Fitting Bonds into your Investment Portfolio – Part 2

Date: November 17, 2020

Risks of bond investing

All financial instruments come with some risk, the only difference being the degree. In the case of bonds, those that are issued by governments are usually considered risk-free in their own countries; however, the defaults by Greece in 2009, Argentina in 2001 and again in 2010, and Venezuela for the past six years when the governments of these countries were unable to pay the interest on their bonds should alert investors to the fact that every bond has risk – even those issued by governments.

Indeed, although investors have to bear risks which could impact the whole market like sudden economic downturns, if there is one single overriding factor that investors must bear in mind when evaluating bonds, it is default risk, ie the likelihood that the issuer will default on its payments.

Default or credit risk, the role of ratings agencies

When an investor buys a bond, he or she is basically loaning money to the issuer in return for a regular interest stream known as coupon payments that in theory should last until the bond matures.

Just like a loan to any party, the most important question to ask is: how sure is the lender (bondholder/investor) of the ability of the borrower (issuer) to pay everything on time and in full?

The answer is that it depends on the issuer’s credit quality which in turn comes from its financial strength. This in turn requires analysis of financial statements, track records, current market conditions, the interest rate outlook and many other factors.

To assist investors in gauging credit quality, there are independent parties known as credit rating agencies which analyse the creditworthiness of bond issuers and issue opinions known as ratings on how investment-worthy the bonds are.

The three are Moody’s Investors Service, Standard & Poor’s and Fitch and their credit ratings are letter-based credit scoring schemes which give investors an idea of how safe an issue is. For example, a Triple A rating or AAA is the highest possible and indicates that the issue is very investment worthy.

It is important to understand that rating agencies use their own rating criteria and frameworks to make their assessments. Their methodology might not be the same as what retail investors consider important. Furthermore, ratings are assigned on a particular day and remain current until the rating agency changes the rating assessment. The rating at the point of issuance may not necessarily be the same some time later if there is a change in the issuer’s credit quality.

It is therefore important that individuals who are considering investing in bonds be able to perform their own homework and assess an issuer’s creditworthiness on their own.

Ratings aside, you have to do your own homework

The Singapore Exchange’s then-chief regulatory officer Tan Boon Gin highlighted some important points about bonds in his 1 June 2016 article “What retail investors should be aware of when investing in bonds’’.

In it, he reminds investors that “Singapore operates a disclosure-based regime. The financial institutions managing the bond issue perform due diligence on the bond issue. SGX does not evaluate the merits of the issuance’’, adding that defaults are rare but still do occur.

“Investors should therefore ensure they are well-informed when investing in bonds by paying close attention to information contained in the offer document’’ said Mr Tan.

Read the offer document carefully

There have been some issuers in the market (e.g. Azalea, Temasek) that have incorporated gatefolds in their offer document. These gatefolds make it easy for retail investors to understand what is being offered by containing a range of information such as the main features and risks of their bond issues, issuer fund flows and credit ratios in simple language, using pictorials, flowcharts and/or Frequently Asked Questions.

Together with the product highlights sheet the information in such gatefolds should give investors a broad overview of the main factors to consider before investing. However, investors should then go further and read the offer document to gain a more complete picture of the issue.

An important feature to check is the ranking of the bond in case the company is liquidated. Here, investors should check if the bond is secured against any assets or unsecured, and if it is subordinated or unsubordinated. A bond that is secured provides greater security as the assets could be sold to repay bondholders, whilst unsubordinated bonds would generally have to be paid before those that are subordinated.

Another important consideration is whether the bond can be redeemed or repaid before maturity.

“Redemption generally occurs at maturity, but the offer document may state other circumstances where redemption would be triggered. Investors should take note of such provisions as they may shorten the period of their investment in the bonds’’ said Mr Tan.

He also recommended investors scrutinise the ‘Use of Proceeds’ section of the offer document to understand how the issuer intends to spend the money raised, and to see if the uses fit with the company’s long-term goals.

When evaluating use of funds, Mr Tan suggested that investors should question perfunctory descriptions such as “general corporate or working capital purposes’’ that do not provide meaningful guidance.

Perform your own financial checks to gauge creditworthiness

One way to gauge the credit quality of an issuer is to perform financial ratio analysis using past financial data, paying particular attention to a company’s interest coverage ratio (how much cash it has to cover its annual interest payments).

Also important are leverage ratios, which are a set of different financial measurements of the amount of debt the issuer holds.

One leverage ratio that is often used is the debt-to-equity ratio. High leverage ratios could be of concern as they suggest high debt levels and therefore, high expenses in repaying the issuer’s lenders. This could increase the risk of a default. When considering the leverage ratios of a company, investors should also look at the issuer’s past records and the ratios of other companies in the same industry.

Investors should also read the disclosures made by the company in its offer document and check if the issuer has ever defaulted on loans in the past.

In other words, investors must do as much as possible to assure themselves that their money is going to a reliable borrower who will put the money to good use and has strong ability to meet its payments on time.

Interest rate risk

As fixed income instruments, bonds are sensitive to changes in general interest rates. A rise in interest rates for example, will make other interest-bearing instruments more attractive which usually leads to bonds being sold. In other words, interest rate rises will lead to a fall in bond prices, whilst the converse is also true – a fall in interest rates leads to a rise in bond prices.

Choose carefully – and constantly monitor your portfolio

Investors should constantly monitor their portfolios and rebalance when their circumstances change. For example, a couple in their mid-30s may have a growth-oriented portfolio comprising a large proportion of stocks when they have no children, but when they do, they might wish to reduce their exposure to riskier assets whilst increasing their holdings of bonds that mature in say, 20 years.

This way they have greater certainty of obtaining the cash they need for their child’s education when the child reaches university-going age.