Diversifying your Portfolio with Bonds
Experienced investors know the importance of having a diversified portfolio to grow their wealth. Equities, property, a variety of unit trust funds, cash as well as bonds, should form core elements of your financial portfolio.
Due to the general unavailability of bonds to the ordinary retail investor and the high entry-level investment required, the avenue for investors to bonds has traditionally been via unit trust funds.
Standard Chartered offers you greater access to bonds in multiple currencies at a minimum amount of US$50,000 or its equivalent*.
* US$50,000 applies to foreign currency bonds only. A minimum of RM250,000 will be required for local currency bonds or RM denominated bonds.
The Basics on Bonds
When companies and governments need to raise money for various reasons, from infrastructure to expansion, they issue bonds which can run into hundreds of million in Ringgit and foreign currencies. Institutions and investors then lend money by purchasing the bonds in return for interest, much like how a loan works. These bonds can then be bought and sold on the secondary market.
|Basic Bond Terminology
||The party seeking to raise funds
||The party lending funds to the Issuer
||The interest rate paid to the Investor
||The return on your bond investment
||The amount borrowed stated on the bond
|Trading at a Discount
||The bond price is lower than its face value
||The total yearly amount at which the bond price is trading lower than the face value
||The length of time till the bond maturity date
||The date on which the Issuer has to repay the face value to the Investor
The Pricing of a Bond
Regardless of the face value of the bond or the price at which it was issued, the price of a bond on the secondary market may rise or fall, depending on various factors. This bond price is usually quoted as a percentage of the face value. There is an inverse relationship between market interest rates and a bond's price: as a general rule, when market interest rates rise, the prices of existing bonds decline, and when the market interest rates decline, prices of existing bonds increase. This relationship is one of the factors that explains why a bond can trade at a premium price (above face value), at face value, or at a discount (below face value).
||Current Market Value
||Price of Bond Described as a % of the Face Value
|Bond at discount
|Bond at par
|Bond at premium
Calculating the Yield on a Bond
Assume the market value of a RM100 bond with 5% p.a. coupon is at RM102. The bond is therefore said to be at 102. Let us now calculate the yield on this bond.
Annual coupon on the bond = 5% x RM100 = RM5
Yield on bond = RM5 / RM102 x 100% = 4.90%
The above computation of yield is true if the bond had a 1-year tenure. But what if the bond had a 10-year tenure? This involves a few additional simple steps.
Calculate the annual premium you are paying
= Premium paid on bond / tenure years
= RM2 / 10 years
Annual premium expressed as a percentage of market value
= Annual premium / market value of bond x 100%
= RM0.20 / RM102 x 100%
Deduct the annual premium from the annual bond yield
= Yield on bond - annual premium on bond
= 4.90% - 0.20%
= 4.70% is the annual yield on the 10-year bond
- If the bond was trading at a discount, then for Step 3, you would need to add the annual discount to the coupon yield.
- While the above example may not provide a precise answer due to compounding effects over the tenure of a bond, it provides an acceptably good indication of the returns or yield you can expect to earn.
The Importance of Bonds as an Investment
When equity markets are going through a bull run, investors are excited and many make the mistake of neglecting to balance their portfolios with more neutral investment choices like bonds. It is only in the face of a bear market that we realise how important the safety and stability of bonds are to an investment portfolio.
Before you invest, however, you need to understand there are risks involved when it comes to investing into bonds. Some of the main risks in investing in bonds are:
- Interest rates risk: Bonds usually pay a fixed coupon, This means that a rise in interest rates generally result in bond prices falling conversely, when rates decline, bond prices rise.
- Credit risk or default risk: This is the risk that a bond issuer will be unable to make interest or principal payments when they are due.
- Currency risk (for investment in foreign currency bonds): Foreign currency investments are subject to exchange rate fluctuations which may affect, unfavourably or favourably, the effective return on the bond.
- Liquidity risk: Investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value. Also, most bonds are subject to a minimum transaction threshold. If your investment is less than that threshold, you will not be able to sell until and unless there are enough other investors who also want to sell.
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