Investing in Bonds
INVESTING IN BONDS
Malaysian retail investors have never actively participated in bond investing. Some of you may have bought bond funds offered by the unit trusts, however, most of you may not know what a bond investment is really about and the effect of it has on your investment portfolio.
So then….What is a bond?
A bond represents the debt owed by either government units or corporations. By investing in bonds, you basically become the lender to the issuers and you will be paid a specified percentage of interest. This percentage of interest is called coupon payment, and it is given to you by the issuer because of the use of your money. At the end of the maturity date, you will get back your principal. An example to quote is the Bond Simpanan Merdeka 2008 issued by Bank Negara for the senior citizens, which has a 3-year tenure and pays 5% interest per year.
In Malaysia, the main issuers of public debt are the Government of Malaysia, the central bank (Bank Negara Malaysia), and quasi government institutions (Khazanah, Danamodal and Danaharta). Private debt securities and asset-backed securities are issued by the National Mortgage Corporation (Cagamas Berhad), financial institutions and non-financial corporations. The major investors in Malaysian Bond market are the Employees Provident Fund (EPF), pension funds, insurance companies and other financial institutions.
The price of a bond is determined by many factors, with the main drivers being interest rates, inflation, maturity and credit quality.
* Interest rates
Bonds are highly sensitive to interest rate fluctuation. When the prevailing interest rate goes up higher than the coupon rate, the prices of the outstanding bonds will fall below the principal value. If you are buying a bond fund, higher interest rates will cause lower fund prices.
During periods of rapid economic growth, we will see increasing inflation. This will eventually lead to higher interest rate and cause a drop in the value of bonds.
Due to the sensitivities to inflation and interest rate fluctuation, longer term bonds will face more uncertainties compared to shorter term bonds. As such, longer term bonds should offer better interest payment as the additional risk premium for the investors. Nevertheless, it will suffer higher price fluctuation as a result of the longer period it takes to mature.
* Credit quality
When we lend out our money, we would want to make sure that we will be able to get it back. Therefore, the credibility or credit quality of the bond issuers plays an important role in the bond price. A corporate bond will have higher yield than a government guaranteed bond, due to the additional risk that the investor has to bear for facing the possibility of the corporate bond getting defaulted. The recent global financial crisis was partly attributed to the decline in credit quality for certain corporate bonds.
Why invest in bonds?
Investing in bonds offers an alternative to investors to diversify their investment portfolios due to its nature of having relatively lower risk compared to stock investing. As bonds provide periodic interest payment and repayment of principal at the end of the maturity, it will be suitable for you if your investment objective is to preserve capital and receive a predictable stream of income. Depending on your investment time horizon, you can choose to invest in short, medium or long term bonds. However, you must understand the factors that drive the price of the bond that you invest in.
As retailers, most of the time we will be investing in bond funds offered by some unit trusts or commercial banks. Bond funds are combinations of various bonds, therefore, the risk of investing in bond funds is relatively lower compared to individual bonds. However, you must take note of the factors listed above while selecting an appropriate bond fund. In addition, you will also need to know about the fund management companies and make sure that the approaches they take are suitable for your risk profile and investment objectives. The timing of investing in bond funds is also very important.
What to watch out for when investing in bonds?:
- Watch out for the interest rates especially if it is too low or unstable.
- Avoid speculative bonds. Even when you are investing in bond funds, make sure that the bonds in the portfolio are investment grade, which carries a credit rating of BBB and above. Bonds with rating of BB and below are considered ‘high yield’ and below investment grade.
- Don’t invest a large portion of your portfolio in bonds. It will limit your portfolio growth, as over time, inflation will erode the fixed income stream and principal. Bonds are suitable to complement stock investing.