Like 007: Successful Bond Selection

Bonds are one of the most essential investments available for those who hope to live off the money generated from their portfolio. The art of good income investment is about putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that generate the highest possible annual income, at the lowest possible risk. The volatility in 2018 is a clear example of why portfolio diversification is a wise move. You really shouldn’t be keeping all your eggs in one basket.

If you're more risk-averse and can't bear the thought of losing money, bonds might be a more suitable investment for you than stocks. Of course, the safest investment you'll come across is none other than cash in the bank, but bonds typically pay better when it comes to interest.

Bonds are a great choice if you're near retirement or if you are already retired. At that point in your life, you may not have the time to ride out the stock market downturns, in which case bonds are a safer place for your money. Most people are advised to shift away from stocks and move into bonds as they get older, and this isn't terrible advice, provided you don't make the mistake of dumping your stocks entirely in retirement.

Benefits of Investing in Bonds

One advantage of putting bonds in your portfolio is that they're a relatively safe investment. Bond values don't tend to fluctuate as much as stock prices, so they're less likely to keep you up worrying at night.

Another benefit of bonds is that they offer a predictable income stream. Because bonds pay a fixed amount of interest twice a year, you can generally rely on that money to come in as expected. Municipal and Treasury bonds offer the additional benefit of paying tax-exempt interest to varying degrees.

Furthermore, some investors prefer municipal bonds because these bonds offer the chance to invest in communities. When you invest in a municipal bond, you might help to improve a local school system, build a hospital, or develop a public garden. There’s a social angle, combined with the potential for a completely tax-free interest income, which is why some investors forgo the higher interest rates of corporate bonds and invest in municipal bonds instead. If these terms are new to you, you can refer to my first power read, Introduction to Bonds, where I explain these various terms.

Drawbacks of Investing in Bonds

Though there are plenty of good reasons to invest in bonds, there are some disadvantages you should keep in mind. Much like other types of investments, bonds are also subject to risks such as call and prepayment risk, credit risk, re-investment risk, exchange rate risk, default risk, inflation risk, sovereign risk, and yield curve risk. The key risks with bonds however, are the interest risk and default risk.

Since bonds are a relatively long-term investment, you'll face what's called interest-rate risk once you buy them. For instance, what happens if you buy a 10-year bond paying 3% interest and a month later, that same issuer offers bonds at 4% interest? Suddenly, your bond drops in value, and if you hold it, you'll lose out on potential earnings by getting stuck with that lower rate.

Furthermore, while bonds are a relatively safe investment, there is a default risk involved. If an issuer defaults on its obligations, you risk losing out on interest payments, getting your principal repaid, or both. A company’s bondholders may lose much or all their money if the company goes bankrupt. There is no guarantee of how much money will remain to repay bondholders.

Another critical point to consider is that bonds aren't all that conducive to long-term investment growth. That's because the return on investment you'll get from bonds is substantially lower than what you'll get with stocks.

Between 1928 and 2010, stocks averaged an 11.3% return, while bonds averaged just 5.28%. Now, imagine you're able to save $300 a month for retirement over a 30-year period. If you load up on bonds and average a 5.28% return during that time, you'll end up with a $251,000 nest egg. However, if you go with stocks instead and score an average annual 11.3% return on investment, you'll grow your retirement account to $759,000. This growth is important because you'll have a hard time keeping up with inflation and maintaining your buying power when you're older.

A final drawback of buying bonds is that, due to the way they trade, there's less transparency in the bond market than in the stock market. As such, brokers can sometimes get away with charging higher prices, and you might have a harder time determining whether the price you're quoted for a given bond is fair.

However again, it’s vital to recognise that there is less risk when investing in bonds as compared to stocks and you’re still making your money work for you by investing in bonds.

Buying bonds can prove a little trickier than buying stocks, where it’s easy for investors to get started with just a little cash. With bonds, it can take quite a bit of cash to begin investing.

Bonds are sold over the counter, which means that they're not an exchange and the prices are not transparent to everyone. It is not like with equities, like the S&P, which could be 5000 euros anywhere in the world at the same time. Bond prices are a little more like when you exchange your money with a money changer. Each shop has a slightly different price because they want to get rid of or keep certain currencies, so they offer a specific rate accordingly.

Bonds work similarly, particularly if you're going for more exotic names, you might need to do some shopping at different avenues to get a better price. The price depends on whether the dealer has too little of the bonds, too many of the bonds or holds a particular view about the direction of these bonds.

To find a good price for bonds, it's best to shop around more. If you're going to buy into a bond fund, take a look at the different bond funds available. They might all be rated the same, be from big institutions, and have similar duration risks but one may have a better price than the other. You’d also want to consider counterparty risk which can be determined by looking at who created the fund, for instance Aberdeen or BlackRock, and the risk would then depend on when they started the bond or how much interest there is in the fund.

Who can you buy bonds from?

Firstly, you could buy bonds from a broker, just as you would buy stocks, though not all brokers offer this service. So, you’ll be buying from other investors looking to sell. Also, you may be able to receive a discount off the bond’s face value by purchasing a bond directly from the underwriting investment bank in an initial bond offering.

