Investing in bonds can be a great way to diversify your portfolio and earn a steady stream of income. Given the rising interest rate environment, the risk-free rates are going up steadily and have become quite attractive for investors. In Singapore, the latest Singapore Savings Bond (SSB) tranche yields an average of 2.99% p.a., which is slightly higher than our CPF OA which is 2.5%. But before you start investing in bonds, it’s essential to understand what they are and how they work.
What are Bonds?
Bonds are debt securities issued by governments, municipalities, and corporations to raise money. When you invest in a bond, you are essentially lending money to the issuer in exchange for regular interest payments and the return of your principal when the bond matures.
There are different types of bonds to choose from, each with its own risks and potential rewards. Government bonds, also known as Treasuries, are issued by the federal government and are considered to be among the safest investments. Corporate bonds are issued by companies and carry higher risks, but also offer the potential for higher returns. Municipal bonds are issued by state and local governments and are exempt from federal taxes, making them attractive to investors in high tax brackets.
When investing in bonds, it’s essential to consider the creditworthiness of the issuer. This refers to the issuer’s ability to pay its debts, including the interest and principal on the bonds. You can research the credit ratings of different issuers, or work with a financial advisor to help you make informed decisions.
One thing to consider when investing in bonds is the term, or length of time until the bond matures. Long-term bonds have a longer time until maturity, typically 10 years or more, while short-term bonds have a shorter time until maturity, typically one to three years. The term of a bond can impact its potential returns, as well as its risks.
For example, long-term bonds typically offer higher interest rates than short-term bonds, so they have the potential for higher returns. However, they also carry more interest rate risk, which means that if interest rates rise, the value of your bond may decrease. Short-term bonds, on the other hand, typically offer lower interest rates than long-term bonds, so they have the potential for lower returns. However, they also carry less interest rate risk, so their value is less likely to be impacted by changes in interest rates.
Different Type Of Bonds Available in Singapore
In Singapore, we have a few different options when it comes to investing in bonds. For the government-issued bonds, we have the Singapore Savings Bonds (SSB), Treasury Bills (T-Bills), and Singapore Government Securities (SGS). Alternatively, there are also corporate bonds available that can be bought on the Over-The-Counter (OTC) market. Occasionally we also have retail bonds, some of which are listed on the Singapore Exchange, like the Astrea VI and Astrea 7. Last but not least, investors can also look into Bond ETFs in Singapore and overseas. In the Singapore market, there are a few notable ones such as the ABF Singapore Bond Index Fund (SGX: A35) and the Nikko AM SGD Investment Grade Corporate Bond ETF (SGX: MBH)
Advantages of Investing in Bonds
#1 Predictable and Stable Source of Income
One of the key benefits of investing in bonds is that they can provide a predictable and stable source of income. As the interest rates on bonds are fixed, you know exactly how much income you will receive each period. This means that bonds might be a more suitable investment for investors who are more risk-averse or are looking to preserve their capital.
#2 Portfolio Diversification
Another key advantage of investing in bonds is that they can offer potential diversification benefits. When you invest in stocks, you are taking on the risk of the stock market, which can be volatile and unpredictable. By adding bonds to your portfolio, you can potentially reduce your overall risk and improve the stability of your returns.
Another important question investors might ask is, “How much of my portfolio should be allocated in bonds?”. To answer this, we can refer to the stock-to-bond allocation rule, which is a guideline that is often used by investors to determine the appropriate mix of stocks and bonds in their investment portfolios. The rule suggests that an investor’s age should be used to determine the percentage of their portfolio that should be allocated to stocks, with the remainder allocated to bonds.
For example, if an investor is 30 years old, the stock-to-bond allocation rule would suggest that they should allocate 70% of their portfolio to stocks and 30% to bonds. As the investor gets older and approaches retirement, the rule suggests that the percentage of their portfolio allocated to stocks should be gradually reduced and the percentage allocated to bonds should be gradually increased. This is because stocks are generally considered to be more volatile and risky than bonds, and older investors may be more interested in preserving their capital and generating a steady stream of income.
It is good to note that the stock-to-bond allocation rule is not a hard and fast rule, and it is not appropriate for all investors. It is important to carefully consider your own investment goals, risk tolerance, and financial situation before making any decisions about how to allocate your portfolio.
#3 Hedge Against Inflation
Last but not least, bonds can be used as a hedge against inflation because the interest rates on most bonds are adjusted for inflation. This means that the purchasing power of the interest payments will not be eroded over time.
When an investor buys a bond, they are essentially lending money to the issuer of the bond, such as a government or a corporation. In return for lending the money, the investor receives regular interest payments, known as the coupon, over the life of the bond. The coupon is typically set at a fixed rate when the bond is issued, and it will remain at that rate unless the issuer defaults on the bond or the bond is called early.
However, if the rate of inflation increases, the purchasing power of the fixed interest payments will decrease over time. To compensate for this, many bonds are issued with an inflation-adjusted interest rate, also known as a real interest rate. This means that the interest rate on the bond will be adjusted periodically to account for changes in the rate of inflation.
For example, if an investor buys a bond with a real interest rate of 2%, and the rate of inflation increases to 3%, the interest rate on the bond will be increased to 5% to maintain the purchasing power of the interest payments. This means that the investor will continue to receive interest payments that are sufficient to maintain their purchasing power, even if the rate of inflation increases.
In Singapore’s context, the SSB does not offer an inflation-adjusted interest rate but rather, just a fixed rate that improves over time as you hold the bond longer. Using the August 2023 SSB above as an example, we can see that the first 7 years offer a lower interest rate of 2.97% p.a. This is then slowly increased starting in year 8 to 2.98% all the way until year 10 to 2.99%. It is good to note that every month’s SSB has a different step-up structure.
In conclusion, investing in bonds can be a smart way to diversify your portfolio and earn a steady stream of income. By understanding the different types of bonds and their risks and potential rewards, you can make informed decisions and potentially improve your financial future.
It is important to understand that the value of your bonds can fluctuate based on changes in interest rates and the creditworthiness of the issuer. When interest rates rise, the value of existing bonds can decline, which can affect your potential returns. And if the issuer of a bond defaults on its payments, you may not receive the full amount of your principal and interest.
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