The second part in our Investment Instruments 101 series explores the often-overlooked yet fascinating world of fixed income investments. While not as headline-grabbing as equities, fixed income plays a critical role in a diversified investment strategy.
Introduction
Fixed income’s name is derived from its payment structure of fixed interest payments over a certain period of time until maturity. Companies and governments issue bonds to raise funding for their operations or projects. In return, the issuers pay investors regular payments (“coupons”) at a set interest rate, together with returning the original amount they had borrowed at maturity.
Fixed Income vs. Equities – A Comparative Glance
To gain a better understanding of fixed income, let’s compare bonds (a typical fixed income instrument) with equity, which we have learned previously in Part 1 of our series.
| Fixed Income | Equity | |
|---|---|---|
|
Payout Structure |
Bonds offer regular coupon payments following a predetermined interest rate.
Principal invested is returned at maturity (given that the issuer does not default). |
Equities may provide dividends, but these are not guaranteed and vary with the company’s performance.
Principal invested is not guaranteed as it is dependent on stock price.
|
|
Risk Profile |
Bonds are generally lower-risk, offering predictable returns and less volatility in prices.
In the event of bankruptcy, bondholders are paid before shareholders in the liquidation process. |
Equity is more volatile, affected by factors including market sentiment, economic conditions, and company performance.
During bankruptcy, shareholders claim the remaining value after bondholders have been paid. |
Diving into Fixed Income Products
The fixed-income universe is vast and varied:
- Treasury bills (T-bills): Offered by the government, T-bills are short-term investments maturing in one year or less. Investors do not receive coupon returns, but instead buy the bill at a lower price and receive the full price at maturity, earning from the difference.
- Treasury notes / bonds: T-notes (2-10 years) and T-bonds (10 years+) offer long-term investment opportunities, featuring regular coupon payments and full principal return at maturity. While generally low-risk compared to corporate bonds and equities, these bonds are susceptible to inflation and interest rate fluctuations. Bonds issued by companies facing economic challenges, such as Venezuela or Zimbabwe, may carry elevated risks.
- Corporate Bonds: Issued by companies, these bonds carry extra risks that government bonds do not, such as default risk, credit risk and liquidity risk. As a rule of thumb, higher risk investments are usually compensated with higher returns.
- Junk Bonds: Typically rated poorly by credit rating agencies, indicating higher risk of default (BB+ or lower by Standard & Poor’s and Ba1 or lower by Moody’s). However, this also presents an opportunity for risk-seeking investors to gain higher returns, hence, junk bonds are also called “High-yield bonds”.
Fun Fact!
Green bonds have been increasing in popularity in recent years as a sustainable investment choice. Issued to fund environmentally friendly projects, these financial instruments offer investors tax-exemption benefits, providing a dual incentive to support eco-friendly initiatives while enjoying potential financial advantages.
The Role of Fixed Income in a Portfolio
Incorporating fixed income into a portfolio is useful for safeguarding capital, earning income, diversification, and mitigating risks during an economic downturn.
Capital Preservation & Income
Bonds repay the principal invested upon maturity, which is appealing to investors who do not want to risk losing capital and to those who must meet a liability at a particular time in the future. Additionally, most bonds offer regular interest payments that can serve as a source of income.
Diversification
The value of government bonds typically has a tendency to move inversely to the stock market, helping to mitigate some of the volatility associated with equities.
Hedge Against Economic Slowdown
One of the key roles of bonds is acting as a potential hedge against economic slowdowns or deflation. In such scenarios, these bonds tend to outperform other asset classes. This is because:
- Interest Rates and Bond Prices: In an economic downturn, central banks often lower interest rates to stimulate the economy. Lower interest rates typically lead to higher bond prices, offering capital gains to bondholders.
- Deflationary Environment: During deflation, the purchasing power of the fixed income from bonds increases, making them more valuable.
- Stability and Predictability: In uncertain economic times, the predictable income from bonds can be a safe haven for investors, contrasting the higher uncertainty in equity markets.
Good job on digesting everything so far! If you need to take a break, feel free to bookmark this page and come back to read later 🙂
Important Terminologies
Understanding how to value bonds is essential for investors and financial analysts. Before we look at valuing bonds, it is paramount to understand the terminologies used in the bond market.
Par Value: The face value of a bond or the principal amount to be repaid at the time of maturity. (Usually $1,000)
Maturity: Specified date on which the bond’s par value is paid.
Term: The time remaining until maturity.
Yield to maturity: The interest rate earned by the holder until maturity
Coupon rate: The stated annual interest rate paid by the bond to the holder of the bond.
