Download 7 key questions you should be able to answer before investing in

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7 key questions you
should be able to answer
before investing in bonds.
1.Apart from coupon payment frequency, tenor of the bond and creditworthiness of the bond issuer (or
bond credit rating), what are other features that are relevant when considering an investment in bond?
Bond Status
One of the factors that should be considered is the status of the bond’s security. Broadly, bonds may fall into
these various categories, from secured to unsecured, from top priority to low in terms of claims.
Secured/Unsecured debt
Secured Debt is debt obligation backed by specific assets or revenues of the borrower. In the event of default,
secured lenders can force the sale of such assets to meet their claims. Unsecured Debt is debt obligation
with no collateral over any assets from the borrower in the case of bankruptcy or liquidation. Senior/Subordinated debt
Senior Debt refers to debt obligations that are given a higher claim priority to Subordinated Debt and to equity
on the issuer’s assets in the event of liquidation. Subordinated Debt refers to debt obligations that places
the investor in a lien position behind or subordinated to a company’s senior creditors. Securities issued as
subordinated debt will pay interest and principal but only after all interest that is due and payable has been
paid on to all senior debt and creditors in the case of bankruptcy or liquidation.
Subordinated Debt issued by banks often can be further classified into Lower Tier 2, Upper Tier 2 and Tier
1 issuances in the order of claims priority. Investor’s risks increase when they go down the capital tiers.
Investors also inherit higher coupon and principal payment risks when they go down the capital tiers, as some
Subordinated Debts allow the issuer to defer/suspend coupon and principal payments.
To compensate for the higher risks taken by Subordinated Debt investors compared to Senior Debt investors,
the former often are traded at higher yields than the latter. Yet for investors, it is necessary to recognise that
while the returns are higher the risks are also higher.
Bond maturity types
Bonds may have varying maturity periods or none at all. Ideally, they should fit into your investment time frame.
Bullet bonds
Bonds with repayment of the principal on a fixed maturity date.
Callable bonds
Bonds with a call date where the issuer has the option to repay the principal earlier than the final maturity date.
Perpetual bonds
Bonds with no maturity date. The issuer will not specify a maturity date where it repays the principal like bullet
or callable bonds. Rather, a perpetual bond pays the investor a fixed coupon indefinitely. Most perpetual bonds
are callable, where the issuer has the option to repay the principal on a pre-specified date when it was issued.
Convertible bonds
A convertible bond is a bond that can be converted into ordinary shares of the issuer. Typically the conversion
price to ordinary shares is pre-defined at issue.
2. How do I calculate the return of a bond ? Is the return the same as the coupon rate?
There are several concepts to keep in mind: yield, capital and total return.
For an individual bond, coupon payments are expected to be paid and this stream of coupon payments is the
bond’s yield. If the bond is held to maturity, the yield will be the return. As such, when you want to determine
the return you will get from a fixed rate bond, you should look at the bond’s yield and not the coupon rate.
The yield is the return you earn from the bond after taking into consideration the current price of the bond
assuming that you will hold the bond to maturity.
But if the bond is sold before maturity, which can be higher or lower than the price that was paid, and
the difference can be an additional source of earnings, or it may result in a loss. This change in price will
contribute to the bond’s total return. As such, should you decide to sell the bond before maturity, you will
enjoy additional return from capital gains if you manage to sell at a higher price than the price you have paid.
Conversely, you may suffer capital loss if you sell at a lower price.
3. Why do bond prices go above 100%? What causes a bond price to rise or fall?
The price and yield of a bond are affected by market interest rates, demand and supply of bonds in the
market, and perceived creditworthiness of the issuer. In general bond prices rise (and yield falls) when
interest rates fall or when perceived creditworthiness improves and vice versa.
To make things simple, let’s assume perceived creditworthiness remains the same. When interest rates
change, the price of an existing bond with fixed coupon rate must adjust in price to provide the same return
as an equivalent, newly issued bond that has a higher or lower coupon rate. Let’s illustrate with a simple
example that a company wants to borrow USD100. The company issues bond and it offers to pay USD4 a year
to the bondholders for 10 years. At maturity, the bondholder gets USD100 back.
