Bond Investing Principles

To begin, let us start off by asking the perennial question – why should investors even look at bonds?

Definitely there are several reasons why, but the central one is that bonds can effectively diversify an investment portfolio. Indeed, bonds typically experience less volatility compared to stocks and as such the addition of bonds into an investment portfolio serves to stabilize it. Furthermore, bonds typically pay out regular coupons, which in turn mean a predictable and steady stream of income for a bond investor. This regular flow of income also adds to the overall returns of an investment portfolio while reducing its volatility, in the process enhancing its risk-return profile.

Last but definitely not least, bond prices tend to react differently to stocks at different points of the economic cycle. This means that any adverse effect of the market on one asset class can be partially cancelled out by the other – again thereby adding stability to an investment portfolio. The benefits of bond investing are not only that it can offer a stable investment with a lower risk level within a diversified portfolio, but there is also benefit from capital appreciation if bond prices move upward.

Having discussed why one should invest in bonds, let us talk about what exactly a bond is. Typically, a company or government needs money to fund their projects or initiatives. They can raise this money by selling bonds to investors. In return, the investor will receive something extra in the form of interest payments (or coupons) at a predetermined rate and schedule.

In other words, a bond is a loan 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 – that the loan will be repaid on a predetermined date
2. To pay regular coupons - a set level of interest paid to the investor during the life of the loan

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

1. 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.
2. The more risk, the higher the interest rate
   This is because investors need to be compensated for the amount of risk they are taking.
3. The higher expected inflation, the higher the interest rate
   To prevent inflation from eroding away their profits, investors include an inflation premium in the interest rate they earn.

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

So, how do you make money from bonds?

As mentioned earlier, bonds (with the exception of zero coupon bonds, which will be discussed later) pay out a regular stream of interest known as coupons. There are several ways the bond issuer can go about this, depending on the type of bond. Below are some examples:

• Fixed rate bond - a bond with a fixed coupon rate
• Floating rate bond - a bond with a variable coupon, usually tied to a reference rate like HIBOR, for example
• Zero coupon bond - a bond that pays no interest during the life of the bond, but is instead issued at a deep discount from its value at maturity

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

As mentioned, the price of a bond can fluctuate throughout its tenure. This fluctuation is in response to the current interest rate environment. Since bonds cannot change their coupon rates to align with current interest rates, their prices will adjust accordingly so that their yields can do so.

What is yield? Put simply, it is a measure of return available from a bond. Take the example of a one-year bond with a par value of $100, which pays out a 5% coupon (i.e. $5) on an annual basis. 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 the market. This way, the bond will not be any less attractive than any other investments in the market.

Conversely, should market interest rates drop to 4%, the price of the bond will increase accordingly to adjust for the change in yield.

Therefore as you can see, the price of a bond is inversely related to its yield.

Another 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 assumes that any coupons received from the bond are reinvested at a rate equal to the YTM. The calculation for YTM is based on the coupon rate and length of time to maturity, as well as the market price.

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

This is where duration comes in. Duration expresses 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 2% if interest rates fall by 1% and increase in value by 2% if interest rates fall by 1%.

In other words, duration can be an indicator of how risky 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 relation between the interest rate and the time to maturity of the debt for a given borrower in a given currency. Yield curves are usually upward sloping: the longer the maturity, the higher the yield. A longer-term loan usually involves more risk that the borrower will default, or interest rate will change, or the lender will find a better potential use for their money.

Generally speaking, yield curve can be broadly classified into three main types.

There are several ways to invest in bonds. Most individual bonds are bought and sold in the over-the-counter (OTC) market. The OTC market comprises securities firms, banks, brokers or dealers that trade bonds every day. Often, brokers will not charge a commission to buy bonds but will mark up the price instead. Hong Kong investors can buy and sell bonds in the secondary market. Many dealers keep inventories of a variety of outstanding (i.e. previously issued) bonds. However, the entrance threshold of individual bonds is high, in relation to which a minimum amount of investment is required.

Bond funds offer Hong Kong investors another way to invest in the bond markets. Bond funds, like stock funds, offer professional selection and management of a portfolio of securities. They allow an investor to diversify risks across a broad range of issues and offer a number of other conveniences, such as the option of having interest payments either reinvested or distributed periodically. Fees and charges apply when investing in both bonds and bond funds. General charges of bond funds include subscription fees and management fees.

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 stocks and shares.

So, how do you invest in bonds? The easiest way to get started is to invest in a bond fund. But why not invest in a bond direct? Here are the reasons:

1. Diversification
As the old adage goes, do not put all your eggs into one basket. As the past year has seen, 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 a fund manager, ensures proper diversification across regions, sectors and companies.

2. High investment amount
A purchase of a single bond typically needs a much higher entrance threshold, e.g. HKD100,000*. A bond fund offers a much more convenient and affordable way to invest, with thresholds as low as HKD3,000. 
* the minimum investment amount starts from HKD100,000, depending on the type of bonds and the respective market prices at the point of trading.

3. 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).

4. 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 maximize 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) based on an economic forecast or adjust the credit quality of the portfolio when economic growth is accelerating.

Often in the newspapers, you may have come across news about a company being downgraded (or upgraded) by a rating agency. What does this mean?

A credit rating agency is an independent rating agency that analyzes and publishes a credit rating on companies and governments which issue bonds. These rating agencies periodically 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 or decrease depending on the changes. Common rating agencies include Moody’s, Standard & Poors and Fitch, and rating agencies' rating decision is 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

Put simply, a rating assigned to a bond issuer can be a useful guide to the question: "when I lend my money to this company today, what is the possibility that I will get part or all of my money back?"

Each credit agency has its own grading system. 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).

