Making up a $120 trillion global market, 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 (interest) on their lending.
These financial instruments 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 hike decisions, and what that means for your portfolio.
Very simply put, a bond is a financial instrument that represents a loan. Governments, corporations and other entities issue bonds to investors when they want to borrow capital that is needed to either acquire assets or invest in their business.
There are essentially three components of a bond. The first component is the face value, or the par value or the principal. This is the amount of money that is being borrowed.
The second component is the coupon rate. Bonds issue coupons — or interest payments — that are generally paid out on a quarterly, semi-annual or annual basis. Think of the coupon rate as an interest rate that is paid on a loan or a mortgage.
The third component is the maturity of the bond. The time from issue to the time of maturity is the life of the bond. When the bond matures, the principal is returned to the buyer of the bond (creditor).
Let’s say we have a bond that pays interest semi-annually, with a maturity year of 2027. The dollar value of the interest payment or coupon will then be the coupon rate multiplied by the principal. For example, a bond bought at $1,000 par value and that offers a 10% annual coupon on the principal will pay $50 to its investor every six months, for the next five years. Figure 1 shows what the cash flow for this bond would look like.
How are bonds constructed for sale?
There are three main factors that determine the coupon rate on bonds. Firstly, what is the credit worthiness of the company or corporate issuing the bond? These borrowers are judged on the probability that they can honour the commitment of paying both the coupon (interest) that they are offering to entice investors, and returning the principal. Failing to do either would mean that the bond issuer has defaulted on the bond. The measure of the probability that a borrower would default on the bonds they sell is known as the credit rating.
The second factor comes down to how the bond is structured, such as the loan term, known also as the tenor. In return for borrowing money from investors for a longer period of time, bond issuers would typically need to pay a higher coupon rate for longer dated bonds. This is to compensate investors for the opportunity cost in lending the money to the bond issuer instead of investing the money elsewhere.
The third and final factor is the current interest rate, such as the fed funds rate determined by the Federal Reserve, in the case of the US. Most borrowers offer more on top of the benchmark rate to entice investors to buy their bonds over government-issued bonds that are the least risky form of bonds.
Assessing credit worthiness, maturity, and interest rate together gives us the coupon rate.
Bonds are typically traded, which means bond holders can buy and sell the asset based on the price quoted to interested buyers and sellers. An important thing to note here is that the bond price can and will often differ from the par value.
If the price is greater than the par value, the bond is trading at a premium. Bonds trade at a premium under three circumstances:
- When the demand for a bond is greater than the supply
- When 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
- When the credit rating of an issuer improves
Conversely, if the price is lower than the par value, the bond is trading at a discount. This could be happening for the following reasons:
- When the prevailing interest rate increases above the coupon rate. This means new bonds are issued at a higher interest rate
- When the credit rating of an issue declines
Why you should have bonds in your portfolio
Many investors find bonds attractive because they can be a predictable source of income. Barring a default, regular coupon payments will continue until the maturity date, at which point, the principal amount is returned. That’s why bonds are also known as fixed income.
Another reason for investing in bonds is the diversification benefit the asset class brings to a portfolio. Traditionally, correlations between fixed income and equities have been low — this tells us that the two asset classes do not move in the same direction or magnitude as each other at the same time. Having these assets put together in a portfolio helps to diversify away portfolio risks. The lower correlation means that there is a lower likelihood of equities and fixed income securities underperforming at the same time.
The 3-year monthly return correlation between the MSCI All Country World Index (ACWI) and the Bloomberg Global Aggregate Index is about 0.50. The correlation decreases as the time period gets longer and the 20-year correlation stands at about 0.34 (see Figure 2).
Getting bond exposure
Now that the benefits of having bonds in your portfolio is clear, the next natural question pops up: how should you get that exposure?
The average investor in Singapore can buy a Singapore Government Securities (SGS) bond for just $1,000. This security is issued by the Singapore government and has a top-tier (AAA) credit rating, but having a more diversified bond portfolio allows investors to extract a larger coupon payout from bonds from different issuers from different markets. For example, investment grade bonds issued by top blue-chip companies have a higher coupon than Treasury bills, and are much less likely to default than those from companies with poorer financial health that issue high-yield bonds. Having a diversified mix of bonds — so long as that meets your risk appetite — can bring stronger income streams.
Yet, purchasing corporate bonds issued by blue-chip companies and industry stalwarts requires a much heftier investment in the order of hundreds of thousands of dollars. So to reap additional diversification benefits, an easier approach might be to invest in bond funds.
