When it comes to investment, the first thing that comes to your mind is probably investing in stocks. People argue about stock investment all the time. Market goes up, market goes down. This stock is good, that stock is bad.
But where do you put your money when no stock market is worth investing now?
To some people, the natural alternative seems to be bond investment. Bond investment is “boring” to some people. I am not going to discuss the merits of investing in bonds today, but I will give you my opinion of what kind of bond investments you should consider.
In a nutshell, a bond is a debt instrument. You lend money to a company or government, and they guarantee to
- Return 100% of your money back upon bond maturity
- Pay you a pre-agreed interest (known as the coupon) every year.
The key word here is “guarantee”. In a volatile and uncertain stock market like now, that sounds good right?
When people talk about investing in bonds, they are actually referring to bond funds. This is because in Singapore, most direct bond investment requires at least $200,000 capital outlay (except Singapore savings bond). Investing in bond funds is usually more efficient for two reasons
- You do not need as big a capital outlay as if you were to buy all the bonds in the fund. You can typically start with just $1,000.
- There are many bond fund options for you to choose based on your desired risks and returns.
But if you think you can just buy some top bond funds as safe haven, you’d be deadly wrong. The bond funds you are buying may be even riskier than stocks. Let me explain.
Types of bond funds
First, let’s understand the types of bond funds out there. Geographically speaking, you have
- Global bond funds – the fund managers invest bonds globally
- Regional bond funds – for example, emerging market bond funds or European bond funds
- Country-specific bond funds – for example, Singapore bond funds
On the other hand, you can categorize bond funds by the quality of underlying bonds. For example:
- Investment grade bond funds – high-quality bonds such as bonds issued by the Singapore government
- High yield bond funds – it is actually a nicer name for junk bonds. Unfortunately, many investors bought such bond funds for the “high yield”, not realizing the huge credit risks.
If you are not aware, many high yield bonds are in the oil and gas sector. Given the sharp falling oil price, many of these bonds are just like time bombs waiting to explode (default). When they default, not only you will lose your “high interest”, you will lose your capital too.
Nevertheless, most fund managers can manage such risks if they do a good job. But there is one common risk which nobody can escape.
Interest rate risk
If you want to invest in bonds, you must know one very important fact.
The interest rate has an inverse impact on the price movements of bonds.
In another word, when interest rate drops, bond price goes up; when interest rate rises, bond price goes down.
Because interest rates in Singapore tend to be influenced by US interest rate, rise in US interest rate has caused Singapore’s interest rate benchmark Sibor doubled in just one year’s time (as you can see from the chart below). That is why I have been reminding the readers to refinance your home loan (if you can) since last year.
How does a rise in interest rates translate to drop in bond price?
While you can receive regular income return from your bond funds, you should be clear that your real investment return includes two portions
- Income generated by bond interests
- Gains or losses of those bonds over a period of time.
You should always examine total returns when evaluating a bond fund’s performance. Here is why:
According to JP Morgan’s research (take US treasury bond as an example), a mere 1% increase in interest rate will cause 17.6% drop in 30-year bond price, 8.5% drop in 10-year bond price and 4.7% drop in 5-year bond price.
You may earn 3% to 5% interest from your bond funds, but I don’t think you will enjoy a 17.6% drop in your bond fund price right?
You may also realize that if the bond has a longer maturity date, more price will fall given the same 1% movement in interest rates. In another words, 30-year bond is much more sensitive to interest rate movements than a 5-year bond.
The time to invest in short-term fund is now
When you invest in bond funds, you should understand the fund’s investment objectives as well as the factors that can impact the returns the fund offers. You’ve got to choose the right strategy.
To recap what we have discussed just now. The main risks of investing in bonds are
- Credit risks
- Interest rate risks.
A short term bond fund will significantly reduce such risks.
Just imagine you are lending your money to two similar friends, both promise to pay you interest. One promises to give you back your money one month later, and the other promises to give it back one year later. Which one would you prefer?
Also known as short duration bond fund, a short term bond fund typically adopts a strategy to primarily invest in bonds with shorter maturity terms. I will use United SGD Fund, which is managed by UOB Asset Management, as an example.
This is a short term bond fund which “invests substantially all its assets in money market and short term interest bearing debt instruments and bank deposits”. From the latest fund factsheet, you can see the top 5 bond holdings as below
What “Bao-Trans Enterprise 3.7% 12/12/18” means is that
- The fund manager is getting paid 3.7% for this bond and
- The fund is supposed to get back 100% principle of this investment on 12/12/2018.
If you dive a bit deeper, you will realize that this short term bond fund has
- Weight average yield to maturity (average bond return in layman’s term) of 3% per year
- Effective Duration (average bond holding period) of only 2 years.
Moreover, this fund has nearly 17 tears of track record and only one negative return year during the global financial crisis in 2008, a mere 0.64% drop. The looks like pretty decent performance to me.
If 2016 is another year of crisis, such short-term bond fund is where you should park your money.
Well, I have covered a lot today. It is a bit technical but I hope it gives you a new perspective the alternative of stock investments. If you want to find out more about how I can help you with your investments, you can submit your request via the form below.