Single digit millionaires tend to have more types of bonds to choose from; either because you’re accredited, or have enough capital for less mainstream options. But if you’ve gone your entire life without understanding more than “buy-units-in-a-bond-fund” this can get confusing. Here’s a general snapshot of various bond types, because there’s no end to innovation when it comes to borrowing money:
The role of bonds in most portfolios
Bonds are often referred to as fixed-income securities, which at this point is absurd as many bonds today don’t provide “fixed income.” But in essence, bonds are debt instruments, as opposed to stocks, which represent ownership in companies.
When you buy a stock, your returns fluctuate based on how well or how poorly the market thinks the company is doing. When you buy a (corporate) bond, you’re lending money to a company. Whether the company does well or does poorly, they’re still obliged to repay the agreed-upon interest.
This means that, aside from situations such as loan restructuring, defaults, etc., most (not all) bonds provide absolute returns. If the coupon on a vanilla bond (see below) is five per cent per annum, then you get five per cent – no more and no less.
Simplified example:
If you buy $1,000 worth of stocks in a company that then grows 1,000 times in value, you now have $1,000,000 in its stock value. If you happen to invest in the next Google or Apple, stocks can make you very rich, very quickly, because your stock value rises alongside the company.
But if you had loaned $1,000 to this company via a vanilla bond, then you would only get ($1,000 + interest / coupon rate), no matter how much the company grows. But on the flip side, the company must repay the loan at the given coupon (interest) rate, even if they’ve had a bad year, or the economy is in recession.
So in most portfolios, bonds constitute the safer portion of the assets, and balance out the volatility of the stocks.
Older investors tend to have more bonds, as bonds are less volatile and good for wealth protection. Younger investors tend to have few or even no bonds, because the interest rate on bonds (1) may not keep up with inflation, and (2) stocks generally outperform bonds over a long period like 15 to 20 years.
That said, not all bonds are low risk. There are certain bonds, such as high-yield bonds, that can be riskier than even many equities (see below).
A snapshot of different bond types:
1. Bond funds
With bond funds, you don’t buy the bonds yourself. Rather, your money is pooled with other investors, and a fund manager(s) uses the combined capital to buy and sell bonds. The returns are then distributed among the investors.
Most retail investors use bond funds, and they can be a good idea even for more affluent investors (e.g., single digit millionaires who don’t want to be too hands-on.)
Not all bond funds are the same, and some can be quite specialised. There are, for instance, bond funds that only deal with bonds in certain regions (Asia, EU, US), or bond funds that only deal with currency (Forex) related bonds.
Like equity funds, bond funds have different risk levels, and some can be more volatile than others.
2. Treasuries and Gilts
Bonds issued by the US government are referred to as Treasury bonds and bonds issues by the UK are referred to as Gilts. In Singapore, the government issues Singapore Government Securities (SGS).
These bonds tend to have a lower interest rate, because they are among the safest loans you can make. It’s highly improbable that the US or UK will be unable to repay its loans, and the Singapore government has never defaulted on a loan in its entire history.
Do note that, due to the high trustworthiness of the lenders, the interest rate paid out on these bonds is often lower than your CPF Special Account (CPF SA). As CPF rates are also guaranteed, you may want to check with your wealth manager / financial advisor if its worth buying these types of government bonds.
3. Vanilla bonds
These are the most “basic” bond types, with no embedded options or structured elements. It may also be called a straight bond.
The bond has a face value, a maturity date, and a coupon rate. For example:
Consider a bond with a face value of $250,000, with a 10-year maturity period, and a coupon rate of four per cent.
The coupon rate ($10,000) is paid every year for 10 years, or $100,000. Upon maturity, the bond-issuer will pay back the face value of $250,000, so in total you’d get $350,000 after 10 years.
4. Zero coupon bonds
Also called deep discount bonds or accrual bonds, these bonds have no coupon (i.e., no interest rate). However, they still have a maturity date. The appeal here is that the price of the bond is below the face value. As a simplified example:
A zero-coupon bond has a face value of $250,000, and a 10-year maturity period.
