Introduction to Fixed Income and Bonds

Fixed income is an asset class that is a commonly held investment because it helps preserve capital. Fixed income investments typically provide a premium above inflation and experience less return volatility compared to equity investments.

Fixed income securities, or bonds, are investments that typically provide a relatively predictable stream of cash flows to investors as long as the bond issuer does not default (i.e. fully repays the coupons and principal). These securities typically pay either a fixed or floating rate of coupons to investors, and the principal is repaid upon maturity. Bonds are usually held for the steady income stream the regular coupon payments provide.

Bonds can offer diversification benefits because they often move in the opposite direction to shares. In a recession, equities normally do not perform well due to expectation of deteriorating corporate earnings. However, this is usually the scenario when central banks cut policy rates to support the economy – a positive for bond investments. By the same token, in an economic expansion, normally equities are supported by buoyant corporate earning expectation while the performance of bonds is not as strong due to the rise of policy rates. Bond investments, therefore, help to lower the risk level within a diversified portfolio over the market cycles.

In this article, we'll explore what bonds are, the risks and rewards of investing in them, and Schroders’ investment capabilities and expertise in this asset class.

One way a government or a company can obtain the money they need to fund their projects or initiatives is to sell bonds.

In other words, a bond is a loan sold or issued by the borrower (issuer) and purchased by the lender (investor). The borrower in turn makes two key promises to the lender:

1. To repay capital at maturity – the loan will be repaid on a predetermined date
2. To pay regular interest payments at a rate known as the coupon rate. This forms the interest on the borrowed amount paid to the investor during the life of the loan

What determines the level of coupons to pay? There are a few factors to consider:

1. Economic conditions: The higher the expectation of economic growth and inflation, the higher the interest rate/return expectation.
2. Investment timeframe: The longer the maturity, the higher the interest rate. In general, the longer the period of time investors have to give up the use of their money, the higher the interest rate they will want.
3. Risk premium: The higher the credit risk of an issuer, the higher the interest rate. This is because investors need to be compensated for the amount of risk they are taking.

The following are some commonly used terms that may be useful when talking about bonds.

The fixed income universe is massive and is an important asset classes for investors to consider when building a diversified investment portfolio. These securities provide a range of benefits to investors, including regular income, capital preservation, and diversification.

• Regular Income
  • One of the key benefits of investing in fixed income securities is the regular income they provide. Fixed income securities pay a fixed or predictable rate of return to investors (assuming the issuer does not default), typically in the form of interest payments. This can be a valuable source of income for investors who are looking for stable returns.
  • For retirees or other investors who are looking for a steady stream of income, fixed income securities can be an attractive option.
• Diversification
  • Fixed income securities can be an important part of a diversified investment portfolio, as they provide a different risk and return profile than other asset classes, such as equity stocks.
  • By investing in a mix of fixed income securities with different maturities, credit ratings, and issuers, investors can create a diversified portfolio that provides a balance of income, capital preservation, and growth potential.
• Risk Management
  • Fixed income securities can also be an important tool for managing risk in an investment portfolio, and can be used as defensive assets to protect your investment portfolio against market volatility and inflation. They are generally less volatile than other types of investments, such as equity stocks. By investing in fixed income securities with different characteristics, investors can create a portfolio that is less sensitive to changes in interest rates and credit markets. This can help to reduce overall portfolio risk, preserve capital, and increase the chances of achieving investment goals.

How do bonds make money for you?

Bonds (with the exception of zero coupon bonds discussed below) pay out a regular stream of interest known as coupon payments. There are several ways the bond issuer can go about this, depending on the type of bonds. Below are some examples:

1. Fixed-rate bond - a bond with a fixed coupon rate.
2. Floating rate bond - a bond with a variable coupon, usually tied to a reference interest rate, such as the Singapore Overnight Rate Average (SORA) and the Secured Overnight Financing Rate (SOFR) in the US, for example.
3. Zero coupon bond - a bond that pays no interest during the life of the bond, but is instead sold at a deep discount from its value at maturity.

However, coupons are just part of the total returns that investors can receive when investing in bonds. The other source of return is capital gain. Bonds, like stocks, are subject to market conditions and their value can fluctuate (or move up and down) from the time they are issued until their maturity. Factors affecting the price of a bond during its life are discussed later.

