Of course the risk reward is applicable in bonds as well. The higher the credit risks, the higher is the yield as companies will need to pay more coupons to entice investors to buy into their bonds. The higher rated the bond, the lower the bond yield. Bond yield refers to the return realized on a bond. As such, investment-grade bonds will always provide a lower yield than non-investment grade bonds. It is due to investors demanding a higher yield to compensate for the higher credit risk in holding non-investment-grade bonds.
Other names for speculative grade bonds are high-yield bonds or junk bonds.
Default Rates for Global Corporate Bonds
Historically, investment-grade bonds witness a low default rate compared to non-investment grade bonds. For example, S&P Global reported that the highest one-year default rate for AAA, AA, A, and BBB-rated bonds (investment-grade bonds) were 0%, 0.38%, 0.39%, and 1.02%, respectively. It can be contrasted with the maximum one-year default rate for BB, B, and CCC/C-rated bonds (non-investment-grade bonds) of 4.22%, 13.84%, and 49.28%, respectively.
Therefore, institutional investors generally adhere to a policy of limiting bond investments to only investment-grade bonds due to their historically low default rates.
What about government bonds?
A government bond is a debt security issued by a government to support government spending and obligations. They are often considered low-risk investments since the issuing government backs them.
The Government of Singapore issues bonds as well like your Singapore Government Securities (SGS) bonds. They are backed by the Singapore Government which has the highest sovereign credit rating of AAA.
The US treasuries with different tenure are another example of government bonds.
What are the factors that affect bond prices?
- Interest rates – Interest rates are inversely related to bond prices. Rise in the interest rates means a fall in the bond prices and vice versa. This is due to the discount rate as future cashflow from the bond coupons are discounted at a higher rate when interest rates rise. Longer maturity bonds are more sensitive to interest rates environment. The sensitivity of a bond or a bond fund to interest rates can be understood by looking at its duration. Duration should not be confused with time-to-maturity.
- Credit risk – Bonds are rated by independent credit rating agencies such as Moody’s, Standard & Poor’s and Fitch to rank a bond’s risk for default. If a credit rating agency lowers a particular bond’s rating to reflect more risk, the bond’s yield must increase and its price should drop.
- Inflation – When an economy is facing inflationary pressure, central banks will hike interest rates to manage these pressure by reducing money supply in the market. This in turn will result in point 1. above happening.
How bonds compliment my investment portfolio?
Bonds are typically less volatile than other asset classes like stocks and therefore, considered to be defensive in nature. Some of the benefits are listed below:
- Income generation – Bonds pay a coupon, sometimes annually, semi-annually or quarterly. The terms of the bod dictates that the issuer will need to pay this coupon regardless whether the company is making a profit. Dividend from stocks are different in the way that the company can stop paying dividends or reduce the payout in the event of a recession or if the company is not doing well.
- Capital Preservation – The principal value of the bonds are returned to investors in full at the bonds’ maturity. But this event is not a guarantee as there is always a default risks of the issuer. As such, the selection of the bonds are very important.
- A Hedge against economic slowdown – As economy slows down, inflation will also start to weaken which is a good thing for bond holders. Prices of bonds are sensitive to interest rates and thus, when the government starts to reduce interest rates to stimulate economy, the prices of bonds will appreciate. Of course the reverse is true as well.
- Capital Appreciation – There are opportunities for bond prices to appreciate as well. As such, investors can choose to sell their bonds at a profit on the secondary market prior to the bond maturing. An example is attached below:
The bid price is SGD$103.055 in which the investor can choose to sell to the market at that price. This bond is issued at par of SGD$100. As such, the sale will equate to about 3% gain on capital, not considering fees and past coupons received as well.
From the above, bonds may be another instrument that investors should include at various times of an economical cycle. The percentage allocation into different asset classes depends on the investment objectives and risk profiles of the investors. As such, it is best to speak to your financial advisor with regards to the above to have a clearer assessment on whether this is something to include in your portfolio.