The bond is sold to you for $150,000 ($100,000 less than the face value), and nothing is paid to you for 10 years. Upon maturity, you’ll get paid the face value of $250,000.
Note that governments as well as companies can issue zero coupon bonds.
Financial experts will usually recommend “zeroes,” as these bonds are called, for highly specific purposes. For example, if you know you’ll need $250,000 in 10 years because you’ll be buying another house, sending your children overseas, etc., then it might make sense to get a bond like the above.
Most of the time though, these bonds are considered to have a poor risk-return profile, and are more sensitive to inflation rate risks.
5. Singapore Savings Bonds (SSBs)
SSBs have an interest rate pegged to the current SGS rate. The interest rate steps (gets higher) up every month. But if you were to hold the SSB to the end of its 10-year maturity period, the interest rate you’d get is equal to the SGS rate at the time.
Unlike other bonds, you can choose to stop on any month, and get back your principal with the accrued interest; but this means you’ll get less than the stated interest rate.
This provides more flexibility than many other bond types, even if the interest rate is not particularly high (as mentioned in point 2). This can be an option for investors facing known-unknowns (e.g., you know for a fact that you’ll need the money within the next 10 years, but you don’t know when exactly you’ll need it).
The interest rate may be low, but it’s still better than leaving cash in a current account (0.125 per cent per annum).
6. High Yield Bonds
The more polite term for junk bonds. These are high-interest bonds, often issued by borrowers who are less creditworthy, or who are undertaking risky ventures (This is the entire reason they need to pay such high interest rates).
High yield bonds may be bonds issued by economically weak countries, bonds from fallen angels (i.e., bonds from entities that were once financially strong, but have since run into trouble), or even just bonds paid in weak currencies.
These bonds have a much higher risk of default, or loan restructuring (the lender may end up needing to pay a lower interest rate than expected, partway throughout the bond’s lifespan).
Usually, only accredited investors can buy these types of bonds; and when they do it constitutes the high-risk portion of their portfolio.
7. Perpetual income bonds
Also called perps, these are bonds with no maturity date. The bond-issuer intends to just pay the interest, and allow the bond to run on and on (possibly for centuries!) By the time the bond-issuer makes repayment, inflation would probably have made the loan amount irrelevant.
As an example of how long these can go on for, the oldest known perp was issued in 1624 by the Dutch Water Board of Lekdijk Bovendams; it’s still considered active currently.
Perps are often among the last financial products bought by ageing investors. Someone in their 70s or 80s, for instance, might consider buying a perp to obtain a lifetime income: all they want is the constant interest repayments, for the rest of their life. Perps are almost never bought by young investors, as inflation can make the interest payments insignificant over a period of decades.
8. Inflation-linked bonds (ILBs)
These are bonds where the coupon rate is pegged to the inflation rate. These are usually offered to citizens by their governments, to help protect savings from inflation.
The exact measure of inflation used may vary. A UK-based bond may be pegged to the Retail Price Index, whilst in the US the Consumer Price Index (CPI) is used. Note that in Singapore, SSBs (see above) are considered to fill a mostly similar function as ILBs in other countries.
As you might expect, the popularity of ILBs fluctuates based on whether the economy is in a high or low interest rate environment. Also note that, based on how they’re structured, some of these bonds have variable interest rates (they may move up or down with inflation); this may be off-putting to some investors, who like the “fixed income” aspect of bonds.
This is just scratching the surface of the bonds market
There are plenty of other factors to consider, and this doesn’t even go into the issue of buying and selling bonds yet. But you don’t need to know every detail; that’s the role of your wealth manager or financial advisor. It is worth having at least a general grasp of these different bond types though; if for no reason than besides being able to better understand your financial advisor.
For more help on the topic, do reach out to us at Single Digit Millionaire.
