How fixed income assets fit into your investment portfolio

What is fixed income?

Usually, fixed income is an investment where the borrower or issuer has to pay a fixed interest rate or dividend payment till the product reaches its maturity date. At maturity, the borrower or issuer repays the principal or the original invested amount to the investor.

How fixed income works

The most common type of the fixed income asset class is bonds, which are essentially loans, or IOUs. For centuries, bonds have been a way for governments and companies to raise money.

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For instance, if Party A requires $1 million, he can borrow the amount from Party B, who will issue him a fixed income instrument, or a debt with fixed interest for a period of five years. Party A gets the $1 million upfront, and in return, he will have to return Party B an interest of about 1% per annum (every year) for the next five years. At the end of the five years, Party A will have to return the principal amount of $1 million in addition to the interest he has paid.

Due to their more stable nature, bonds are seen as safer investments, although there are also high-risk, high-yield bonds for those with the stomach for the possible defaults. Generally, in return for its stability — especially the kind issued by highly-rated governments or blue chip companies — the rate of return for bonds is lower than that of equities, which are more volatile in nature.

However, not all bonds are made equal. In Singapore, the larger REITs offer bonds with lower yields in exchange for the stability they offer, whereas other, usually smaller REITs offer higher yields for their bonds.

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Similarly, government bonds, which are from first-world countries, offer lower interest rates in return for their stability compared to bonds from emerging markets. Bonds issued by the Singapore government, for example, come with the top “AAA” rating; those with struggling economies might have “C” or lower ratings, depending on the rating agency.

Advantages of investing in fixed income

While regarded as the more stable (and boring) cousin of other more volatile asset classes such as equities and commodities, it is good to include fixed income assets in an investment portfolio. After all, the volatility of equities means investors get to enjoy higher returns at the risk of suffering from higher losses as well.

There are several advantages in investing in fixed income, which is usually seen as a hedge against the risks of the stock market.

Mainly, fixed income offers a steady source of income through interests and carries a lower risk compared to equities, as equities are generally exposed to more macroeconomic and other factors. Relative to equities, fixed income provides realised returns through coupon or interest payments, while dividends payments from equities are not an obligation.

Also, if the worst-case scenario happens — a default or if the company winds up, bondholders or the company’s creditors will get payment priority compared to the equity investors.

Disadvantages of fixed income assets

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All asset classes come with risks. For one, the price of bonds moves in an inverse relationship with interest rates. In other words, when interest rates go up, bonds tend to lose their value.

The risk of inflation is also another disadvantage since bonds are a means of preserving the absolute value of your initial capital.

You risk losing money as well. This happens when you invest in corporate bonds that are rated on the lower end. While these bonds offer higher returns, the possibility of the issuer defaulting is higher, too. The local investment community might recall the spate of bonds issued by offshore and marine companies, such as Ezra Holdings, which went on a borrowing binge to fund their overzealous capacity expansion. When oil prices slumped, they could not meet their debt obligations.

Historical performance of bonds vs stocks

Based on the one, three, five and 10-year returns of the benchmark indices compared to the indices that represent fixed income, the returns of stocks vary more than the returns of fixed income.

The stock benchmark indices are represented by the Straits Times Index (STI), MSCI World and S&P 500, whereas the fixed income indices are represented by the S&P 500 Bond Index, Bloomberg Global Investment Grade Debt Index (IG) and Bloomberg Global HighYield Debt Index (HY).

As fixed income offers fixed returns per annum, it should come as no surprise that the returns of stocks appear more volatile. That said, the returns for bonds or fixed income are less predictable should you choose to trade those asset classes.

This indicates greater volatility as more investment risk is involved. Between the fixed income indices, we can also see that IG is less volatile than HY, again, denoting the higher risk, which high-yield fixed income debt carries compared to investment-grade fixed income debt.

When should you buy bonds?

It depends on your objectives. If you’re closer to retiring, it might be time to accumulate investments that offer you steady, recurring income. If your goal is to increase your total returns, buying a bond in a high-interest rate environment is one way to enjoy higher recurring returns.

Other factors include the looming concern of a crash, as well as the prospects of a company. If you’re concerned about the prospects of a company you’ve bought into, it’s time to accumulate bonds in the company, since its share price isn’t expected to grow as much as expected. Should a company go bankrupt, bondholders are paid before stockholders as well.

When should you sell bonds?

When interest rates are expected to go down, that is when bond prices increase. During the tenure of a bond, its interest rate that was agreed upon initially remains. This means that the likelihood of the bond’s interest rate standing higher than the benchmark rates are very likely.

During the tenure of a bond, where the interest rate has been fixed at the beginning, the borrower of the bond will have to pay the same rate as opposed to a lower rate set by the government.

