A Beginner’s Guide to Bonds
1. What are bonds?
- Bonds are instruments that represent borrowings by either companies or governments.
- They can be seen as IOUs between borrowers and lenders.
- Borrowers are known as issuers.
- Issuers use the money to finance their operations.
- Lenders are those who have bought the bonds and are therefore known as investors.
- Investors get paid interest periodically; hence bonds are referred to as “fixed income’’ instruments.
- Because of the regular interest payments, bonds are generally seen as being safer instruments than shares, however, much depends on the credit worthiness of the issuer as this determines its ability to pay and continue paying.
2. What are the main features of bonds?
- They are usually issued in units of 100 or 1,000.
- The face value per unit is typically $1.
- The annual interest payment is known as the coupon rate that is expressed as a percentage of the face value.
- The interest is usually paid every six months.
- Bonds have a maturity date, which is sometimes known as the redemption date. This is when the issuer has to pay the lender (or investor) the principal, ie. is the original amount that was lent.
- Bonds can be traded on an exchange and therefore have a market price – on SGX, there are many bonds issued to retail investors.
3. How do bond prices move with changes in interest rates?
- If interest rates rise, the coupon payment from a bond may appear less attractive to the market, in which case investors may sell the bond, leading to a fall in its price.
- If interest rates fall, the bond’s coupon may appear more attractive to investors, in which case the buying will push its price up.
- In other words, bond prices are inversely related to interest rates.
4. What determines bond prices?
- Bonds can trade above or below their face value, depending on several factors like the general level of interest rates, the credit quality of the issuer and overall demand for fixed income instruments.
- If bonds trade above their face value, they are said to be selling at a premium.
- If bonds trade below their face value, they are said to be selling at a discount.
- If the market is in “risk off’’ mode, it means that investors are generally reluctant to take on risk, so this would benefit bonds thus pushing prices up.
- If the market is in “risk on’’ mode, it means that investors prefer riskier instruments like shares, which usually results in bond prices falling.
- Time to maturity – the longer the time left until the principal is repaid, the higher the chance that interest rates can rise, thus adversely affecting the bond’s price. This means that longer-dated bonds will be more volatile than shorter-dated bonds.
- Coupon rate – a bond with a low coupon rate will be more vulnerable to a rise in interest rates, hence a low-coupon bond will exhibit greater volatility.
- If interest rates are falling, it is better to be invested in volatile bonds because of the greater chance of prices rising, ie. Long-term, low coupon bonds.
- If interest rates are rising, it is better to be invested in bonds with low volatility to minimise the impact on your investments, ie short-term, high coupon bonds.
- Credit rating – There are three credit rating agencies, Moody’s, Standard & Poor’s and Fitch. These companies perform financial checks on bond issuers and rate the latter’s bonds in terms of the chance of a default, ie. The likelihood that the issuer cannot pay the annual coupon or redeem the bond at maturity.
5. What are the risks?
- Interest rate risk: A sudden rise in interest rates can drive bond prices down.
- Credit risk: This is the risk of issuers running into financial problems and therefore being unable to pay the interest or principal payments, leading to a default.
- Inflation risk: Rising inflation erodes the real value of bond payments and could also lead to higher interest rates which could then hurt bond prices.
- Liquidity risk: Holders of bonds that are not actively traded run the risk of not being able to sell at their desired price.
6. Who are bonds suitable for?
- Risk-averse investors who want to earn regular interest that is higher than bank deposits;
- Investors looking to diversify their investment portfolios.
- Short-term traders looking to exploit changes in interest rate and/or inflation expectations.
For free and unbiased financial education on personal investing, you can visit the Institute for Financial Literacy (IFL). IFL provide talks and workshops to the public and do not promote financial products. Their financial education programmes cover basic money management, financial planning and investment know-how.
The information presented here is to provide general awareness and educational purposes and does not constitute specific financial or investment advice. Any mention of private or public organisations, reference to products or numbers used, are for the purpose of providing illustrations to help in understanding concepts being presented.
You are always encouraged to consult a licensed financial advisor, relevant government agencies and/or your family before making any major financial decisions.
Credit Counselling Singapore
Published 10 February 2023.