4 Reasons Why Some Investors Choose Bonds Over Stocks
6 November 2017
When it comes to investing, there are two main asset classes people in Singapore typically choose to invest in. These are bonds and stocks, and between them, bonds are often touted as the safer option. But why do some investors choose bonds over stocks?
To understand why this is the case, you first need to understand the main characteristics of each of these asset class.
Investing In Bonds VS Equities
When you invest in equities, you become part owner of a business. However, when you invest in bonds, you are investing in the debt obligation of a bond issuer, which are usually corporate or the government entities. What this means is that you are lending money in return for the promised repayment of the principal amount at maturity and an agreed upon interest payment.
The maturity of bonds can be as short as one year or as long as over 30 years. Bonds with a shorter maturity period are characterised as less risky as there is a shorter timeframe for interest rates to fluctuate or, for the bondholders to fall into financial difficulties.
Here are four common reasons many investors include bonds as part of their overall investment portfolio.
#1 Returns Are Not Tied To Profitability
The main reason why bonds are perceived as less risky is that returns of bonds are not tied to a company’s performance or profitability. As a bond investor, you receive the same returns regardless of whether a company makes record profits or losses. This is contrary to how equity investors receive returns – usually only when companies make profits.
Even when companies have to restructure or face a cyclical downturn, they are obliged to continue coupon payments on their issued bonds. Bondholders do not have to worry about how profitable a company is, only whether or not they can meet their debt obligations.
Of course, if a loss-making company is unable to turnaround their operations after an extended period, it may be forced to default on its repayment. This is when bond investors would find the value of their investment declining.
#2 Capital Preservation
Many investors use bonds as a way to guarantee their entire principal even as they seek returns to grow their wealth. This can be important for investors who require the money for a future expense such as a child’s tertiary education or to upgrade their home in the coming future.
It also allows investors to enjoy returns in the form of regular coupon payments till the maturity of the bond. This is a savvier choice compared to leaving their money in a savings account earning next to nothing.
Capital preservation is also important to investors during economic crises. During periods of uncertainty, people typically turn to investing in high quality bonds as they tend to retain their market value better, as compared to stocks which may fall more quickly.
#3 Steady and Visible Cash Flows
Another reason investors choose to invest in bonds is to receive a steady and visible flow of income. This is especially attractive for investors nearing retirement and seeking passive income to replace their earned income.
Details of coupon rates, payment dates and maturity are all typically specified at the time of a bond purchase. This provides strong cash flow visibility for over 30 years.
#4 Legal Protection
Bond investors do not have any rights to a company’s profit as they are not equity owners, but they do have rights to the assets of an organisation in the event of a default.
In such scenarios, companies may be forced to sell their assets or even liquidate completely if they are unable to meet their debt obligations. When this happens, bondholders have superior claims to assets over equity owners. This is another reason why investing in bond is considered safer to investing in equity.
Are All Bonds Less Risky?
Naturally, lending money to different entities means you are exposed to differing levels of risk. To simplify what this means, you can think about this as lending money to two different people.
In the first scenario, you lend some money to your dad at the hawker centre as he doesn’t have enough money in his wallet to buy dinner. In the second scenario, you lend some money to your sister who is in primary four as she has run out of money to buy lunch for the week.
It is quite straightforward to see that your chances of being repaid is much higher when you lend money to your dad than your younger sister. This is the same way you can view bond investing.
Certain organisations, such as the Singapore government or Statutory Boards, are as safe as they come by. In fact, one could argue that buying bonds issued by the government (e.g. the Singapore Savings Bond) is even safer than keeping money in the bank since it’s guaranteed by the Singapore government. As such, these bonds also tend to offer a lower interest rates.
In order to attract investors, corporate bonds issued by companies tend to offer interest rates that are higher. The logic here is simple; these corporations are viewed as riskier entities and if they were to offer the same interest rates offered by government bonds, then investors would opt for government bonds.
Here are some types of common bonds that you can invest in.