Bond funds give investors exposure to different sub-asset classes such as sovereign debt, corporate debt and mortgages. Investing in a globally diversified bond fund also means that the risk of changing interest rates in one country or region would be mitigated by exposure to other countries experiencing a different phase of the economic cycle.
What is the yield to maturity?
The yield to maturity (YTM) of a bond is the total rate of 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 $1000 with an annual fixed coupon rate of 5% and a maturity date set to exactly one year later (2023).
- When the bond was first issued, the YTM would be equal to the coupon rate. If the price of the bond increases by $200 to $1200, the YTM changes as well. The coupon payment is $50 and the YTM then changes from 5% to ($50/$1200 = 4.17%).
- If the bond’s price decreases to $800, the YTM then changes to ($50/$800 = 6.25%).
- All this while, the coupon rate remains at 5%.
Simply put, yields are the future interest rates you’re expected to receive if you wait until the moment you get your principal and all coupons back at the maturity of the bond.
For more on the yield curve, click here.
If bond funds are great, why are they posting negative returns now?
With all that said, investors made the biggest redemption out of bond funds and ETFs in Q1 of 2022 — marking the latest outflow since Q1 2020. This time has been characterised as one of the worst bear markets for fixed income in the last few decades.
The reason is something called a rate hike, and it was triggered by the Fed. As red-hot inflation surges higher, the Fed — the authority behind US monetary policy — has an important mandate to ensure price stability. In other words, its job is to curb inflation. It does so by raising the interest rate to make it more expensive to access money. By doing so, it aims to cool consumer demand, and bring inflation down to more sustainable levels. When the Fed raises the federal funds rate — the rate at which banks charge one another for overnight loans — the cost of borrowing and conducting business increases. This spurs a domino effect on other consumer loans such as mortgages.
Other central banks are likewise working to fight off inflation, as the Russia-Ukraine war launched in late February has pushed up the global food prices. Meanwhile, China’s zero-Covid policy draws question marks over how long supply-chain disruptions would persist, since China is a pivotal global player in the production of goods. Inflation is a global problem today.
Remember that a bond is essentially a loan from the investor to the issuer. If an investor sees that the opportunity cost of his investment has increased because he or she can now invest in a newly issued bond that pays a higher interest, he or she will likely consider selling the current bond to purchase another with a higher coupon rate.
As investors move into higher yielding bonds, bonds that pay a lower coupon become less attractive. When they are sold in the market, their prices fall. This is why there is an inverse relationship between the change in prevailing interest rate and the bond price: when rates increase, bond prices decrease.
A bond fund, with its portfolio of bonds with varying exposure and maturities would also see the same relationship. As the bonds’ market prices decrease, a bond fund’s net asset value (NAV) follows accordingly and registers a negative return as well.
Depending on the fund’s objective, as it balances higher yield versus total return, the portfolio manager of that fund may consider trimming the lower yielding assets to invest in higher coupon instruments. This means disposing lower coupon bonds at their current lower market price and paying a premium for higher yielding bonds.
What do we do with bond funds now then?
To recap, the NAV (the market value of the 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 also take advantage of these mispricings in the market. For example, say the bond price is down to $950. If you buy it now and hold to maturity, you get $1,000 back. The bond also comes with the coupons that you are now entitled to as the asset owner. If the annual coupon is 6% at par or $60, and the bond matures that at the end of that same year, you get a rough 6.3% yield by buying the bond at $950. At the point of the bond maturity, you would get a total of $1,060 by year-end off an investment of $950. This is the value that active fund managers bring to portfolio management, especially in volatile times like these.
The bond funds that Endowus invests in are already managed by managers that have passed our screening. Their 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 YTM over the duration of the bond fund.
So when and how do bond funds return to positive territory? How soon a bond fund recovers depends on the duration of the fund, the credit risk that you’re taking, and the exposures.
But more importantly, what matters are your realised returns. It is what you've already earned right when i) the coupon has been paid out; or ii) you've sold the bond at a higher price and realised the gain; or iii) it's matured and you get back your principal.
At Endowus, we advocate staying invested and diversified both in equities and bonds, especially amid a market downturn. Selecting diversified, well-managed bond funds gives you access to best-in-class portfolio management teams who are better equipped to navigate the fixed income markets in these choppy times.
Next on the Endowus Fin.Lit Academy
Read the next article in the curriculum: Unit trusts vs ETFs: What are the key differences and similarities?
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