Bonds are fixed income instruments that are very common among investors. It is a loan given by the investor to a company or the government who will in turn pay an interest rate annually to the investor. These loans are usually used to fund projects and operations within the company/ government. Bonds have a maturity date (e.g. 5 years/ 10 years) where the principal amount must be paid back to the investor. The interest rates, principal amount and maturities vary depending on the time period as well as the issuer of the bond.
E.g. If the interest rate of a bond is 4% annually and the investor buys $1000 of the bond with a maturity date of 10 years, he will receive $40 per year and at the end of the 10 years receive the full principal amount of $1000. Thus, the returns in total are $400 over 10 years for the investment.
Bond Issuers
A corporation or the government usually issues bonds to fund their operations. For example, corporations will often need money for research and development while the government will require money to build infrastructure such as roads, schools etc. A common government bond in Singapore is the Singapore Savings Bond. Corporate bonds are issued by the different companies directly to investors.
Risks
Bonds are generally considered a lower risk financial asset as it gives regular annual payment of interest as well as return of the full principal amount at the maturity date. They are not as volatile compared to equity instruments (e.g. stocks, ETFs) and thus can be included in your investment portfolio if you are looking to diversify your risk profile.
However, there are still some risks involved when investing in bonds. Firstly, the issuer of the bond may default on paying the investor the full principal amount at the maturity date. This may be due to a company going bankrupt during the period and thus unable to pay their investors. This is more so in the case of corporate bonds compared to government bonds. Therefore, before investing in bonds, you will have to look at its historical rating to judge the financial strength of the company.
Secondly, bonds are affected by the current interest rate levels in the region. When interest rates increases, the bonds that you own are worth less. This is because the new bond coupons being issued will be of a higher interest rate compared to the one that you have purchased. This is especially in the case if you had invested in a bond ETF. The value of the bond ETF will drop as it has a lower interest rate and is worth less compared to the newly issued bond coupons.
Conclusion
Before investing in bonds, you still have to do your research to understand the ratings of the bond as well as the bond issuer. Bonds are considered a lower risk financial asset that can be used to diversify your portfolio and risk profile. It can provide a conservative return of 3-5% per annum that is sufficient to grow your wealth against inflation. However, it may not provide the higher returns when compared to equity stocks that can return up to 10% per annum. If you are a more conservative investor, you can allocate a greater proportion of your portfolio into bonds, as they do not fluctuate as much when compared to equity stocks. If you are a more risky individual, you may want to limit your exposure to bonds and increase allocation towards equity stocks instead. Thus, you can then allocate these financial assets in your portfolio to suit your risk profile accordingly.
Wealth Wrangler 