Debunked: Bond investment myths
It is well established that an investment in bonds should form part of every individual’s asset allocation strategy. Fixed-income securities are meant to provide stability to your portfolio when other asset classes, notably stocks, experience volatility.
The commonly held belief is that although stocks are inherently risky, they have the potential to register significant increases in value. Bonds, on the other hand, will provide steady returns and reduce your level of risk. In other words, stocks are high risk/high return investments while bonds fall into the low risk/low return category. For more personalised assistance with your bond or fixed income securities investments, click here.
This line of thinking is strengthened by the “100 minus age allocation rule,” which says that a greater percentage of your funds should be deployed in fixed investment securities as you age. According to this maxim, 100 minus your age is the percentage of your investible resources that should be in stocks.
Hence, as a 35-year-old you should allocate 65% of your savings in stocks and 35% in bonds. As you age, you will need to rebalance your portfolio so that a greater percentage is allocated to fixed income securities.
But this rule, and bond investments in general are based on several widely held beliefs that may not necessarily be true.
Let us examine some of the myths surrounding fixed income securities.
Myth #1 – bonds are absolutely risk-free
Losing your money when you make an investment in fixed-income securities is a very real risk. If you purchase corporate bonds, you are assured of receiving regular coupon payments only if the company continues to have the ability to meet its financial commitments.
However, bonds issued by the Singapore government fall into the category of risk-free investments. Singapore Savings Bonds, which have a term of 10 years, are a totally secure way to deploy your money. You will receive interest payments every six months and at the end of the 10-year period, you will get your principal back.
But, you pay a price for keeping your principal safe. An investment in Singapore Savings Bonds will provide a low return – you cannot expect to earn more than 2% to 3% per year.
Corporate bonds can give you much higher returns. It is quite possible to earn double the return, or even more, of what a government bond offers. But, companies are at the mercy of market conditions. If the industry that they operate in goes through a downturn, they may be unable to meet their debt servicing obligations.
According to a recent Bloomberg report, Ezra Holdings Ltd, a firm providing engineering services to offshore oil and gas companies, has filed for bankruptcy as it is unable to generate the cash to pay its bondholders. In fact, large numbers of Singapore’s companies could face the prospect of defaulting on their repayments in the coming years.
Source – Bloomberg
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Myth #2 – bond yields remain unchanged
Bond prices and the prevailing interest rate, share an inverse relationship. If interest rates rise, you can expect bond prices to fall. Why does this happen?
If you purchase a bond that has a 5% coupon, and interest rates subsequently rise to 6%, your bond becomes a little less valuable because investors now have the ability to earn a higher rate in the market.
Source – Investing.com
This factor exposes you to price risk. In a rising rate environment, you could face a capital loss if you decide to sell your bond holdings before maturity.
Myth #3 – a higher coupon rate is better
While it is true that a higher coupon rate will give you a greater return on your investment, you also face the possibility of losing part or all of your principal. Bonds that carry a negligible risk of default will invariably offer very low interest rates. Government bonds or fixed income securities issued by highly profitable and stable companies fall in this category.
In fact, if a company issues a bond that carries a high coupon rate, it could be an indication of its lower credit standing. Swiber Holdings Ltd, a Singapore-based company issued bonds yielding 7.125%. The company is under judicial management as it is unable to service its borrowings.
To learn more about FX bond products with high coupon rates that come from a company with a good credit standing, click here.
Myth #4 – bond funds are better than individual bonds
Bond funds offer investors several distinct advantages. They help you to spread out your risks. These funds invest in the securities issued by dozens of companies and a default by a single firm would not have a very great impact on their performance.
But bond funds have some disadvantages that could outweigh the benefits that they offer. They usually employ a number of highly paid professionals and can also carry large administrative costs. These expenses can eat into your returns.
Another downside of a bond fund is that it usually operates in perpetuity. In a rising rate environment, you could suffer a capital loss. If you hold an individual bond, you will not face this issue. By holding the bond until maturity, you would be able to redeem it at face value.
Furong Investments offers the Furong 2 year 9.6% FX Bond product, which is a high return, low risk bond and offers a consistent fixed pay-out semi-annually. To understand how it differs from other FX bonds, click here.
Bond investments should not be made blindly
Like all investments, fixed-income securities carry risks as well. A corporate bond may not pay interest on time. It may even default on the principal amount. An investment in a bond fund may not yield the expected return.
It is essential for an investor to understand the nature of the organisation that is issuing the bond. How will the money be utilised and more importantly, from which sources will repayments be made?
Gathering this information is especially important when you are considering putting your money into the bonds issued by a company about which you have little knowledge. If you carry out a due diligence exercise before you make an investment, you could save yourself from a great deal of grief.