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Investing in Bonds and Losing $250,000. Is It Safe?

SUMMARY

  • What is a Bond?
  • Different Types of Bonds & How They Work
  • The Risks involved
  • How to Evaluate any Bond

1) Introduction

An article in Bloomberg published on 20th Sep 2016 (written by  Chanyaporn Chajaroen) reads “When Elaine Tham signed an “accredited investor” form with her bank in Singapore two years ago, she took a fateful step toward losing all the money she had set aside for her children’s education. Based on her financial profile and investment priorities — her need for S$150,000 ($110,000) to pay university fees — a local branch of HSBC Holdings Plc had initially categorized her as a “medium risk” investor. But because the value of her property and car entitled her to “accredited” status, a category reserved for wealthy investors, Tham says she was persuaded to take a riskier path. She agreed to invest S$250,000 in the bonds of a small Singapore energy-services company, Swiber Holdings Ltd., which said in August that it won’t be able to repay its bondholders.

The intention of this article is for you to know more about bonds so that such unpleasant episode won’t happen to you. Let’s get started.

As per SGX report dated Oct 3, 2016, The Straits Times Index (STI) taking the year-to-date performance to -0.46%.  Singapore Bond Index Fund (SBIF) has taken the year-to-date performance to +5.61%.

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Source: Bloomberg.com

Being an individual investor, investing in individual bonds could be rewarding but there could be some unpleasant surprises.

Given the negative news since late last year, where PT Trikomsel Oke missed payments, Pacific Andes Resources Development reneged on securities in January and Swiber failed payment in Aug, followed by Perisai Petroleum Teknologi and its bond holders are struggling to come to an agreement on the $125 million worth of notes due on Oct 3, 2016, the bond market in Singapore has been shattered.

Is the bond market seeing a risk?  Should there be more regulations to protect investors?

The 5.3 per cent securities of Aspial Corp, a jewellery retailer and developer of high-rise condos, have fallen to 92 cents from about 100 cents, exchange prices show. Also, the 6 per cent perpetual bonds sold to retail investors by water firm Hyflux have slipped to 96 cents from about 100 cents as of Oct 3, 2016.

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Source: SGX.com. Note: Hyflux is considered perpetual securites

While investors could wait for the legislation to be put in place, given the current indicators will mostly be on increasing frequency and requirement of disclosure, it is important to understand some basic on investing in bonds.  After all, value investing is not about studying financial date or reading finance news constantly.

2) Definition of a Bond

A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate[i]. In simple terms, some companies wanted more funds to grow and there are many ways to do it. One of the ways is to borrow from someone and in this case investors who buy the bonds. Since the company is borrowing from someone, it’s fair that the company has to give some form of returns to the investors (or lenders), thus the fixed interest rate.

3) Types of Bonds and How It Works?

There are two main baskets of bond:

(a) Government Bond

US savings bonds, Treasury bonds are only available to US residents with social security numbers.  Foreigners who wish to invest can only do so by custody account of their US brokers.  The latter route will require you to scrutinize the brokers’ risk and creditability.

SG T Bills and SGS are not available to retail investors.  Individual can only invested in SSB. Refer to this link for “how to buy” in detail.

(b) Corporate/ Retail Bond

Retail bonds are sold in the retail market and offered to individual investors.  They are normally offered to fund for a particular project.  The issuer can be government or corporation.

4) Other Varieties of Bonds

  1. Zero-coupon bonds Issued at a discount and converged to face value upon maturity. Instead of paying regular interest, the interest was considered covered by the discount.  This is uncommon in SG.
  2. Convertible bonds are bond that allows bondholder to convert into stock at some point, especially if the share price rises to a sufficiently high level to make such a conversion attractive.

Some corporate bonds are callable or putable, meaning that the company can call back the bonds from bondholder or vice versa.  These bonds typically trade at a premium for the risk of being terminated earlier.

5) Risks Involved in Investing in Bonds

Although SGX quoted fixed income investment as “If your investment goals are to protect against real capital loss on your money over a period of time or generate passive income, then fixed income is a great tool for you”, further down the lines, the risk of investing in these instruments were tabulated as follows:

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Unlike corporate bonds, government bonds are considered risk free as they are guaranteed by the government, it is important to understand that they still carry the interest rate risk.

Interest rate is relevant for both government and corporate bonds.  As the market interest rate rising, the real value of bond will decrease and vice versa.

In addition to interest rate risk, corporate bonds are subjected to event risk.  A company might face unforeseen circumstances which undermined their ability to pay the interest, – or repay the principal.  This risk is highly depending on the company ability to generate cash.

The list of bonds in SGX

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6) How to evaluate

Following are a few criteria to be considered:

1. Four principles of selection of fixed income investment [ii]

a. Safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.

b. This ability should be measured under conditions of depression rather than prosperity.

c. Deficient safety cannot be compensated for by an abnormally high coupon rate.

d. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statute to govern investments of savings banks.

2. Issuer quality

a. Background research of the issuer, if they are corporation or government.  Their reputations and past records of the issuances and repayments.

b. Profitability of the company on its day to day running.  Basically, the company must passed the VIA Funnel (Click HERE to find out what is VIA Funnel) and your margin of safety.

c. Place of Listing is important as it will determine the regulatory oversight of the issuer. Stay clear if you are unfamiliar with the location.

d. The total debts and cash balance of the issuer

3. Financial Ratio

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Source: Benjamin Graham – Security Analysis

4. Credit Rating

A bond is considered investment grade if it is rated BBB- or higher by Standard & Poor’s or Baa3 or higher by Moody’s.  These ratings allow public institutional fund management, e.g., retirement benefit institutes and banks to invest in them.  Credit rating was used as a key selling point in the subprime mortgage bonds.  As credit rating companies were paid by corporation to rate their debt instruments, wasn’t there a conflict of interest?

5. Business case/Project viability

Does the project for the funding make any sense to you?  We should be able to understand and confident that the project will turn in sufficient cash flow to meet repayment.

6. Market Interest Rate

It is typical to have a bond issued at higher than bank fixed deposit interest rate but lower than SIBOR/ LIBOR.  The interest rate should also be higher than those offered in any government bonds.

Is the return (ROI) comparable to other investments with similar risk?  What is the interest rate of SSB, Singapore (T-Bills), etc. (SG context)?  Does the company issue preference share

7. Opportunity Cost

Is the return (ROI) comparable to other investments with similar risk?  What is the interest rate of SSB, Singapore (T-Bills), etc (from SG context)?  Does the company issued preference share?

8. Length of Investment

The longer the maturity, the higher should the interest rate be. Consideration should be given in terms of maturity of the bond and the length of project.

Do note that returns generated from bonds will definitely be lower than that of stocks. But it will be very useful as a temporary parking place for your spare cash while waiting for great opportunities.

If you want to learn How to Generate Much Higher Returns, click on the picture below to join our Free Value Investing Masterclass or <<CLICK HERE To Register>>

cta

Neish C.
Research Analyst, Mind Kinesis Value Investing Academy

[i] Investopedia
[ii] Security Analysis – Benjamin Grahams

Comments 2

    1. Post
      Author

      Hi Shane, thanks for the feedback. Mary Buffett has once said the best way to get out of trouble is to stay out of trouble. Do note that corporate bonds are mostly unrated whic means that most of them are junk bonds. The best way is to stay away.

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