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Introduction

A lot of people find bond investment boring. After all, the volatility range of debt securities tends to be narrower than that of equities, meaning that its potential return is also lower. Yet regardless of your investment approach - be it conservative or aggressive - do always include bonds in your portfolio. Why? Because such asset class may provide relatively steady return, and also balances out the risk of a portfolio.

Investing 101: Introduction to bonds

Bonds can provide potential income regularly and balance the overall risks of a portfolio. They are therefore indispensable in any comprehensive investment portfolio.

What is bond investment?

Bond is a form of loans issued by governments or companies in order to raise funds. Take a bond with a face value of $100, coupon rate 5% and tenor of five years. Its holders can receive $5 of coupon payment in the first four years and another $5 plus the principal the final year.

Advancing loans for regular income

Bond is a form of loans issued by governments or companies in order to raise funds. Such issuers promise to return the principal to investors (bond holders) upon an agreed date (also known as the ‘maturity date’). Before the bond is due, investors are liable to receive coupon payments regularly, which explains why bonds are also called fixed-income products.

Take a bond with a face value of USD100, coupon rate of 5 per cent and tenor of five years. Its holders can receive USD5 of coupon payment in the first four years and another USD5 plus the principal the final year. In the event of bankruptcy of the issuer, bond holders will get paid before stock investors.

Hedging default risks

Credit rating agencies usually grade a bond based on its issuer’s repayment ability. The higher the grade, the better the issuer’s fundamentals, and the lower its default risks. Bonds can be broadly classified into investment grades and non-investment grades. Those rated below BBB- by S&P Global are generally considered non-investment grade debts, or high-yield bonds.

Guard against default risks by heeding credit ratings

Buying a bond means lending to an issuer. Due to financial difficulties or bankruptcy, the issuer might not be able to repay the principal or coupon on time. A situation as such is called ‘default’. Credit rating agencies such as S&P Global, Moody’s, and Fitch Ratings usually grade a bond based on its issuer’s repayment ability. The higher the grade, the better the issuer’s fundamentals. Generally an issuer with lower default risks enjoys lower borrowing costs.

Bonds can be broadly classified into investment grades and non-investment grades. Those rated below BBB- by S&P Global are generally considered non-investment grade debts, or high-yield bonds. With higher default risks, these bonds tend to carry higher coupon rates than better-graded bonds, which is a reflection of their higher risk premium.

Bond prices and interest rates

Bond prices are subject to interest rate changes - they are negatively related. That means when interest rate rises, bond price will drop.

Bond prices seesaw conversely with interest rate changes

The concept of yields is fundamental to bond investment because it measures the return on a particular debt security. The prices of bonds traded on the secondary market are dependent on the dynamics between supply and demand. A bond that sees higher demand will receive stronger inflows. That in turn pushes its prices up and drives down its yields, and vice versa.

Bond prices are also subject to credit ratings and interest rates. They are negatively related to interest rate changes. That means when interest rate rises, bond price will drop. The duration of a bond is likewise important as it indicates the sensitivity of the prices of a bond to interest rate changes. The longer the duration, the higher the volatility of the prices and yields of a bond.

Yield Definition
Nominal Yield The interest that an issuer pays annually as a proportion of a bond measured at face value, also known as coupon rate
Current Yield The expected return of a bond in a year from now. It is calculated by dividing the coupon rate by the current bond price
Yield to Maturity The total anticipated return on a bond held till maturity, normally expressed as an annual rate based on its purchase price
Yield to Worst The lowest potential yield on a bond assuming the issuer does not default

Balance risks with bonds

The volatility of bonds tends to be lower than equities due to their vastly different characteristics. As a result, giving a certain weight to bonds or bond funds within a portfolio helps diversify investment risks and lessen its volatility.

Bond allocation helps a portfolio diversify its risks

In the universe of investment, bonds are generally considered to carry relatively lower risks than equities. Assuming the issuer does not default on its bonds, investors may expect to receive regular interest payments and the principal upon maturity. To lower volatility as much as possible, an investor tend to hold the bond to maturity. Of course there are investors trading on bonds for arbitrage. But since the threshold for bond investment is rather high, a lot of investors tend to gain relevant exposure through buying bond funds, as such strategy helps lower the entrance fee for investing in a basket of bonds.

Although the long-term return of bonds tends to be lower than equities, its volatility is also lower due to its vastly different characteristics. As a result, giving a certain weight to bonds or bond funds within a portfolio helps diversify investment risks and lessen its volatility.

Investing 101: The basics of bond prices, bond yields and duration

When yields rise, bond prices fall. The longer the duration, the more sensitive of the prices to interest rate movements.

 

 

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Risk Warning

This page is prepared for general information purposes only and does not have any regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive it. This page does not constitute an offering document and should not be construed as a recommendation, an offer to sell or the solicitation of an offer to purchase or subscribe to any investment. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management (Hong Kong) Limited (“AMHK”) accepts no liability for any failure to meet such forecast, projection or target. AMHK has based on information obtained from sources it reasonably believes to be reliable. However, AMHK does not warrant, guarantee or represent, expressly or by implication, the accuracy, validity or completeness of such information.