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In a nutshell, bonds are loans that are made to large organisations like corporations and national governments. They are issued to raise funds for various purposes, including providing operating cash flow, financing debt, and funding capital investments. Bonds are a type of fixed-income investment, which means that they pay a regular stream of interest income the whole time an investor is holding them.
Interest is paid at set intervals (typically twice a year) during the lifespan of the bond. The interest paid is also known as the coupon, and is usually expressed as a percentage of the principal amount you’ve invested. The issuer will repay your principal amount (also called the face or par value of the bond) when the bond matures.
A bond’s maturity date is set by the issuing organisation, and they have to pay back your entire principal amount on this agreed-upon date.
There is also a secondary market for bonds, and some investors resell them before their maturity date if they can get more than they initially paid for it. They can be publicly traded on exchanges or privately sold between an investor and creditor, and since this is the case, a bond’s value goes up and down until it matures.
Bonds are suitable for investors who desire a source of regular income through the interest payments. A steady stream of predictable returns make bonds a relatively safe and low-risk investment, and the only way you lose your principal is if the issuer defaults on the bond.
The flip side of a “safe” investment is its low interest rates – as you barely take on any risk, the interest rates on offer cannot match those of other high-risk investments like stocks and derivatives. Determining your risk appetite can help shape your investment strategy, and whether the returns from bonds are sufficient to meet your financial goals.
If your goal is to increase your savings and preserve capital for retirement, bonds are a good way to do so since their interest rates are much higher than those provided by your savings accounts. However, if you require a more aggressive investment strategy to achieve big short-term gains, bonds will not yield such results.
Some investors also use bonds to diversify their investment portfolio. A well-balanced portfolio should consist of multiple asset classes, including high, medium, and low-risk investment instruments. Bonds can provide stability to help buffer against the volatility of the stock market.
Certain types of bonds offer the benefit of liquidity, and the ability to access your funds whenever you need to can be an important factor when deciding on an instrument. The Singapore Savings Bond is one such instrument that allows you to redeem it before it matures. You will receive less interest than if you had waited until maturity, but you will receive your principal back without any penalties.
In contrast, the stock market is also fairly liquid, but there is no guarantee that you will receive your principal back. You may even make losses if the market is depressed at the point of sale.
The fixed rate of return that makes a bond so safe and appealing can also be its downfall. Over the years, the value of your return will decrease due to the effects of inflation, which according to the Monetary Authority of Singapore, is around 2% per year.
This means that if your returns are less than the rate of inflation, you are essentially not making any money at all. One way around this is to take on a little more risk in your bond purchase by opting for a floating coupon rate instead of a fixed one.
While a fixed coupon rate provides the same interest throughout the bond’s lifetime, a floating one changes along with market rates set by central banks worldwide. When market rates are low, it may be better to secure a floating rate due to the chances of it rising, but when rates are high you might want to secure that high fixed rate instead.
Essentially, if the market is doing well and already offering a high fixed rate that is enough to combat inflation, there is no point in taking on more risk. But if it’s not, then taking a slight gamble can greatly increase your bond’s value upon maturity.
Like any investment, bonds still come with their own set of risks even though they are frequently touted as the safest investment there is. Considering the factors above and your goals would be a good place to start before you decide if bonds are the right instruments for you.
In our next article on bonds, we dive deeper into the different types of bonds and how you can start investing. Subscribe to Asia Finance’s weekly e-newsletter to stay updated on articles related to investing and smart personal finance management.