Another option would be through an Exchange-Traded Fund (ETF) or Bond Fund. An ETF typically buys bonds from many different companies, and some funds may be focused on short, medium, and long-term bonds, or provide exposure to specific industries or markets. A fund is an excellent option for individual investors because it offers immediate diversification and you don’t have to buy them in thousand-dollar increments.

Finally, you could buy bonds directly from governments. Many developed governments have set up a program in which investors can buy government bonds directly without having to pay a fee to a broker or other middleman.

Personally, I would use age as a rough gauge of whom you should go to. If you're in your 20s, I would suggest that you go for more risky investments with high yields like equities because you’ve got another 60 years to make it back. If you have a terrible year, you're going to have many more good years. Of course, if you are risk averse, then you can stick to safer investments.

There's a standard wall street rule, which is to take 4% of your earnings each year and invest it. Your investment will make you much more money than that initial 4%. You’ll be able to take out that amount equivalent to 4% continually, and it will replenish itself. So, if you want to leave money for your children, and want to have a certain amount of savings, then start the 4% rule. Work out how much 4% is, and how much do you need to live on. If you don't have kids, you can take out a bit more. You can take out a good 5%- 6% and that could last 30 years.

It’s important to note that it’s now an era of lower interest rates and longer lives with the help of medical innovation. These factors contribute to highlighting the importance of actively managing your investments.

Selecting a Suitable Issuer

In your 20s and 30s, you want to go for slightly more aggressive bondholders. I wouldn't be looking at government bonds, or Singapore saving bonds, as those are risk-averse, which means you're not going to lose much money, but you're also not going to make much. In essence, I would concentrate more on the riskier investments, which are corporate credits from bond funds.

If you have a significant investment capital that enables you to buy from individual names, I would recommend that you consider bonds from the emerging markets in Asia. If you can't buy individual names, then look at a Bond Fund or ETF from emerging markets in Asia because it’s the best place to invest in right now.

For instance, let’s compare a US bond by a prominent US energy player like GE versus a Chinese bond by a prominent Chinese energy player like Sinopec. Both of them have the same interest rate risk for five years and are rated BBB. The US company that has been around forever, whom everyone knows, may pay out 4% for five years. The Chinese company which is known everywhere in China (1.4 billion people) but not necessarily all around the world, may pay out 5%. Since people aren't that familiar with this Chinese company, it doesn’t get the same attention and prestige as the American company. This Chinese company gives a 100 basis points or a 1% difference between the two companies, even though the risks are the same. So, it would be financially smarter to invest in emerging markets.

Another reason why emerging markets are better investment choices is because of the way banks work. Since the US market is a bit more developed, US companies can get larger loans from banks, which has resulted in large corporate debts. Whereas for China and other emerging markets in Asia, the banks aren't that open to giving these companies large loans. As a result, they have a lot less debt and even if they do have debt, the duration to pay off that debt is much shorter.

Ultimately what you’ll realise is that with developed markets like the US and Europe, you get paid less, and there's actually more risk involved. With emerging markets, on the other hand, you get paid more and have less risk involved for similar rated countries. This is despite the fact that the duration and the risk ratings of these two companies are the same. It’s important to remember that not all emerging market countries are economically weaker: Singapore is defined as an emerging market, whilst Portugal is defined as a developed market. Of course, be sure to invest in EM premium and Asia premium as they offer one of the highest returns. Look into big companies in India, Indonesia, China and other emerging markets.

A good bond allocation might have pieces of each type of bond, diversified by issuers which reduces principal risk. Investors can also stagger maturities to reduce interest-rate risk. Diversifying a bond portfolio can be more difficult than diversifying a stock portfolio. Typically, bonds are sold in $1,000 increments, so it takes a lot of cash to build a diversified portfolio.

To get around this difficulty, it’s much easier to buy exchange-traded funds focused on bonds. They can provide diversified exposure to the bond types you want. You can also mix and match bond ETFs, even if you can’t invest a thousand dollars at a time. Finding a low-cost fund is particularly important because interest rates have been so low since the financial crisis.

When Is the Right Time to Buy Bonds?

Once a bond’s interest rate is set and made available to investors, the bond trades in what’s called a debt market. The moves of prevailing interest rates then dictate how the bond’s price fluctuates. Bond prices tend to move countercyclically. As the economy heats up and interest rates rise, bond prices fall. As the economy cools and interest rates fall, bond prices rise. You might think that bonds are a great buy during boom times (when their prices are lowest) and a great sale when the economy starts to recover. However, it’s not that simple.

Bond investors are always wondering whether rates will go higher or lower. But waiting to buy bonds can amount to trying to time the market, and market-timing is a no-no for non-professional investors.

To manage this uncertainty, many bond investors “ladder” their bond exposure, much like savers do when they set up CDs at a bank. Investors buy many bonds that mature across a period of years. As bonds mature, the principal is reinvested, and the ladder grows. Laddering effectively diversifies interest-rate risk, though it may come at the cost of lower yield.

Can the Borrower Pay Its Bonds?

