The World of Bonds
Most people don't realise how big the bond market is. Everyone is following what’s happening with stocks like the Apple share price, but Apple has over 300 bonds. Each of these bonds is slightly different and worth a few hundred million. You shouldn’t ignore the bond market because its market value is much larger than the stock market. The U.S. Publicly Traded Stocks is about $27 Trillion while the U.S. Bond is about $40 Trillion. The Global Publicly Traded Stocks is $70.1 Trillion while Global Bonds is $92.2 Trillion.
So how do stocks and bonds differ? If you own shares of stocks in a company, you are an “owner” but if you own a bond of a company, you are a “loaner”. When you buy a bond, you're loaning a sum of money to its issuer for a specific period of time. In exchange, the issuer promises to make regular interest payments at a predetermined rate until the bond period ends. They then repay your principal amount upon maturity. For example, you might buy a 10-year, $10,000 bond paying 3% interest. The issuer, in exchange, will promise to pay you the interest on that $10,000 every six months, and then return your $10,000 after ten years.
It is often said that the bond market is smarter than the stock market and there’s a lot of truth to this. The bond market provides useful insight into the future state of the economy through the shape of the yield curve (a conglomeration of bond yields at various maturities). An inverted yield curve, which means that short-term rates are higher than long-term rates, has correctly predicted the last seven recessions dated back to the late 1960s. The last two times the yield curve inverted was in the years 2000 and 2006, before each of the last recessions. While the stock market is also somewhat of an economic indicator, it is more of an emotional and volatile market. The mid-cycle sell-offs in the stock market, which are common, are easily confused as signals of an impending recession.
Bonds have developed so intricately from a personal level loan to a mass level loan. In the past, companies that wanted to start growing had to find partners who would lend them money. This was at a time when there was no real trust or governance around lending money, so there was no form of guarantee. As such, for companies to get money and grow, they had to offer equity to partners. When the law came along, and records were better kept, loans started getting issued officially.
When the government began taxing people, wars were started because taxes were too high. This then caused the creation of a system where the government loaned a certain amount from citizens and then returned it with interest. Such a concept extended across to farms, big industries, and filtered down to small corporates. Bonds became preferred over equity because companies preferred to give less ownership to others. As a result, the bond market expanded quickly. What started as a simple loan between two people has become large scale loans between conglomerates and hordes of people.
Due to this natural development of bonds, they don’t just come in one form. They come in multiple shapes and forms, and I’ll lay this out for you in the next chapter.
Shape and Forms of Bonds
There are two ways to make money from investing in bonds. The first is to hold bonds until their maturity date while collecting interest payments twice a year. The second way to profit from bonds is to sell them at a price that's higher than what you paid for initially. For example, if you buy $10,000 worth of bonds and then sell them for $11,000 when their market value increases, you can pocket the $1,000 difference.
Before you can begin doing that, you need to be familiar with the several varieties of bonds – corporate, municipal, and government – and even though their nuances might differ, they're all the same at their core: debt instruments used to raise capital.
Treasury bills are short-term debt securities issued by the treasury department of countries. For instance, the Monetary Authority of Singapore (MAS). Treasury bills typically have a maturity of one year or less. Due to the short-term nature of these bonds, there may be no coupon payments paid on these bonds. Instead, they are usually sold at a discount to their par value, or the amount you will receive at the end of the bond. The difference between the price of the bond and its par value makes up returns earned by investors. For instance, a bond worth $10,000 with a 1-year maturity could be sold for $9800, and an investor would pay $9800 now and receive $10,000 in 1 year.
Government Securities are longer termed debt securities issued by the governments, usually with maturity periods ranging from 2, 5, 10, 15, 20 and 30 years. In Singapore, the Singapore Government Securities (SGS) bonds pay a fixed coupon, usually every six months, for the entire duration of the bond. Upon maturity, investors will receive the par value of the bond. The current Singapore 5 year bond has a 2% coupon annually, paying every 6 months until it expires in 2024 returning the par value invested.
A savings bond is a 10-year bond issued by a country. In Singapore, it is issued by MAS and backed by the Singapore Government, which also makes it a virtually risk-free investment. Singapore Savings bonds (SSB) and Government securities are very similar, both are issued by the Government of Singapore and both are very safe. The key difference relates to the investment amount. SGS Bonds come in multiples of $1,000 and have no real maximum limit. SSB come in a smaller multiple of $500 and have limits: maximum of S$50,000 per issue and a maximum of $100,000 across all issues
The ABF Singapore Bond Fund
This fund comprises of some of the safest and highest rated debts issued in Singapore. These usually include high-quality bonds that are issued by the Singapore Government and quasi-Singapore Government organisations. Singapore quasi government issuers are the likes of Temasek, Port Authority of Singapore, Singapore Housing Authority and other public organisations.
The price of these bonds could be more volatile as they are dependent on the performance of the company that issued them, market sentiments as well as the interest rate environment, especially if they are unrated or junk bonds, a term commonly reserved for younger and riskier companies.
