Bonds are relatively safe investments with predictable income from coupon payments, but just because investors are supposed to lock in their money doesn’t mean they won’t be able to grow it.
All investors who buy bonds actually lend money to the bond issuer. In return, the bond issuer promises to pay a fixed interest periodically and the full amount owed at the end of the term. This consistent stream of coupon interest payments is the bondholder’s main source of income.
However, there are still several approaches to investing in bonds that allow potential bondholders to increase the growth of their principal investment apart from the usual. The most crucial step is choosing the right bond to invest in.
How to choose a bond
The first thing an investor must understand is that each bond is different, no matter how similar its terms are to another.
For example, if a person is looking for a potential 5-year bond investment with a $100 face value and 4 per cent interest rate, they may narrow down their options to the 4 choices below:
- Exchange-traded Treasury Bond (eTB);
- Exchange-traded Treasury Indexed Bond (eTIB);
- Bonds issued by a 12-year-old well-known research and development institution; and,
- Bonds from, a business that recently changed management after 52 per cent of its shops recently closed down due to financial constraints.
Note that eTBs and eTIBs come in the form of Clearing House Electronic Subregister System (CHESS) depositary interests (CDIs). This means bondholders are technically buying an interest share and not the actual bond.
All the choices above offer the same terms, so how should an investor choose which one is the best? They must do the following:
1. Know and understand the terms of the bond issuance
An investor should be aware of the basic bond features, such as its face value, coupon, coupon interest payment schedule, maturity and callability. For a quick refresher, here’s what the terms mean:
- Face value: the amount a bond issuer promises to pay upon the bond’s maturity, regardless of increase or decrease in its market value and the bondholder’s principal investment.
- Coupon: the interest rate applied to the face value throughout the life of the bond. Coupons are usually fixed unless the specific issuance indicates floating interest bond.
- Coupon interest payment (CIP) schedule: the schedule for coupon payments. CIP is usually paid out quarterly or semi-annually. The CIP schedule may be found on the bond’s prospectus.
- Maturity: The date when the bond issuer is expected to pay its lenders the face value and last CIP.
- Callability: A condition which allows the bond issuer to terminate the bond early if interest rates move to unfavourable levels.
2. Consider the risks associated with the issuer
Investors must remember that bonds are first a debt before a favourable investment.
An investor should be aware of the risks associated with each borrower, such as how the institution fared in the past few years, how good it is with paying debts on time, if there are any changes that could endanger its ability to pay debts, and the likelihood that it will close down and be unable to pay bondholders.
Fortunately, there are professionals who look into each bond issuer’s credit risk, and rate them based on how their ability to pay their debts. Government bonds usually have the highest credit rating, which means they are a very safe investment.
3. Read each bond’s prospectus
All bond issuers are required to prepare an updated prospectus for each bond they issue, and market participants offering bonds as investment are required to show these to potential investors.
Reading the prospectus is highly advised so bondholders don’t come in blind into an investment. Investors may also want to read the issuer’s financial statements and investor reports for the past few financial years, just to have an idea of the company’s trajectory. At the very least, an investor should discuss options with their financial advisor or stockbroker.
Going back to the four bond options earlier, it would seem as if only choice ‘D’ poses a great risk, so they may choose any bond from A to C. Of course, the choices are never this easy in reality.
The investor is assured of returns from the eTB and eTIB since they are both government bonds, and the eTIB may be the better choice since returns are based on adjusted capital that moves with inflation. However, an investor could lose liquidity in their investment if the government decides to convert the CDIs to actual eTIBs because they will be unable to sell them.
As for the two corporate bonds, it may seem as if option C is the better choice, but what if the well-established institution has actually been slapped with several lawsuits?
There is also the possibility that Company F in option D closed down the shops which incurred the greatest loss, and the management changes were due to a merger with a well-funded company.
The best course of action is to read the prospectus and investor reports to make informed decisions.
Once in investor purchases a bond, their money is supposed to be locked in the investment until maturity. However, some bondholders still manage to move their money around even with the ‘locked-in’ condition.
There are several approaches to investing in bonds that allow investors to increase their earnings. Here are some strategies bond investors employ:
The buy-and-hold approach means purchasing a bond and holding onto it for the full term.
Long-term bondholders who go for this approach are usually conservative investors who like the idea of know what to expect, and wish to avoid losing their principal investment by playing it safe.
This is not a bad option, but unless the purchased bond is protected from the effects of inflation, the total income upon maturity may be worth less than expected.
This approach may be better for short and medium-term investments, since bondholders can still get the full term benefits without locking away their capital over long periods.
However, this could also work well even with long-term investments when paired with any of the other strategies, especially the next four approaches in this section.
Laddering requires the investor to divide their principal capital into equal amounts to invest in several bonds with different maturities. Once the shorter-term bond matures, it can either be reinvested to the next maturing bond or to another bond with a longer term.
For example, an investor can spare $20,000 in the next five years for a bond investment. Laddering would require them to divide the total principal into five different $4,000 investments with maturities ranging from one to five years.
Consider bond investments A1, B2, C3, D4 and E5, wherein the letters are issued bonds and the numbers indicate the years to maturity. An italicised investment means it has matured.
When the 1-year bond matures, the principal and interest will be invested to the 2-year bond, which now has only a year left before maturity. This way, the bondholder can take advantage of a higher coupon interest payout from the higher principal.
This means the investment portfolio would look like A+B1, C2, D3 and E4 after a year, then (A+B)+C1 +D2+E4 in two years, and so on.
Likewise, the investor can also reinvest the full earnings of the 1-year bond to a 5-year bond because the previous 5-year bond only has 4 years left to maturity.
This version means the portfolio after a year would be B1, C2, D3, E4, F5, where F5 is the previous A1.
The version of the laddering strategy an investor could use depends on their goal. If they need the money after five years, then reinvesting to the next maturing bond may be ideal. If they simply want to ensure some liquid funds annually, a full reinvestment may be the better choice.
The barbell strategy involves investing in only long and short-term bonds to manage interest rate risk.
Long-term bonds assure better coupon rates, but since the actual value of its earnings decrease over time, short-term bonds open up the opportunity for continuous gain in the face of interest rate risks.
Bond swapping requires a bondholder to sell their bond and use the proceeds of the sale to purchase a bond with similar characteristics.
This strategy is used by investors who switch to a higher quality bond for improved returns or a lower quality bond for tax credits.
They can do this by looking for bonds issued by companies with higher or lower credit rating, better coupon rates, or to remove the risk of callability in their portfolio.
Most investors who swap to lower quality bonds do so to lodge capital loss and take advantage of the tax offset; but if this is the bondholder’s goal, they should discuss it with a tax advisor because some rules could apply.
Bondholders who want more than what the techniques above can give turn to active bond management strategies despite the greater risks.
What is active bond management strategy?
Active bond management strategy requires investors and fund managers to study and monitor market conditions, and adjust their investments based on its movement to maximise their capital.
Active managers do this is by identifying opportunities based on credit risks, market and macroeconomic analyses, risk management and rolling down the yield curve, among others.
This strategy employs techniques ranging from choosing underdogs to selling bonds at a premium for profit, but an investor needs to be knowledgeable and perceptive about market movements.
Some professional fund managers employ this strategy for profit, but there are some who are sceptical about the perceived returns of active management.
Investors may want to consider seeking the advice of professionals if they want to try their hand at this, especially if they are not well versed in the inner workings of the trade.
This information has been sourced from Investing in Bonds by SIFMA and Nest Egg.