1. Bonds always make money
While bonds are structured to make money for investors, there are two key instances where investors may lose money when investing in a bond. First, the fixed nature of coupon payments and principal repayment are only valid if the bond is held to maturity. Should an investor sell the bond in the secondary market prior to maturity, there is the possibility of realising a mark-to-market loss, particularly in the case where interest rates have risen in the interim, resulting in a rise in bond yields. As such, investors who want to “lock-in” returns may wish to consider holding a bond to maturity. The second instance where investors may lose money when investing in bonds is in the event of a default, where the issuer is unable to make good on coupon payments or bond principal. Nevertheless, when companies go belly-up, bondholders usually receive some of the proceeds from the bankruptcy process (the recovery rate is the amount received expressed as a percentage of face value of the bond), given that bonds are ranked above equity in the capital structure hierarchy.
2. A higher yield is always better!
All things equal, a higher yield on a bond should be preferable to a lower yield. However, all things are rarely equal! A higher yield on a bond is usually offered to compensate investors for higher risk undertaken. For example, a lower quality company will have to offer investors a superior coupon rate vis-à-vis a company with better fundamentals to compensate for the higher risk of default. Even for bonds of the same company, yields on different issues can differ if their maturity dates are different, if there are differences in their capital hierarchy (senior versus junior), or if there are embedded options. In general, longer maturity bonds will offer a higher yield compared to shorter maturity ones, given that there is more interest rate risk inherent in the former. While yields are a good starting point when looking for a suitable bond to buy, it is also important to know about the various differences between bond issues and not base your investment decisions solely on yield alone.
3. Bonds will always lose money when interest rates rise
It is common knowledge that bond prices and interest rates are negatively correlated – that is, when one rises, the other falls. However, the relationship is not always that straightforward. Bond yields are a reflection of both the interest rate environment, as well as the credit risk of the issuer. For risk-free sovereign bonds, the inverse relationship between interest rates and bond prices generally holds true. However, for corporate bonds which entail some credit risk, the relationship may not be that straightforward. Interest rates tend to rise when economic growth improves; the perceived default risk may be lower as investors expect fewer corporate defaults under stronger economic conditions. As such, it may be the case that corporate bond yields actually decline even as interest rates rise.
4. Government bonds have no risk!
While it is common to refer to government bonds as “risk-free” securities, this may not be completely accurate. While it is true that credit risk is not a concern for most government bonds, investors who invest in a government bond are still exposed to interest rate risk – should yields rise in the interim (prior to a bond’s maturity), an investor who wants to sell a government bond in the secondary market could still realise mark-to-market losses. In addition, sovereign credit risk is generally not an issue when investors lend to credible governments with a good track record of paying principal and interest. However, history has shown that even governments have defaulted on their debt obligations - while these cases have generally been limited to selected Emerging Market issuers, the fairly recent restructuring of Greek sovereign debt may dispel the myth that all developed country sovereign debt is free from credit risk.
5. Bond funds are better than investing in direct bonds
While bond funds certainly help to bring a strong element of diversification to investors, it must be remembered that bond funds are structured to be perpetual investment instruments, while bonds (with the exception of perpetual securities) have a known maturity date. This is an important distinguishing factor between the two, as the fixed maturity date and coupon payments for a particular bond provides the certainty of a known rate of return for an investor, assuming the bond is held to maturity. This is impossible to replicate in a bond fund, unless the fund is structured with a fixed maturity as well (which is rarely the case). Both instruments have their respective pros and cons, and it is important to understand their differences and limitations prior to making an investment in either.
The Research Team is part of iFAST Financial Pte Ltd.