For instance, using the same example earlier, in the fifth year of the tenure of the bond, Party A is supposed to continue paying a fixed interest rate of 1% or $10,000 per year. Should the government announce a fall in interest rates, Party A will be paying a lower amount of interest. If the risk-free rate falls to 0.5%, Party A will only have to pay an interest of $5,000 per annum without any initial agreement. But as the contract had been fixed at 10 years, the contract, which was originally worth less, is now worth twice as much, hence the price increase.

How much should bonds factor in an investment portfolio?

It depends on your risk appetite. When it comes to a balanced portfolio, investing experts usually recommend a mix of equities and bonds. Equities are seen as drivers, whereas bonds are relied on to be the “bedrock” of the portfolios. The most common allocation for a balanced portfolio is 60% equities, 40% bonds. If you’re ultra-conservative and want to be sure of your returns, you’ll want a portfolio that has a higher percentage of bonds.

Another rule of thumb to determine the ratio of equities to bonds is to take the investor’s age as the percentage of bonds he should have in his portfolio. That is, if you’re 30 this year, you should ideally have 30% of bonds in your portfolio and leave the remaining 70% for equities, whereas if you’re 60 this year, you should have 60% of bonds and 40% for equities, for more stable returns.

Where can you buy bonds as a retail investor?

Traditionally, bonds are the exclusive purview of the institutional investors — lots quantified in the millions of dollars change hands typically. In recent years, it has become more accessible for retail investors here to invest in bonds.

You can trade over-the-counter through your broker, or make your application via the ATM machine.

Bonds can also be bought and sold on the secondary market once they are issued. To purchase a bond on the secondary market, an investor will have to sign up for an account with a bond broker. Institutional investors who purchase bonds from the primary market will sometimes sell their holdings on the secondary market to retail investors.

Bonds can also be purchased through exchange-traded funds (ETFs) like the ABF Singapore Bond Index Fund, the iShares Core US Aggregate Bond ETF and the Vanguard Total Bond Market ETF.

What to consider before buying bonds

1. Know your objectives. What are you hoping to achieve out of buying a bond? Are you looking to conserve capital for a later date, are you looking to save up for your retirement, or do you have other obligations to fulfil?

2. Focusing on higher yields only. The returns may look attractive, but you have to remember that the higher the yield, the higher the risk. This is why government bonds from mainly developed countries or bonds from blue-chip companies offer lower yields.

3. Be informed. Among other things, read up on the company offering the bond if you are considering buying a corporate bond. Read the bond prospectus, where you will find a company’s financial statement and history, management experience, and so on.

4. Locate a broker who is experienced in dealing with bonds.

Types of fixed income securities

Bonds

• Government bonds are investment-grade debt securities issued by the governments of first-world countries to support the countries’ spending and obligations.
• Municipal bonds are debt securities issued by cities and states to fund projects such as highways and schools.
• Corporate bonds are similar to government bonds, except they are issued by companies. Proceeds from corporate bonds usually go towards mergers and acquisitions or general working purposes.

Within bonds, there are two categories:

• Investment-grade bonds, which are rated Baa3 or BBB- and anything higher, depending on the credit rating agency’s system.
• Junk bonds. These are categorised as non-investment-grade speculative bonds, which are rated Ba1 or BB+ and below. These mean that the yields on these bonds may be higher, but the tendency of the issuer defaulting is higher too.

Others

• Perpetual securities, which offer fixed income returns with no date of maturity. This particular product also means that the issuer is not obliged to pay the perpetual security holder the principal amount at a specific date.
• Treasury bills (T-bills) are short-term debt obligations issued by the US government and backed by the US Treasury Department.
• Treasury notes are another government-issued fixed income security. A treasury note has a fixed income rate and a maturity deadline of between two and 10 years.
• Certificate of Deposit (CDs) are similar to fixed deposits (FDs), in that they are like savings accounts that restrict your access to the money you put for a period of time in return for a higher interest rate. Unlike FDs, CDs are freely negotiable.

Key words

• Credit rating: An assessment of how creditworthy a fixed income asset is. Such ratings are published by agencies. The three main agencies are Fitch Ratings, Moody’s and Standard & Poor’s.
• Credit risk: The possibility of an issuer defaulting on interest payment or on the principal amount upon the maturity of the bond.
• Coupon: The rate of interest you’ll receive from the bond.
• Risk-free rate: Also known as the risk-free rate of return, this is the rate of return on an investment where it is assumed to make all payments on time.
• Yield: This is the rate of return from your investment. This is calculated by using the coupon amount divided by the price of the fixed income asset.