If you have not read, click here for “Introduction of Bond Investment in Singapore”.
To understand bond investment risk, you need to understand bond price first.
Bond prices are usually quoted as a percentage of the par or face value of the bond, e.g. 101% or 96%.
|Bond Price > Face Value||Premium|
|Bond Price < Face Value||Discount|
|Bond Price = Face Value||Par|
Bond prices may be affected by many factors. Two important factors which cause bond prices to fluctuate are
- Credit quality of the bond issuer
- Prevailing interest rates
Bond issuer’s credit quality risk
Bonds of issuers with higher credit quality generally trade at lower yields than bonds of issuers with lower credit quality. A higher yield compensates investors for the higher risks they are exposed to with poorer quality bonds.
Investors are advised to find out more about the bond issuer and the business sector it operates in. Events or factors which may impact the issuer’s business operations, financial conditions and creditworthiness (ability to repay its debt or likeliness to default), will also impact the issuer’s share price or bond price.
Bond issuers may be rated by credit rating agencies such as Fitch, Moody’s or Standard and Poor’s. Credit ratings represent the opinion of the credit rating agencies as to the creditworthiness of the issuer. This is additional information which investors may wish to take into account in their assessment.
Credit ratings are not a recommendation to invest in the bonds. They also have their limitations – the ratings are based on information available at the time the rating is assigned so they are subject to revision or withdrawal. As issuers’ financial strength can change quickly, there is no assurance that any revisions to the ratings will be made in a timely manner.
Investors should therefore carefully consider all relevant information before making their investment decisions, rather than rely solely or mechanistically on individual yardsticks such as credit ratings.
How are credit ratings issued?
Issuer credit ratings are usually divided into long-term and short-term categories based on the maturity and form of the debt instrument. Short-term ratings are assigned to instruments with maturities of 1 year or less. Ratings are also grouped into investment-grade debt and non-investment grade (speculative grade) debt. Within these groups are further ratings.
Rating agencies also give Outlooks which assess the future direction of an issuer’s credit rating over, say the next six months to two years). A Positive rating outlook indicates a potential rating upgrade while a Negative outlook shows a potential downgrading. A Stable outlook means there is likely to be no change.
Issuers are placed on a rating watch when a credit rating agency is reviewing their current credit rating.
Price risk and interest rate risk
Generally, bond prices are inversely related to interest rate movements. A rise in interest rates could see a fall in bond prices. The price adjustment compensates the buyer for the coupon which is lower than comparable market rates. Similarly, if rates fall, the buyer pays a higher price for receiving a coupon that is higher than comparable market rates. Investors who choose to sell their bonds in a rising interest rate environment will suffer a capital loss if bond values are now below the price they paid. On the other hand, if investors continue holding the bond, they will incur opportunity cost as their funds could have been invested in higher yielding instruments.
Market price fluctuations may not matter as much for investors who buy and hold as they will receive interest throughout the life of the bond and principal at maturity, provided there is no issuer default. Investors in bond funds, on the other hand, may be affected by interest rate movements as these will have impact on the funds’ net asset value and so the price at which investors can redeem their units.
Interest rates are in turn determined by macroeconomic factors, such as the state of the economy, inflation, unemployment, international trade and government fiscal and monetary policies. The longer the life of the bond the more sensitive will its price be to changes in interest rates.
What are other risks investing in bonds
|Factor / risk||What this means|
|Default (or credit risk)||Bonds are forms of debt, so bond prices will be affected by the perceived credit quality or probability of default of the bond issuer. When an issuer defaults, you may lose all or a substantial part of your investment.|
|Call risks||Some bonds have a callable feature which gives the issuer an option to buy back (redeem) the bond before its maturity date. If a bond is called when prevailing interest rates are lower than at the time you bought it, you will be exposed to reinvestment risks.|
|Price risk and interest rate risk||Bond prices are inversely affected by interest rate movements. A rise in interest rates could see a fall in bond prices. If interest rates fall, buyers pay a higher price to receive a coupon that is higher than the prevailing market rates.|
|Reinvestment risk||In an environment of declining interest rates, investors may have to reinvest the income received and any return of principal at lower prevailing rates.|
|Exchange rate risk||Investing in bonds denominated in foreign currencies exposes the investor to the risks of adverse currency movements if investor’s own currency base is different.|
|Liquidity risk||Some bonds are less liquid than others. This may happen if the investors of a particular bond issue are largely buying to hold, so there are fewer buyers and sellers. This may make it harder to buy or sell the bonds. Even in cases where the bonds are listed or traded on an exchange, there is no certainty that a liquid secondary market will develop.|
|Inflation risk||This arises when the rate of inflation is higher than the bond’s coupon rate. This will erode the value of your investment as the purchasing power of the bonds’ coupons and principal falls.|
|Event risk||This is usually described in the prospectus. It can cover events that can unexpectedly erode an issuer’s credit strength and ability to make good on its debt payments, for example, natural disasters, takeovers, and restructurings.|
|Market risk||A bond’s price will fluctuate with changing market conditions, including the forces of supply and demand and interest rate changes.|
Is investing in bond safe?
As we can see from above, apart from market driven price fluctuations, an issuer’s bond price will suffer if investors feel that the issuer’s creditworthiness (its ability to repay its debt obligations) has deteriorated. For instance, if the issuer gets into serious financial difficulties, the likelihood of a default will increase. A missed coupon can also result in a credit event or default. If a default occurs, you may lose all or a substantial amount of the money you invest.
However, the bondholder is a creditor. If the bond issuer becomes insolvent or bankrupt, creditors are generally repaid first, before shareholders. Bonds are therefore generally regarded as less risky than shares.
Nevertheless, you should consider the suitability of an investment in bonds in light of your own circumstances. In particular, you should consider whether you:
- have sufficient sufficient knowledge and experience to make a meaningful evaluation of the merits and risks of investing in the bonds;
- understand thoroughly the terms and conditions of the bonds;
- have access to, and knowledge of, appropriate analytical tools to evaluate the investment in the bonds and how such investment will impact your overall investment portfolio;
- have sufficient financial resources and liquidity to bear all the risks of investing in the bonds or holding the bonds to maturity;
- are able to monitor or evaluate (either by yourselves or with the help of a financial adviser) changes in economic or other factors that may affect the issuer or the bonds.
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