The price of a bond (typically with fixed-rate coupons) can fluctuate throughout its life. This fluctuation is in response to the current interest rate environment. Since bonds cannot change their coupon rates to align with current interest rates, both their prices and yields-to-maturity will adjust accordingly.

Put simply, it is a measure of total return available from a bond, taking into consideration the whole stream of cashflows from coupons and repaid principal. Take the example of a 10 year bond with a par value of $100, which pays out a 5% coupon rate (i.e. $5) each year. The yield on the bond is therefore 5%.

Suppose interest rates in the market increase to 6%. Because the coupon rate on the bond is already fixed, the price of the bond will have to drop proportionately so that the return from the bond (i.e. the yield) increases to 6%. In other words, the price of the bond will drop to about $83 so that the yield on the bond will increase to 6% ($5 / $83), in line with prevailing interest rates. This way, the bond will not be any less attractive than any other investments in the market.

Conversely, should prevailing interest rates drop to 4%, the price of the bond will increase to about $125 so that the yield on the bond will decrease to 4% ($5/$125).

Therefore, the price of a bond is inversely related to its yield.

A term that is commonly used is the yield-to-maturity (usually abbreviated to YTM). YTM is a useful measure, especially when comparing bonds of different coupons and maturities. It is the expected return of a bond if the bond is held until it matures, and provides investors with a better understanding of the bond’s coupon payments and the value at maturity by accounting for the time value of money, assuming that the bond issuer does not default.

So far, we have seen how bond prices move in relation to interest rates. However, how can we know how much a bond’s price will change in response to a move in interest rates?

This is where duration comes in. Duration is used to measure the sensitivity of a bond’s price to changes in interest rates and tells us the approximate change in the price of a bond in the event of a 1% change in interest rates. Duration is stated in years. For example, a two-year duration means that the bond will decrease in value by approximately 2% if interest rates rise by 1%,and increase in value by 2% if interest rates fall by 1%, holding other things constant.

As the table below shows, bond prices are impacted by interest rate changes - bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.

In other words, duration can be an indicator of how risky (in terms of interest rate risks) a bond is. For example, if you are not risk averse and think that interest rates are going down, you should buy a bond with a longer duration, so that you will benefit more from a fall in interest rates compared to a shorter duration bond. Conversely, should your view be wrong and interest rates increase instead, you would suffer a greater loss.

The yield curve is the relationship between the interest rate and the time to maturity of the debt for a given borrower in a given currency. It is drawn by plotting yields, or interest rates, of bonds against time. The slope of the yield curve can help with predicting future interest rate changes and economic activity.

Generally speaking, yield curves can be broadly classified into three main types:

1) Normal Yield Curve

Yield curves are usually upward sloping, meaning the longer the maturity, the higher the return (yield). A longer-term bond usually involves more risk that the borrower will default, or interest rates will change, or the lender will find a better potential use for their money. Investors therefore demand greater compensation for the uncertainty over a longer time period, also known as term premium. Generally, a normal yield curve implies stable economic conditions and a normal economic cycle.

2) Inverted yield curve

An inverted yield curve arises when short term interest rates are high relative to long-term expectations. This curve indicates that investors expect interest rates to be lower in the future. Term premium in this instance is negative. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to trend lower in the future.

3) Flat yield curve

This curve indicates the yields of bonds with different maturities are relatively constant, and is seen when interest rates are expected to decline moderately but offset by positive term premium. A flat yield curve reflects similar yields across all maturities, implying an uncertain economic situation.

Credit Rating Agencies

A credit rating agency is an independent rating agency that analyses and publishes a credit rating on companies and governments which issue bonds, which helps investors in deciding which bonds to invest in. Based on historical data and future growth potential, this rating assesses a company’s creditworthiness. Bonds are typically split into two large categories: Investment grade (or high grade) or non-investment grade (or high yield). Investment grade bonds indicate a low risk of default, while non-investment grade bonds usually yield a higher interest rate but are at a high risk of default.