Treasury Bills and Singapore Government Securities
Treasury bills are short-term debt securities issued by the Monetary Authority of Singapore (MAS), typically with a maturity of one year or less. Due to the short-term nature of these bonds, there may be no coupon payments paid on these bonds. Instead, they are usually sold at a discount to their par value, or the amount you will receive at the end of the bond. The difference between the price of the bond and its par value makes up returns earned by investors.
For example, a treasury bond with a par value of $1,000,000 may be sold at $987,000. When it matures, the bond issuer repays the bondholder the par value of the bond, which is $1,000,000. The difference of $13,000, or close to 1.3%, is the return the bondholder receives.
Singapore Government Securities, or SGS, are longer termed debt securities issued by the MAS, usually with maturity periods ranging from 2, 5, 10, 15, 20 and 30 years. SGS bonds pay a fixed coupon, usually every six months, for the entire duration of the bond. Upon maturity, investors will receive the par value of the bond.
In Singapore, both T-bills and SGS bonds are backed by the Singapore Government, which has an AAA-rated credit rating, making it virtually risk-free. They can be sold at prevailing market prices to other investors in the secondary markets offered by SGS dealers banks such as DBS, United Overseas Bank Limited (UOB) and Oversea-Chinese Banking Corporation Limited (OCBC), making it a liquid investment as well.
Singapore Savings Bonds
Similar to the T-bills and SGS, the Singapore Savings Bonds (SSB) is a 10-year bond issued by the MAS and backed by the Singapore Government, which also makes it a virtually risk-free investment.
Each Singaporean is allowed to purchase up to $100,000 worth of these bonds, subjected to a minimum subscription amount of $500. Unlike SGS bonds, the SSB cannot be resold in the secondary market to other investors. However, bondholders also enjoy high liquidity as they are able to redeem their bonds at any time.
ABF Singapore Bond Fund
The ABF Singapore Bond Fund comprises of some of the safest and highest rated debts issued in Singapore. These usually include high quality bonds that are issued by the Singapore Government and quasi-Singapore Government organisations such as the Housing & Development Board (HDB), the Land Transport Authority (LTA), local port operator PSA International and Temasek Financial (I) Ltd.
Unlike regular bonds, a fund does not have a maturity date. This is because every time a bond within the fund matures, the proceeds will be used to purchase other similar bonds, rolling over the principal each time.
One benefit of the ABF Bond Fund is that it is traded on the Singapore Exchange (SGX). This makes it even more liquid and easy to monitor. Investors are also able to purchase as little as 100 stocks each time, making it very accessible.
However, without a maturity date, the only way to get back your initial investment would be to sell the fund at prevailing market value, which could be lower, or higher, than the price you purchased it at.
There are also several types of corporate bonds, usually issued by large publicly listed companies, some of which can be bought and sold on the SGX.
Other ways investors can buy corporate bonds is through banks or other specialised and online brokerages. These are considered Over The Counter (OTC) purchases, where transactions take place without the need for an exchange.
Many OTC bonds in Singapore are sold in denominations of $250,000 and may only be opened to accredited investors, making them hard to access for new investors. Those on the stock exchange, which can be bought for under $1,000, represents the easiest way to invest in corporate bonds.
The price of these bonds could be more volatile as they are dependent on the performance of the company that issued them, market sentiments as well as the interest rate environment, especially if they are unrated or junk bonds, a term commonly reserved for younger and riskier companies.
If a company gets into financial trouble or reports losses, the price of their bond may decline, thus offering a higher yield to investors, given it has become a riskier investment. Similarly, if a company continuously reports stronger results, the price of the bond may go up, offering new investors a lower yield.
Diversification into Different Asset Classes
In addition to the advantages of investing in bonds, investors should consider an asset allocation strategy that includes having stocks, bonds, properties and even a cash or gold component. By spreading your investment risks across asset classes, you will essentially be lowering your overall portfolio risk.
Furthermore, not all asset classes react to economic and financial events in the same way. During uncertain economic periods, investors may rush to sell stocks and invest in gold and bonds, or even keep a larger proportion in cash to preserve their wealth. The opposite holds true for periods of economic prosperity where investors may seek to invest in stocks and some bonds.
It is this imperfect or negative correlation between asset classes which allows you to enjoy lower risk when you diversify your portfolio.