It’s of paramount importance to answer this question because if a company can’t pay its bonds — its promise to you, the investor, to pay back the money you lend it, with interest — there’s no reason for the average investor to consider buying them. With just a little sleuthing, you can have a pretty good estimate of whether the company can meet its debt obligations.

Rating agencies are the ones who rate bonds by companies, and the three big agencies — Moody’s, Standard & Poor’s and Fitch — dominate the industry. These agencies estimate creditworthiness by assigning credit ratings to companies and governments and the bonds they issue. The higher the rating — AAA is the highest, and it goes down from there, like in school — the higher the likelihood that the company will honour its obligations and the lower the interest rates it will have to pay.

Beyond ratings, the quickest way to determine the safety of a company-issued bond is by looking at how much interest a company pays relative to its income. Like a homeowner paying off a mortgage every month, if the company doesn’t have the income to support its payments, there will be trouble eventually.

Understanding Rating Agencies

Rating agencies assess two key risks when they rate bonds. The first risk is the duration and the second risk is the credit risk and defaults, which I’ve briefly mentioned earlier.

Duration risk is about how long you loan money to someone. For instance, if I lend you money to buy lunch and you return me the money after lunch, it’s a very low duration risk. If I lend you the money for ten years, my risk skyrockets. I don't know where you’ll live and what you’ll be doing in 10 years. To account for that risk, I need to be compensated more, hence the return should be with an interest that makes up for the risk.

Long durations are more common for stable countries and corporates who are often rated AAA, A, or B. There are minimal credit risks involved, and the key risk is duration risk. If you're rated AAA like Singapore, it's doubtful that in 2, 5, 10, or 15 years, Singapore will be in trouble. Between A, AA, AAA – there’s not a lot of difference. The real risk and concurrently the reason why people buy into those bonds is the duration because with the risk also comes the return. If there is no risk, you’re not going to be paid, so why are you investing? For instance, if you buy into Singapore for a two-year paper, you will get very little back. If you want to earn some money, you should get a 30-year paper because you're going to get more yield for that because you're taking a bit more risk.

If a bond moves within the top few credit ratings, like from AAA to AA, nothing really changes. Unless something terrible happens that changes things up in a country, like a new president who starts to mess things around, then there could potentially be a lot of change, but it's not common.

When you move further down to the Bs, BBB is the strongest, while a single B is the worst, and this is where the credit rating becomes incredibly important. For instance, no matter how long the duration risk, if I invest in Venezuela for six months, a year, three years or any other duration – they will all be risky investments. We don't know what's going to happen in the near term.

The issue with rating agencies is that companies sometimes pay them for the rating. So even though rating agencies say they are independent, they're not 100% independent. Some rating agencies are trying to grow their business in China. As a result, they have to rate the Chinese government highly, or they don’t get access to the 1000 companies they are looking to rate. Investing is not a perfect world. If something's called a BBB, you need to understand who's calling it a BBB, and why.

In addition to that, rating agencies will have a better view than an investor but not necessarily the best. For instance, as an investor, I may have only spoken with the company once or twice but rating agencies would have visited the company four times a year. However, it’s important to note that while they get more information and get access to management, they are not auditors, and the company won’t tell them everything. They try to get as much information as possible, but you have to take these ratings with a pinch of salt because they are all backward looking (they look at records).

Every commercial company has an angle, and they obviously have to keep independent from the business model. As seen with Fannie Mae and Freddie Mac, the rating agencies rating for all the mortgage-backed securities (MBS) and collateralised debt obligations (CDO) were classified as AAA. The rating agencies became complacent, the 10,000th CDO is likely based on the first CDO without additional due diligence done.

The movie “Big short” perfectly reflects this issue – the movie depicted rating agencies doing business with big guys which were large companies issuing millions and millions of bonds. These rating agencies just had to rate all of these companies with AAA. If they didn’t, they would lose the contract, and the big guys would go down the street to another rating agency for a good rating.

Another example would be in India where there are external rating agencies and internal rating agencies. Internal rating agencies basically rate everything as AAA. But in reality, the government is rated BBB by the external agencies. So, in India, if you see a local area agency giving a rating of AAA, it means BBB. Those internal agencies are small businesses themselves, and they're trying to grow, so they're very friendly to many companies and the government.

At the end of the day, rating agencies are one consideration amongst many other considerations when it comes to making an investment decision. Looking at bonds holistically is crucial when it comes to selecting the right bonds for yourself.

1. Start Saving Now

You don’t want to be taking loans to invest. Your investment should be coming from your savings. Saving should be seen as a long-term sustainable habit that you start building now. Even if it’s a small amount like 1% of your salary, start somewhere. As Warren Buffet says, “Do not save what is left after spending, but spend what is left after saving.”

2. Start Defensively

You can start defensively with low risk investments and a diversified portfolio. While learning how to invest better, you can put your money in low-risk investments. While the returns are low, at least you get more money back to cover for inflation. Also don’t put all your eggs in one basket. ETFs and other instruments offer a attractively low entry level to create diversified portfolio – spread the risk.

3. Create and Track a Model Portfolio

It’s good to start testing your investment understanding. Go to saxotrader.com, ig.com and cmcmarkets.com and create demo investment accounts to practice.