Different credit rating agencies have different grading systems. Periodically, rating agencies review their ratings and occasionally move them higher or lower. When a rating change occurs it is normal for the outstanding bonds affected to increase in value (in an upgrade) or decrease in value (in a downgrade). Common rating agencies include Moody’s, Standard & Poor’s and Fitch, and rating decisions are based on factors such as:

• Background and history of the company
• Corporate strategy and philosophy
• Analysis of business risks
• Analysis of the company's financial risks
• Analysis of the management team

Standard & Poor’s grading system, for example, ranges from AAA (highest quality) to D (in default). Ratings of AAA, AA, A and BBB are considered investment grade (or high grade), while any rating below BBB is considered non-investment grade (high yield).

Put simply, a rating assigned to a bond issuer can be a guide to the question: "When I lend my money to this company today, what is the possibility that I will not get my money back?"

There are a number of risk factors that affect bond investing, most of which are interrelated.

• Interest rate/duration risk – As previously mentioned, bond investments are sensitive to the movements in domestic and international interest rates (or yield), and the magnitude of this risk is measured by duration. The level of duration is therefore an important aspect to consider when investing in a bond or a portfolio of bonds.
• Credit/default risks – The possibility that a bond issuer will default means that the issuer will be unable to make interest or principal payments when they are due. Bonds issued by government or government agencies or government-sponsored enterprises, in the majority, are less likely to suffer from default due to their ability to raise taxes. In comparison, bonds issued by corporations, particularly high yield bonds, have a higher probability of default.
• Liquidity risk – There is a probability of loss arising from the difficulty of selling an asset because of insufficient buyers or sellers in the open market. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Liquidity risk may be quantified as the difference between an asset's value and the price at which it can likely be sold. To manage liquidity risk, investors can consider investing in higher quality assets, such as investment grade bonds.

There are a number of risk factors that affect bond investing, most of which are interrelated.

• Interest rate/duration risk – As previously mentioned, bond investments are sensitive to the movements in domestic and international interest rates (or yield), and the magnitude of this risk is measured by duration. The level of duration is therefore an important aspect to consider when investing in a bond or a portfolio of bonds.
• Credit/default risks – The possibility that a bond issuer will default means that the issuer will be unable to make interest or principal payments when they are due. Bonds issued by government or government agencies or government-sponsored enterprises, in the majority, are less likely to suffer from default due to their ability to raise taxes. In comparison, bonds issued by corporations, particularly high yield bonds, have a higher probability of default.
• Liquidity risk – There is a probability of loss arising from the difficulty of selling an asset because of insufficient buyers or sellers in the open market. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Liquidity risk may be quantified as the difference between an asset's value and the price at which it can likely be sold. To manage liquidity risk, investors can consider investing in higher quality assets, such as investment grade bonds.

Types of bonds issued today

Now that you're more familiar with bond terms and features, we're going to discuss some of the different types of bonds issued today. Bonds come in all shapes and sizes, and indeed the investment universe for this asset class is large and diverse. Common types of bonds are described below:

