Bond Investing 101 | Manila time
There’s an old adage that stock investors see the sky while bond investors see the ceiling. When you invest in a stock, it can fall to zero, but it can also have unlimited upside potential. If you buy bonds, you are simply lending money expecting to be repaid the principal with fixed interest.
There are two general categories of bonds in the Philippines: government bonds and corporate bonds. They can be denominated in Philippine pesos or in foreign currencies like the US dollar.
National government or sovereign bonds are considered relatively risk-free, as the risk of government default is relatively low. Corporate bonds take priority over its shares in the event of the company’s liquidation.
Bonds have less price volatility compared to stocks. It’s a good way to diversify your portfolio. It pays periodic fixed interest, usually higher than term deposits.
You can buy bonds through selling agents such as banks or even some online stockbrokers. The Office of the Treasury periodically offers bonds to investors. You can invest in bonds such as RTBs (Retail Treasury Bonds) for as low as P5,000. The recent March bond issue offered 4.875% interest with a five-year maturity. You can also buy bonds on the secondary market through brokers such as banks, but this will incur additional brokerage fees or spread. You can also participate in bond funds, whether mutual funds or mutual funds. Bond funds are pooled investments managed by an institution.
Callable bonds, also called callable bonds, are bonds that the issuer can redeem before reaching their stated maturity date. Issuers typically redeem their bonds if market interest rates fall. This will allow them to re-borrow at a lower rate. Due to this feature, callable bonds pay a higher rate than regular bonds.
Puttable bonds, on the other hand, allow the bondholder to demand early repayment of principal. This put option can be exercised on one or more specific dates. It generally pays a lower rate than regular bonds.
A zero-coupon bond is a bond that does not pay regular interest, but instead trades at a steep discount. At maturity, the bond is redeemed at its nominal value. The difference between its purchase price and the face value indicates the investor’s return.
A convertible bond is a type of debt that gives an investor the right or sometimes the obligation to exchange the bond for a fixed number of shares in the issuing company at specific times during the life of a bond . It is a type of hybrid security that exhibits the characteristics of both debt and equity.
Junk bonds are bonds that carry a higher interest rate due to a perceived higher risk of default.
There are two ways to make money with bonds. The first is simply to buy, hold and collect interest. Interest is usually paid semi-annually or quarterly depending on the obligation. The second way to profit is to sell them for a higher price than what you paid. Bond prices may rise if its credit risk profile improves or if prevailing interest rates fall. On the other hand, if the opposite happens, one may suffer a loss.
Investing in bonds also involves risks. Among them are inflation risk, credit risk and liquidity risk. You get a fixed nominal return when you invest in bonds. Any inflation would lower your real returns. This means that bond yields should compensate investors for inflation risk. After their initial issuance, the bonds will be strongly affected by changes in market interest rates. Rates in turn reflect inflation and inflation expectations. Bondholders prefer an environment in which inflation is mild even when economic growth is slowing.
Credit risk is the risk that a company will default on its bond obligations. Corporate bonds are rated according to the creditworthiness of their issuers. Rating agencies rate bonds based on certain criteria to guide investors. Well-known rating agencies are Moody’s Investors Service and Standard & Poor’s Corp. Moody’s rating is Aaa while S&P’s is AAA. Locally we have PhilRatings or Philippine Rating Services Corp. For short term issues it starts with PRS 1 while long term issues use PRS Aaa.
Another risk with bonds is that you may not be able to sell them when you need them: this is called liquidity risk. Just like a thinly traded stock, an illiquid bond issue can be difficult to sell, you may have to pay high commissions through wider spreads. Some investors buy them to capitalize on market inefficiencies as they are slower to react to news.
Bond as an investment vehicle is suitable for those who prefer the predictable periodic passive income it provides and is an important asset class worth investing in.
Josefino R. Gomez is a Registered Financial Planner of RFP Philippines. To learn more about personal financial planning, attend the 97th RFP program in September 2022. [email protected] or SMS to 09176248110.