I am going to admit that talking about bonds will be a dry and boring topic, because bonds generally do not give exciting returns, do not fluctuate as wildly as stocks, and give an extremely predictable and steady stream of income.
Why then, do some people get so interested in bonds?
Should they be an integral part of our portfolio?
Read on to find out.
I am assuming you already understand the definition of a bond, what constitutes a bond and how interest is paid on a high level. You basically lend money to an institution, corporate or government for some period of time, and in return, they pay you interest. They use the money to fund projects/operations and you as a bond holder, takes on the risk of default and you’re compensated via interest. So far, it’s quite simple right?
But it goes further than that of course. There are different grades of bonds, rated by their credit quality. Different issuers have different risk profiles. For example, government bonds are typically safer (in a sense, they tend not to default on their payments as much) and hence pay a lower interest rate. Of course, different governments have different risk profiles too! If we compare the Singapore or any other developed market government, they are typically much safer than emerging market sovereign bonds (or maybe Turkish or Argentinian government bonds). But you get the drift.
Then there’s high yield bonds, a kind of bond that pays much higher interest rates for the additional risk undertaken due to their higher risk of default. They are typically of a lower credit rating compared to other corporate bonds which are typically investment grade. You might find yields ranging from 8-15% here!
There is a whole spectrum of bond types – local vs foreign, government vs corporate, investment grade vs high yield etc. I shall not bore you with the details here, as you can simply Google them.
Then there is the issue of pricing. Bonds can be priced differently, and can be redeemed at a face value different from what you paid for. There are some bonds that pay zero interest for example, but allow you to redeem at a price higher than what you paid for them. Bond prices fluctuate throughout the day as they may be traded on an exchange. It goes a long way, but the gist is that, the pricing of bonds is a function of many factors, including credit quality, timeframe/duration, interest rates and coupon value. You don’t have to know all of these, but they are important concepts to understand how bonds’ prices inversely correlate to interest rates.
After a bunch of stuff, I think I haven’t addressed why bonds are an important part of an individual portfolio. So I’d like to paint it with a simple illustration.
In a 100% equity portfolio, you’re essentially buying only stocks – which are crazy volatile because investors’ short-term emotions are jumpy and unstable, just like Mr Trump.
Note how adding bonds in a portfolio can help to significantly reduce the fluctuations but also the risk you take during economic downturn. This is important because many people panic and sell all their holdings when the stock market crashes – usually at the wrong time (i.e. buy high, sell low). Bonds can act as a hedge to an all-equity portfolio due to their stable and consistent payments, which tend to rise in value when the economy goes to shit because people get scared the hell out of life and find safe assets to invest in.
The problem with bonds, I feel, is that the rising interest rate environment, bonds get discounted further (present value of future cash flows falls) and their price falls further; as existing bonds compete with new bonds issued at a higher interest rate. Furthermore, the attractiveness of cash, money market funds, fixed deposits and government savings schemes rises in comparison to the risk undertaken by investing in bonds.
So are bonds a good or bad investment? Should I buy gold? What about holding cash instead? Does my CPF constitute part of my bond investment? Should I buy overseas/US bonds/treasuries? How do I buy bonds in Singapore?
In the next post, I might talk a little bit more about various asset allocation portfolios and strategies to invest for the long-term. For now, I’ll let you ponder about those questions as I hope to address those in the future too 🙂