• Government bonds – Government bonds are issued by national governments to fund public spending. They are considered to be low-risk investments because they are backed by the full faith and credit of the government. Government bonds are usually referred to as risk-free bonds with very low default risk and are among the safest investments, because the government can raise taxes or print money to redeem the bond at maturity. Although the interest payments on government bonds are typically lower than other fixed income securities, they are considered to be a safe haven investment during times of market volatility. These are bonds issued by a national government, denominated in the country's own currency (for example, Singapore Government Securities, Australian Commonwealth Government Bonds and US Treasuries). Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds.
• Semi-government or Municipal bonds – Municipal bonds are issued by state and local governments to fund public projects, such as schools, hospitals, and infrastructure. Semi-Government bonds often have higher yields than government bonds to compensate investors for the additional credit risk taken.
• Supranational bonds – Supranational debt refers to bonds issued by international organisations, often multinational or quasi-government organisations, such as the World Bank and Asian Development Bank, with a purpose of promoting economic development. Similar to semi-government bonds, these often have a higher yield than government bonds.
• Corporate bonds – These are bonds issued by companies to raise money for business purposes, e.g. to expand operations or fund new business ventures. Corporate bonds usually pay higher rates than government bonds, because they tend to be riskier. Corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly. High yield bonds are issued by lower quality corporates and therefore have higher yields to compensate for the additional default risk.
• Hybrids – These are securities which have characteristics which are equity-like (e.g. perpetuity) and bond-like (e.g. regular coupon payments). Given the nature of these investments, they typically provide higher yields but also have higher risk associated.
• Emerging market bonds – These refer to bonds issued by governments and companies in developing markets such as Latin America, Russia, the Middle East and Asia excluding Japan. Emerging market bonds usually offer very attractive yields and pose special risks such as political and institutional instability and currency volatility. Again, because of the higher risk involved, their yields are generally higher.
• Inflation-linked bonds – The interest rate payments or principal amounts on these bonds are adjusted on a regular basis to reflect changes in the rate of inflation, thereby providing a real or inflation-adjusted return. Inflation linked bonds could experience greater losses when real interest rates are rising faster than normal interest rates. Inflation linked bonds are usually issued by the federal government.
• Mortgage-Backed Securities (MBS) – Mortgage-backed securities (MBS) are investments that are backed by a pool of mortgages. The most common and simplest form of MBS is pass-through MBS, which is structured as a trust such that the principal and interests payments are passed through from the mortgage borrowers to the investors. The value of these securities is sensitive to changes in interest rates, the housing market, as well as credit risks of the mortgages in the collateral pool.
• Asset-Backed securities (ABS) – Asset-backed securities are investments that are backed by a pool of assets, such as mortgages or car loans. The interest payments on asset-backed securities are typically higher than other fixed income securities, but they are also considered to be higher risk because they are backed by the underlying assets. Asset-backed securities are usually “tranched”, which means that loans are bundled together into high-quality and lower-quality classes of securities.

Regardless of which point of the economic cycle we are currently at, there are always opportunities for bond fund managers to make money from the asset class. This is because different types of bonds perform differently at different points of the economic cycle.

For example, during a period of economic downturn, government bonds tend to outperform as risk aversion increases and interest rates fall. On the other hand, during a period of economic recovery, corporates (particularly high yield bonds) would tend to outperform as credit conditions improve.

Having explained the technicalities of how a bond works, it is not hard to see why bonds can be attractive investments. Besides diversification, they also offer higher potential returns over cash deposit rates, but without the volatility of shares.

Benefits of investing in Bond Funds

The easiest way to get started in Fixed Incoming investing is to invest in a bond fund rather than purchasing bonds directly.

Here are the reasons why you should invest in a bond fund:

1. Lower investment amount – A purchase of a single bond typically needs a much higher entrance threshold, e.g. for most retail investors, purchasing a bond from a bank requires at least SGD250,000 *. A bond fund offers a much more convenient and affordable way to invest, with thresholds as low as SGD1,000^.
   *the minimum investment amount varies depending on the type of bonds, the distribution channels, and the respective market prices at the point of trading. A selection of bonds with lower entrance thresholds than the stated amount are available to retail investors, but the breadth of bond investments is far greater in the institutional market. ^minimum direct investment for Schroders funds
2. Diversification – As the old adage goes, do not put all your eggs into one basket. As the past has shown, even big global names can default on their loans or even go bankrupt. This is why investing in a portfolio of bonds, researched and picked by an experienced fund manager, ensures proper diversification across regions, sectors and companies.
3. Access – As mentioned above, for retail investors, the purchase of a single bond typically needs a much higher entrance threshold. Bond funds provides investors with greater access to a carefully selected, diversified portfolio of bonds at a much lower threshold.
4. Liquidity – Given the high investment amount, it may be difficult at times for you to sell off your bond to another investor. Investing in a bond fund, however, means that you can redeem your units at anytime (subject to the terms and conditions set out in the relevant offering documents).
5. Professionally managed with bond allocation and duration – Apart from the convenience of investing in bond funds, when it comes to buying bond funds, a professional manager backed by a strong global research team and credit analysis capabilities to identify potential sectors can help investors maximise the return on a bond portfolio. Active bond managers commonly adjust a bond portfolio’s duration (the weighted average duration of all the bonds in the portfolio) and adjust the credit quality based on expectations of economic growth and credit conditions.

Schroders' approach to fixed income

At Schroders, we believe the fixed income universe is extremely diverse. This breadth, and the diversity of possible risk and return outcomes, means active management is essential. Schroders employs a top down approach to managing bonds and aims to add value through four levers:

Why should you consider Schroders for bonding investing?