Junk bonds are the most alluring types of bonds to new investors because of the high, double-digit yields during ordinary interest rate environments. These dangerous bonds can lure you in with the promise of big checks in the mail, yet leave you high and dry when the companies that issue them miss payments or go bankrupt. Stick to investment grade bonds, instead. If you don't know what you are doing, be extra safe.
Rates, Risks and Indicators
One thing you may not know about bonds is that there is more than one interest rate you need to pay attention to. The first rate you should pay attention to is the bond's coupon rate which refers to the stated interest rate paid based on the par, or face value of the bond. If a bond is issued with a $1,000 face value and a coupon rate of 5.5%, this tells us that the bond will pay interest of $55 per year.
The current yield tells you how much a bond yields based on its current market price. For example, if the same $1,000 bond with a 5.5% coupon rate trades for $950, its current yield jumps to 5.8% since it still pays a $55 annual dividend. The current yield can be calculated by dividing the one-year coupon by the initial price? 55/950=5.8%
Yield to maturity (YTM) is another rate which tells you the total return the bond will produce if you hold it through the end of its lifetime expressed as an annualised rate. This rate is different from the current yield because it takes into account the final payment.
To calculate the actual yield to maturity requires trial and error by putting rates into the present value of a bond formula until the price matches the actual price of the bond. Some financial calculators and computer programs can be used to calculate the yield to maturity. You can also calculate a relatively good proxy using a YTM formula which you can find online.
Yield to worst (YTW) is a rate that shows how much the bond will return based on a worst-case scenario. This rate is especially useful if your bonds are "callable," which means the issuer can choose to redeem them early. If you buy a bond for a premium of $1,100 for a bond with a $1,000 face value, and the issuer chooses to call the bonds early, you'll receive $100 less than you paid; this needs to be taken into account.
There are a few risks you need to consider before you start trading bonds.
Firstly, the interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the investor faces the possibility of pre-payment. If the interest rates increase, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future.
Next, you need to understand credit or default risk which is the risk that interest and principal payments due on the obligation will not be made as required.
To understand credit risk in the bond market, you need to understand bond ratings. There are specialised rating agencies that look at the financials of companies that issue bonds and then make a judgment about their ability to pay compared to other bond issuers. Top-rated bonds are AAA, followed by AA, A, BBB, BB, B, CCC, CC, C, and D. Various rating agencies use different methods of further subdividing these categories.
Some of these agencies use plus and minus signs to distinguish grades while others use numbers 1, 2, and 3 to signify the best, middle, and worst ratings in each broader letter-grade. The better the rating, the safer the bond, but higher-rated bonds typically pay lower interest rates than lower-rated ones.
There is a key boundary between BBB- and BB+ rated debt that you must be aware of. At BBB- or above, bonds are called investment-grade, achieving enough safety to be suitable for risk-averse investors. At BB+ or below, bonds are classified as high-yield debt, referred to colloquially as junk bonds. By setting expectations of how likely a bond is to default and cost you your principal amount, bond ratings can be a useful tool to help you establish the risk level of your bond portfolio and avoid what can become costly mistakes.
Now, what additional research can do before you dive into investing?
5 Economic Indicators to Follow
When looking at all the following indicators, do note the effect on interest rates. When the interest rates move UP, bond prices move DOWN. So, if an indicator suggests that interest rates are to move up, then it’s recommended to consider selling the bond if you want to.
Gross Domestic Product (GDP)
A high GDP growth is considered an inflation risk and may spur the Federal Reserve System to raise interest rates to prevent ‘overheating’. Slow or negative growth will call for a reduction in interest rates to stimulate the country’s economy.
Consumer Price Index (CPI)
CPI is one of the most significant measures of inflation. A high CPI points to rising inflation and will compel the Federal Reserve System to push for higher interest rates.
Consistently low unemployment is considered an inflation risk and the Federal Reserve System may move to raise interest rates. High unemployment, on the other hand, may compel a reduction of interest rates.
Housing Starts and Building Permits
The property market is one of the key pointers of where the economy is headed – robust property construction is usually a sign of economic growth. The Federal Reserve System may choose to increase interest rates to prevent inflation and a potential housing bubble.
The Beige Book
The Beige Book is essentially a backwards-looking publication. Its content can provide hints on the future direction the Federal Open Market Committee (FOMC) is likely to take.
Now that you’ve understood the basics, you can read my upcoming book, Successful Bond Selection, where I share more about where you can buy your bonds and what you can watch out for to confidently start investing in the right bonds for you.
Steps to Take in 24 Hours
- Set up Economic Alert
Go to Economic Calendar select the month, followed by the United States and then select High Impact. You can then set the right indicators to have alerts on.
- Subscribe to key bond indices
Go to CNBC US Markets and set up an account. Then set up alerts for US 10y, US 2-10Y, IG and HY Corporate index.
- Practice Predicting
Start reading the front page of the Financial Times and practice predicting how the current headlines will affect the key bond indices.