In other words, this bond has a coupon rate of 4%. After a month, interest rates rise to 5%. If the company
had waited a month before borrowing the USD100, it would have to pay 5% instead of 4%. This also means
that the 4% bond would be less valuable and the price will fall when interest rate rises to 5%.
When a bond is newly issued at par (100%) and if interest rates fall after issuance, the bond price will rise
above par (premium), as it needs to adjust to be aligned with current market interest rate conditions.
Bond Price
Issuer’s
Creditworthiness
Interest Rates
Demand & Supply
Stronger
Weaker
Higher
Lower
Strong demand / Weak Supply
Weak demand / Strong supply
4. Does it mean that bonds with prices below 100% are cheap and above 100% are expensive. Is it true?
No. It should be emphasised that the return you earn from the bond is determined by the bond’s yield which
has already taken into consideration the price of the bond.
Bond price reflects current interest rate condition vs. bond coupon. Bond price above par means this bond
was issued when interest rate was higher. However, the premium will be covered by regular bond coupon
received up till maturity.
5. Do all bonds carry the same interest rate risk?
No. Longer tenor fixed rate bonds’ prices are more sensitive to interest rate changes than shorter tenor fixed
rate bonds’ prices. So longer tenor fixed rate bond yields are higher to compensate for this higher interest rate
risk. If you are concerned with interest rate risk (you expect interest rates to rise in the near future), you should
consider shorter tenor fixed rate bonds which have maturity not longer than 5 years. Alternatively, you can also
consider floating rate bonds, i.e. bonds that have a variable coupon, adjusted according to the market interest
rates and therefore reflect changes in a market interest rate, like the Kuala Lumpur InterBank Offered Rate
(KLIBOR), USD London InterBank Offered Rate (LIBOR), AUD Bank Bill Swap Reference Rate (BBSW), etc.
Example:Assume investor buys a MYR corporate bond at bond price of 105 with a total investment of
MYR105,000. The bond carries a 6.5% coupon and matures in 3 years time.
Initial investment
= MYR105,000
Redemption at maturity
= MYR100,000
Capital Loss
= MYR5,000
Coupons Received
= MYR19,500
Net Investment Gain
= MYR14,500
The MYR14,500 investment gain is equal to a 4.7% yield per annum,
much more attractive than the deposit yield of 3.1% p.a.!
Coupon payment (Semi-annually):
MYR3,250 (MYR100,000 x 6.5%/2)
Total coupon received: MYR19,500 (MYR3,250 x 6)
MYR100,000
repaid at
maturity
Bond
Initial investment MYR105,000
6. How does a bond’s coupon rate affect its price?
The higher the coupon rate of the bond, the less the bond price will change when interest rates change. If you
are concerned about interest rates rising soon and the value of your bond falling, consider bonds with higher
coupons. Furthermore, if interest rates rise, you can reinvest those coupon payments at higher yields.
7. What does a Bid-Ask spread mean and what affects Bid-Ask spread of bonds?
A bid-ask spread is the difference between the ask price and the bid price. This is basically the difference in
price between the highest price a buyer is willing to pay for the bond and the lowest price for which the seller
is willing to sell it.
There are several factors that contribute to the size of the bid-ask spread. The size of the spread is determined
by supply and demand which translates to the bond’s liquidity. This refers to the volume or the amount of
bonds that are traded on a daily basis. The more liquid the bond is, the smaller the bid-ask spread is. Typically,
bonds with larger issue sizes, shorter time to maturity, recently issued have smaller bid-ask spreads.
Another important factor that affects the bid-ask spread is volatility. Volatility usually increases in periods
of uncertainty and where risk perception is high. When volatility is low and uncertainty and risk are at a
minimum, the bid-ask spread will be smaller.
Issued by HSBC Bank Malaysia Berhad (Company No. 127776-V)