What is a Corporate Bond Anyway?
Companies need capital to run. Before they can start manufacturing, for example, they need to hire employees, buy factory equipment, and find warehouse space. There are two ways a company can get capital. The first is to sell shares in the company, and that’s what the stock market is about. However, they cannot sell too many shares, as they would lose ownership of the company to the shareholders. The second way is through debt (borrowing). Instead of getting money from a bank, a company can choose to borrow by issuing a bond. The bond is a promise to pay back the bond-holder a given sum, at a certain time. In return for loaning this money, the bondholder also gets paid interest, in the form of a coupon.
Why Are Corporate Bonds in Singapore a Big Deal?
Investment grade bonds (bonds issued by big companies that are highly unlikely to fail) are a favourite asset for older investors, for reasons we will describe below. Bonds can be an excellent alternative to just keeping your money in a bank. The interest rate in a corporate bond is much higher than that of any bank account (it’s easy to get five per cent per annum). Unlike stocks, the income they provide does not fluctuate. The company must pay you back, regardless of how well or how poorly they performed that year. For the longest time however, corporate bonds were the province of the rich. Many of these bonds require upward of S$200,000, which the average Singaporean could never afford.This has always been a little unfair, as it means richer people have access to a retirement asset that regular people don’t. Today however, MAS has a new system that makes it easier for corporations to sell bonds to the average Singaporean (retail investors), while still keeping us relatively safe from risks. Pretty soon, we may see corporate bonds that are available for just S$1,000 and up.
How Do You Get Money Out of a Bond?
The only bond types available to retail investors will be vanilla bonds. This is how they work: Say you buy a bond with a par value of S$1,000, and the coupon (interest rate) is five per cent. The bond is for five years. This means you will get five per cent of S$1,000 (S$50) a year for five years, after which you will be paid the par value (S$1,000). In essence, you are loaning the company S$1,000 now, and getting back S$1,250 in five years. Note that the coupon is often paid semi-annually. In the above example, you might get S$25 every six months. If you were to use a fixed deposit, with a typical interest rate of 0.8 per cent, then at the five years your S$1,000 will only grow to around S$1,035.
Why Are Bonds Great for Retirees and Older Investors?
Unlike mutual funds or picking stocks, bonds provide a reliable fixed income stream. Shares do not always pay out dividends, as it depends on how well the company is performing. Likewise, mutual funds have volatile returns. As we get older, it becomes more important to focus on protecting our wealth instead of growing it. Bonds are one of the most important ways to do this, and many financial advisors will rebalance a portfolio to include more bonds than stocks after retirement. On the flip side, note that most financial advisors do not recommend heavy use of vanilla bonds for younger investors, who are in their 20s. This is because vanilla bonds may not cope with the rate of inflation, and the returns are low compared to stocks.
But Are Corporate Bonds Safe?
Under the new MAS framework, the bonds are only available to the public after they have been bought by institutional investors (e.g. an insurance company) or other accredited investors for six months. This means that more professional investors will take the initial risk to determine if it’s safe. The bonds available to the public are also investment grade bonds. They are rated and tested by Credit Rating Agencies (CRAs), and are not speculative in nature (what we call “junk bonds”). That said, there are two main risks inherent in bonds. The first is inflation rate risk. S$500 today is worth much less than S$500 in the year 2050, as the cost of goods always rises. But because the payout and par value of a vanilla bond do not change, they do not rise with inflation. You may not be making enough money to provide for your retirement if you just rely on bonds. The second risk is default risk. There is a chance that the bond-issuer may go bankrupt, or be unable to fulfill its loan repayments. The chances of this happening are small when it comes to investment grade bonds, far less than one per cent. Investment grade bonds tend to come from large, well-established companies. Also, a bondholder is in a safer position than a shareholder. If the bond-issuer declares bankruptcy and is liquidated (which means all its assets are sold off), bondholders are paid before shareholders. Overall, the low risk posed by investment grade corporate bonds, coupled with an interest rate that beats the banks, will be of interest to older investors. Once the new bonds start filling the market, it may be a good idea to call your financial advisor and ask about them.
[Article from SingSaver.com.sg]