There are a number of risk factors that affect bond investing, e.g. credit quality of issues, economic fundamentals, government policy, interest rate and exchange rate fluctuations, etc. All these factors are inter-related and become more significant as different markets evolve and none of them can be neglected. For example, interest rate movements are affected by the change of economic environment and government policy. Below are some of the risks that we as an investor should not overlook.

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, e.g. securities issued by Ginnie Mae, Fannie Mae or Freddie Mac as most asset-backed securities tend to carry bond insurance that guarantees payments of interest and principal to investors. On the contrary, bonds issued by corporations are more likely to be defaulted as companies often go bankrupt.

Counterparty risk – The risk that the other party in an agreement will default on the obligation and fail to fulfil the contractual agreement. In other words, counterparty risk is a type of credit risk. In general, counterparty risk can be reduced by having an organization with extremely good credit act as an intermediary between the two parties.

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 more liquid assets, such as investment grade bonds, or debts rated BBB-/Baa3 or above by S&P or Moody’s. They are more resilient to liquidity risk than non-investment grade bonds.

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:

• Asset-Backed Securities - These are bonds created from car payments, credit card payments or other loans. This kind of loan is bundled together and packaged as a security sold to investors. The most common examples of asset-backed securities include collateralized debt obligations (CDO) and mortgage-backed securities (MBS). Asset-backed securities are usually “tranched”, which means that loans are bundled together into high-quality and lower-quality classes of securities. These loans are backed by a private guarantor and there is no assurance that the private guarantors or insurers will not default.
• Government Bonds – These are bonds issued by a national government, denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds, for example, UK Gilts, US Treasuries, German Bunds, Japanese Government Bonds and French OATs, etc. 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.
• 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 fall into two broad categories: investment-grade and speculative-grade (e.g. high-yield or “junk”) bonds. Corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly. (Please refer to the rating agency section). Corporate bonds often pay higher rates than government bonds, because they tend to be riskier.
• High Yield Bonds – These are speculative-grade bonds which are issued by less well-known companies perceived to have a lower level of credit quality by the rating agencies. They have higher default risk compared to more highly rated investment-grade companies. Because of the higher risk involved they pay higher coupons (and hence the term ‘high yield’).
• 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. The emerging market bonds usually offer very attractive yields and also pose special risks such as currency fluctuation, economics and political risk. An emerging market bond would usually be more volatile than that of developed markets. Again because of the higher risk involved, their yields are generally higher.
• Inflation Linked Bond - The interest rate 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) – These are bond securities created from the monthly mortgage payments. Mortgage lenders sell individual mortgage loans to another entity that bundles those loans into a security that pays an interest rate similar to the mortgage rate being paid by the homeowners. MBS like all other bonds are sensitive to changes in prevailing interest rates and could decline in value when interest rates rise. Most MBS are backed by a private guarantor and there is no assurance that the private guarantors or insurers will not default.

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, high grade bonds tend to outperform as risk aversion increases and interest rates fall. On the other hand, during a period of economic recovery, high yield bonds would tend to outperform as credit conditions improve.

Schroders’ approach to managing bonds aims to add value from three levers:

Credit - Capitalizing on Schroders’ credit research capabilities to generate higher returns from investing in higher yielding bonds at acceptable risk.

Interest Rates - Active duration management to generate returns based on interest rate expectations. For example, the fund manager aims to lower duration in a rising interest rate environment and to raise duration in a falling interest rate environment.

Currency – Aiming to benefit from expected currency trends. For example, a weakening US dollar allows a fund manager the opportunity to enhance the returns potential on a bond fund.

• Experience - Schroders has a long and successful history, commencing in 1804. Managing fixed income investments is an important and well established part of our heritage. We have been investing in bonds for over 50 years, successfully guiding clients through all the stages of market cycles. We currently manage in fixed income assets for clients in the UK, continental Europe, the US, Asia and Australasia. 

• Deep resources - With an integrated team of fixed income professionals in Europe, Asia and North America, we’re able to identify and exploit opportunities across the world’s interlinked bond markets.

• Research commitment - We have a strong belief that independent analysis drives results. Our team is providing our fund managers with unique insights.

• A global business - Schroders is a global asset management company in many countries.

• Focus - We have only one business, asset management. We are 100% focused on delivering strong performance for our clients.

Know more

Q: I purchase a HKD20,000, five-year bond with a coupon rate of 5%. What will your interest payments be each year?

A: The coupon rate is 5%, which means you receive $1,000 each year (5% of HKD20,000)

Q: I own a corporate bond and the issuing company reports a large operating loss for its fiscal quarter. What concern should you have related to the bond’s rating?

A: Moody’s or Standard & Poor’s may downgrade the bond’s rating. A downgrade could indicate further financial problems with the issuer. If you intend to sell the bond, you may not be able to command as high a prices as you paid for it. 

Q: I own a 6% bond and want to sell it in a year. Do you hope that interest rates rise or fall?

A: You hope that interest rates fall. When interest rates fall, newly issued bonds will likely offer a lower interest rate. So your bond paying 6% will be more appealing to investors and thus command a high price.

Q: I buy a bond and intend to hold it to maturity. Are the bond’s changing price and yield a concern to you?

A: No, if you intend to hold a bond to maturity, you typically can ignore its fluctuating price and yield, assuming that the issuer is still able to pay you as scheduled.

Q: I sometimes hear that rising bond prices are a good thing and that rising bond yields are also a good thing. How can both be true when they move in opposite directions?

A: Rising bond prices are good news for a person who owns a bond. They mean that investors are willing to pay more for the bond. Rising yields are good news for a person who wants to buy a bond. Remember that rising yields typically mean that bond prices are dropping. The buyer can get the same interest payments for less money.