Coupon: Periodic interest payment made to the holder of the bond as defined by the coupon rate.
At its core, the value of a bond is the present value of its expected future cash flows, such as the fixed periodic coupon payments to the bondholders and the face value paid at the time of maturity. These cash flows are discounted at the yield to maturity to obtain the present value, reflecting the time value of money.
Example of a Traded Bond
Let us take a look at the Singapore Government Securities (SGS) bond. SGS bonds are debt securities issued by the Singapore government to raise funds. These bonds are considered low-risk investments as they are backed by the government. Investors who purchase SGS bonds essentially lend money to the government to finance major, long-term projects, in exchange for periodic interest payments and return of the principal amount at maturity.
From here, we can extract out the relevant information to calculate the value (also known as PV, or present value) of the bond.
Par Value (i.e. Face Value): $100
Maturity: 1 February 2024
Period: 1 Year, with 2 Payments
Yield to maturity: 3.35%
Coupon rate: 2.000%
Coupon (Annual): $100 * 2% = $2
Coupon (Semi-annual) = $2 / 2 = $1
Refer to the image on the right for an illustration of this bond!
Calculations
The mathematical formula to value a bond is as such:
Using this formula, let’s value the SGS bond from above:
C (Semi-annual) = $1
r = 3.35% / 2 = 1.675%
N = 2
F = $100
Look again at the first screenshot from MAS: We have gotten the same price, $98.68 using this method!
Alternatively, we can use the present value function in Excel to calculate:
Syntax: = PV(rate, nper, pmt, fv, [type])
Substitute in the values: = PV(3.35%/2, 2, 1, 100)
This will give us the same result at $98.68 too. Try it for yourself!
Understanding the Calculated PV
We can compare the calculated PV with the existing cost of the bond on the market to assist us in making a decision whether the bond is undervalued or overvalued in the bond market.
In the previous example, we saw that the SGS bonds were selling for $98.68 to give a yield to maturity of 3.35%. If an investor requires a higher yield of 4% instead, he would have calculated a PV of $98.06 that is lower than the current price*. Therefore, the bond would be overvalued, and he will choose not to invest.
* PS: Try to calculate the PV yourself! Simply substitute the rate to 4% and follow the same steps above.
Almost there! Are you ready for the last section?
Bonds in Singapore
Bonds play a crucial role in Singapore’s financial landscape, serving as an important avenue for both government and corporate entities to raise capital. The bond market in Singapore is well-developed and diverse, catering to various investor needs and risk appetites. The Singapore Exchange (SGX) serves as a platform for trading various bonds.
Singapore’s central bank, the Monetary Authority of Singapore (MAS) boasts a AAA sovereign credit rating, showcasing investors’ confidence in the Singapore economy. MAS offers 3 types of fixed income instruments – Singapore Government Securities Bonds (SGS Bonds), Singapore Savings Bonds (SSB) and Treasury Bills (T-Bills). All three instruments are fully backed by the Singapore Government and represent low-risk investments to many.
| SGS Bonds | SSB | T-Bills | |
|---|---|---|---|
|
What is this? |
Tradable government debt securities that pay a fixed coupon every 6 months. |
Investors may invest for up to 10 years and can exit the investment in any month with no penalties, providing a safe, long-term and flexible investment opportunity. |
Short-term, tradable government debt securities. No coupon payments unlike SGS and SSB. |
|
Maturity |
2 to 50 Years |
Up to 10 Years |
6 Months or 1 Year |
|
Minimum Investment |
S$1,000 |
S$500 |
S$1,000 |
|
Purchasing Process |
Purchase using cash, Supplementary Retirement Scheme (SRS) funds or CPF Investment Scheme. |
Apply through DBS/POSB, OCBC and UOB ATMs/ internet banking/ OCBC’s mobile application.
SRS investors can also use their respective online banking portal. |
Purchase T-bills at auction, which take place 3 business days before issuance and are announced on the SGS website 5 business days before the auction.
Apply through DBS/POSB, OCBC and UOB ATMs or internet banking. |
If you are interested in specific guideline of buying SGS Bonds and T-bills you may refer to this website: LINK
Conclusion
What an exciting week of unraveling the mysteries of fixed income! We’ve explored the captivating world of bonds and dived into the nitty-gritty of evaluation processes. Our discussions on Fixed Income versus Equities provided insights into payout structures and risks. We also examined various fixed income products like Bills, Notes, and Bonds, and saw what Singapore had to offer in this space too.
We hope these insights have sparked a flame of curiosity about fixed income investments in Singapore and beyond. Stay tuned for our next chapter of our blog series: Investment Instruments 101!