Key Considerations When Investing In Bonds

February 11, 2015

3 Key Considerations

Before you make a bond investment, it is perhaps important to ask yourself three key questions:

1. What’s the potential return?

Expected returns are a critical consideration when choosing a suitable bond to invest in. Unlike equity market investors who may have more difficulties in establishing reasonable forecasts for stock market returns, the “fixed” nature of fixed income allows one to have a better sense of potential investment returns. In fact, if an investor holds a bond to maturity, returns are known in advance, in the absence of a default by the issuer. Deciding the level of return required on a bond allows the investor to focus on a particular segment of the bond market where such levels of return could be achieved.

The best proxy for establishing a potential return for a bond investment is its yield-to-maturity*, which is an annualised measure of the rate of return expected from a bond over its lifetime. The higher the yield-to-maturity, the higher the potential investment return compared to a bond with a lower yield-to-maturity figure. Typically, higher yielding bonds tend to be issued by lower quality companies or governments whose credit histories are more suspect. Intuitively, companies or governments which have a better credit standing have bonds which command a lower yield.

*The yield-to-maturity of a bond assumes the reinvestment of bond coupons at the bond’s current yield

2. What’s my risk?

As is common for most investments, the higher the potential return, the higher the investment risk. For bonds, risks centre on 1. Creditworthiness and 2. Interest Rate movements. Creditworthiness is dictated by the likelihood of default by an issuer. Since bonds are essentially loans to companies or governments, a more creditworthy issuer would entail lower risk of default while the converse is true for less creditworthy issuers. Understandably, bonds which offer better potential returns tend to be those of lower quality or highly-leveraged companies and governments.

Since bond prices and interest rates tend to move in opposite directions, investors in bonds are also exposed to interest rate risk (the risk that interest rates rise). A measure of how exposed a bond is to interest rate risk is duration, which is a measure of how much a bond’s price is expected to react to changing interest rates. In general, the longer a bond’s maturity, the longer the bond’s duration and hence the more susceptible the investor is to interest rate risk.

3. What’s my currency exposure?

Currency fluctuations affect investment returns so fixed income investors will do well to understand their currency exposure in any bond investment. While it may be difficult to determine currency risk in a stock due to myriad considerations (the geography of the company’s underlying assets and business lines, the implementation of hedging activity etc.), assessing currency risk is fairly straightforward for a bond investment – investors should note the currency in which a bond is issued, since that represents the currency risk they are exposed to in that particular bond.

Currency fluctuations may add to or subtract from investment returns in a foreign currency-denominated bond. For example, a Singapore investor holding a USD-denominated bond is exposed to USD currency risk; if the USD depreciates against the SGD, the investor receives a lowered rate of return. Conversely, the investor may receive a boost if the USD appreciates against the SGD. Similarly, a Hong Kong-based investor who buys a SGD-denominated bond will be exposed to SGD currency risk over the life of the bond. Where possible, investors should focus on bonds denominated in their home currency to avoid taking on unnecessary currency risk.

The Research Team is part of iFAST Financial Pte Ltd.