A bond is a debt investment in which an investor loans money to an entity (either a company or government) which borrows the funds for a specific period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and governments to raise money and finance a variety of projects and activities.
Bonds are fixed income securities which pay out a fixed interest rate (coupon) at specified intervals (semi-annually, annually, etc). The investor is also supposed to get his/her loaned funds (bond principal) back at a specified date (maturity date) as per the bond contract.
Two main features of a bond – credit quality and duration – are the principal determinants of a bond’s interest rate. If the issuer has a poor credit rating, the risk of default is greater and these bonds should pay higher interests compared to a bond issuer with higher credit rating. For example, Singapore has the best credit rating grade of AAA and as such our bonds can be issued at a lower rate compared to bonds issued by Mexico which has a lower BBB rating. The Singapore Government 10 year bond has an interest rate of 1.9% while the Mexican Government 10 year bond has a yield of about 6%. This is because the Mexican government has to compensate its investors for the higher risk they take on compared to buying Singapore’s bonds.
The longer the bond maturity, or duration, the greater the chances of adverse effects like an increase in inflation which would result in lower real returns on the bond. Longer maturity bonds also tend to have lower liquidity. Because of these attributes, bonds with a longer time to maturity typically command a higher interest rate. A 10 year bond would have an interest rate of say 4% a year while a 3 year bond from the same issuer would have a 2.5% interest rate.
Some bonds can also be traded on the bond market just like stocks. However, the market for bonds in SIngapore is generally much smaller than the stock market. Very few corporations in Singapore issue bonds and the most liquid bonds are the Singapore Government Securities which consist of short term (1 year or less) treasury bills and longer term bonds. Although bonds are generally safer investments compared to stocks, their market prices can fluctuate too. Bond prices are determined by the forces of demand and supply just like stock prices.
Bond prices are affected mainly by expectations of future interest rate levels and any changes to the bond issuer’s credit rating. Usually, bond prices and interest rates are inversely related. For example, if your bond yield is 5% but market interest rates have risen such that newly issued bonds of the similar credit rating and maturity pay a higher yield, the price of your bond may fall as it becomes less attractive to investors. There would be lesser demand on the market for the bonds that you are holding while supply may increase as investors may want to sell off the bonds and get new bonds that have a higher yield.
Occasionally credit rating agencies like S&P, Moody’s and Fitch rate various bond issuers. When you bought a particular bond, the issuer may not be as financially strong as it is now and so it may have issued bonds at a high yield. Subsequently as the issuer becomes financially stronger, credit rating agencies may re-evaluate its credit rating. An upgrade in the issuer’s credit rating with the yield on its previously issued bonds remaining the same may lead to an increase in the market price of its bond.
The bonds you bought earlier are worth more on the market as the issuer is seen as less likely to default but is contractually obligated to pay the higher interest to bondholders. Therefore, there will be a greater demand for the bonds but supply may be low as existing investors would be reluctant to sell such a valuable bond unless they have liquidity needs!
Hence, it is important to do your research before investing in bonds- find out the credit rating of the bond issuer, the outlook of the issuer and the expectations of future interest rate levels at the very least. Typically, one can expect the returns on bonds to be stable; most investors collect the interest or coupons on bonds as passive income till the maturity date when they get their principal back. Thus, the interest or yield of the bond is usually the fixed returns that bond investors expect and this rate is known at the start of the investment. As such, bonds are generally considered safe investments that are suitable for conservative investors and those who seek to reduce the risk on their portfolio.