Bonds 101: What are bonds and bond funds?
Bonds, which are also known as fixed-income securities, can be one of the safest ways to invest your money. These financial instruments provide a steady stream of income and upon maturity, you receive the principal amount that you had invested.
Governments and corporates regularly raise funds by issuing bonds. Older investors and those saving for retirement find these instruments especially attractive because of the safety that they offer and the predictable nature of their returns.
But an investment in bonds could also be risky. If the company that has raised money through this route faces difficulties, it may delay or even default in the payment of interest. In extreme cases, bondholders may even lose the entire sum that they have invested.
How can an individual make a risk-free investment in bonds? The safest route is to put your money into Singapore Savings Bonds, a financial instrument issued by the Singapore government. But remember that although your money will be absolutely safe, the interest rate that you will earn will be fairly low.
If you are looking for higher returns, then bonds issued by corporates provide a better option. But to earn a greater rate of interest, you will have to be willing to take on additional risk, a factor that usually discourages many investors.
Bond funds can offer a viable option for an investor looking for safety as well as returns. Unfortunately, these instruments have their downsides too.
Let us examine Singapore Savings Bonds and bond funds in a little greater detail.
Singapore Savings Bonds
Buying Singapore Savings Bonds involves three simple steps:
- You need to have a bank account with DBS/POSB, OCBC or UOB.
- You also should have an individual CDP Securities account that is linked to your bank account.
- An application for Singapore Savings Bonds can be made at the ATM or through internet banking. At the time of making your application, you will have to mention your CDP account number.
If the total applications in value terms exceed the amount on offer, you may receive bonds of a lower value than you had applied for. But there is a fair chance that you will not be disappointed. In December 2016, the Monetary Authority of Singapore had announced that up to S$2 billion of Savings Bonds would be offered in 2017.
The Savings Bonds have a maturity period of 10 years. In the event that an investor wants to exit earlier, it is possible to opt for redemption at any point in time. In a unique feature, early redemption does not invite any financial penalty.
The minimum investment is just S$500 and it is possible to invest additional amounts in multiples of S$500 for a total of S$50,000 per bond issue. As bonds are issued on a monthly basis, fresh investments can be made in subsequent months, but the maximum individual holding is limited to S$100,000.
The interest rate on Savings Bonds is linked to Singapore Government Securities yields. The Savings Bonds that you buy will have a certain rate of interest that will remain fixed for the entire 10-year tenure.
If you subscribe to the Savings Bond issue of February 2017 you will earn an effective return of 2.44% per year. The total interest that you will receive over the 10-year bond period will be S$2,495.
Instead of buying bonds directly, it is also possible to invest in bond funds. These are funds that invest in bonds and pay regular dividends based on their earnings.
Why should an investor buy a bond fund instead of a bond? As the fund invests in many different bonds, your risk is reduced. This is especially important if you are looking for the higher yields that are normally available on corporate bonds.
But even though a bond fund invests all its money in bonds, the two instruments are very different.
One important difference is that a bond issued by a company or by the government will have a maturity date. When the tenure of the bond expires, you will receive your principal sum in its entirety. But a bond fund does not have a maturity date. The only way to redeem your principal is to sell your holding in the market.
In the event that interest rates on bonds have risen since you made your investment in the bond fund, the value of your holding will have dropped. Interest rates and bond fund values have an inverse relationship as new bonds being issued at higher coupons will lead to a decline in the market value of the lower interest rate bonds being held by the fund.
While bond funds do give you the advantage of diversification, they do not by any means provide an assurance that your principal will not get eroded.
Before investing, determine your risk profile and objectives
Bonds, especially those issued by the government, can be a very safe way to deploy your savings. But corporate bonds do carry a degree of risk and it is important to understand this before committing your money.
A rule of thumb that you can use to determine the risk that an investment bears is to judge it by the interest rate it offers. A bond with a high interest rate will usually be a riskier investment than one which offers a lower rate.