolio are clear, the next natural question is: How should you get that exposure?

The average investor in Singapore can buy a Singapore Government Securities (SGS) bond for just $1,000 as the entry minimum. SGS is issued by the Singapore government and has a top (AAA) credit rating. Moreover, a diversified bond portfolio enables investors to benefit from larger coupon payouts by holding bonds from different issuers and markets. 

For instance, investment-grade bonds from top blue-chip companies offer higher coupons than Treasury bills and lower default risk compared to high-yield bonds issued by financially weaker companies. By maintaining a diversified mix of bonds that aligns with one’s risk appetite, one can potentially generate stronger bond income streams.

Yet, purchasing corporate bonds issued by blue-chip companies and industry stalwarts requires a higher investment minimum, involving hundreds of thousands of dollars. Investing in bond funds can be an easier way.

Bond funds provide investors with exposure to various sub-asset classes, including sovereign debt, corporate debt, and mortgage-backed securities. By investing in a globally diversified bond fund, investors can mitigate the risk of changing interest rates in one country or region. This is because a fund’s exposure to different markets allows it to benefit from varying phases of the economic cycle.

How an active bond fund is managed

The market value of A bond fund reflects the trades made on the bonds that make up this key trillion-dollar market. 

But importantly, these price movements have zero impact on the $1,000 face value or your coupon payments — with those flows reflected in the income that you receive via your bond fund. You will get the principal and coupons all back unless there are bonds that default.  

Active bond fund managers may take advantage of mispricings in the market. 

To give an example, a bond is now priced at $950. Holding to maturity, the bondholder may receive $1,000 back, given there are no credit default events. The bond also comes with the coupons that a bondholder is entitled to. 

Assuming the annual coupon is 6% at par or $60, and the bond matures at the end of that same year, this would mean a rough 6.3% yield by buying the bond at $950. At bond maturity, the bondholder would receive a total of $1,060, from an investment of $950. This is the value that active fund managers bring to portfolio management, especially in volatile times.

How bonds react to rate cuts

After two and a half years, the Federal Reserve announced its first rate cut in Sep 2024 and the policy decision will have significant implications for bond investors. 

Rate cuts can lead to an increase in bond prices as yields move inversely to price. Existing bondholders may see the value of their bonds appreciate, potentially resulting in capital gains if they choose to sell. Given the prevalent lower rate, new bond purchases may offer lower yields.

Secondly, as the yields on bonds adjust in response to interest rate changes, investors may reassess the risk-return profile of their portfolios. Some investors may seek higher-yielding assets or adjust the duration of their bond holdings to manage interest rate risk effectively.

The impact of rate cuts on bond markets can vary depending on the type of bonds. For instance, longer-term bonds may be more sensitive to changes in interest rates. 

Read more: Why you should reassess bond funds for your excess cash

Explore bond funds on Endowus

At Endowus, we advocate staying invested with a disciplined approach through the market’s up- and downturns. Selecting diversified, well-managed bond funds gives you access to Best-in-Class portfolio management teams that are proven to be better equipped to navigate uncertain times.

Bond funds on Endowus Fund Smart and are included in our portfolios are by fund managers who have passed our due diligence and screening. 

To you, a portfolio manager’s job is to execute this active management effectively, generating slightly better returns from exploiting market mispricings than solely holding bonds to maturity. At the minimum, they should generate at least the yield-to-maturity over the duration of the bond fund. 

More importantly, what matters are investors’ realised returns. It is what you've already earned right when the coupon has been paid out, sold the bond at a higher price and realised the gain, or the bonds matured and you get back your principal. 

Explore Endowus Fund Smart today.