Bonds are like IOUs. Borrowers (usually businesses) issue bonds to raise funds by reaching out to investors who will lend them the money for an agreed interest rate for a certain period of time.
Bonds are a great tool for the income investor who wants to balance their portfolio to include assets beyond stocks.
Before you even invest in bonds, here are the essential terms that you should know.
Government bonds: bonds that are issued by a government. The securities with 1 year maturity are usually known as treasury bills. Most government bonds are rated by credit rating agencies. Not all government bonds are investment grades.
Corporate bonds: bonds that are issued by corporations or companies to raise funds for their business operations. These usually carry more risks and hence their interest rates are usually higher. Some of the corporate bonds are not rated and bond investors would need to carry out their own assessments.
Perpetual bonds: bonds with no maturity date. The issuer does not have to redeem the bond, investors can choose to sell these bonds in the secondary market.
Callable Bonds: type of bond that can be redeemed by its issuer before its maturity date. Issuers are more likely to call their bonds when the bank interest rates are low in order to refinance their debt at a lower rate of interest.
Bond prices: Bond prices are used in the secondary market. They can be affected by the supply and demand of the investors just like stock prices. Interest rate and credit rating also influence the prices that investors are willing to buy or sell.
Secondary market: where bonds can be traded – a bondholder can sell it to another buyer before the maturity.
Face value or par value: underlying value of a bond. Upon maturity, bondholders are paid the face value of the bond.
Coupon rate: interest rate payout of the bond, usually presented as a percentage of the face or par value.
Yield to maturity (YTM) is used interchangeably with ‘book yield‘ or ‘redemption yield‘. It refers to the internal rate of return (IRR) for the investor from the point of purchase to the maturity date of the bond. This happens when the bond price you have paid for is different from the par value. Your yield is not equivalent to the coupon rate anymore.
Current yield: annual income of the bond divided by the current price of the bond. It is used to calculate the return of a bond in the condition that the investor buys and sells the bond before its maturity.
Yield to Call: Only applicable to callable bonds. Refers to the yield of a callable bond on the call date.
Clean Price: reflects the current price of the bond with the discounted future cash flows taken into account.
Dirty Price: reflects the clean price of a bond plus accrued interest, which is interest that has been accumulated since the last coupon payout. Bond prices in Singapore’s secondary market are reflected as dirty price. Dirty price of a bond increases as the next coupon payout date draws near.
Although bonds are generally viewed as being ‘safer than stocks’, there have been news of investors losing huge sums of money in their bond investments in the previous months.
Being a lesser understood investment tool, it is of little wonder that investors are unsure of the risks they are taking when investing in bonds. Remember, there are no guaranteed returns in any investment. No matter how ‘safe’.
With that in mind, we have invited Wei Tuck, ex-wealth banker who specialises in fixed income investments such as bonds to share his bond analysis process and strategy at the Bonds Investing Mastery Course.