OCBC OneWealth App– Be mindful of the risks when buying bonds

Bonds

Global

Fundamentals

Vasu Menon

Senior Investment Strategist, Wealth Management Singapore, OCBC Bank

Be mindful of the risks when buying bonds

29 April 2019

Investors who purchase bonds need to be mindful of the risks

Buying a corporate bond is akin to extending a loan to a company in return for interest payments for the funds you so generously part with. So long as the company manages their finances well, a bond investor wouldn’t have to worry too much about the risk of losing their principal.

Put differently, one could think about a bond investor as a mini-bank – they will need to assess the credit worthiness of the borrower and decide if they would be willing to extend the loan, for a given rate of interest or coupon. For this, understanding the company’s financial statements is essential.

The golden rule of finance applies – higher risk for higher returns. The lower the credit-worthiness or the higher the risk of a given company, the higher the borrower would need to offer in interest as compensation for the risk that the investor is potentially exposing him or herself to should they extend the loan.

Indeed, a 2 per cent per annum coupon on a bond of a blue-chip company may not be as exciting as a 6 per cent interest offered by a small corporate. In the crowded search for yield, investors would inevitably gravitate towards questionable issuers who can offer higher coupons. The yields may be high, but on a risk-adjusted basis, returns might not be as attractive.

Two key risks with bond investing

In times of economic distress, default rates among corporate credit issuers can jump sharply, especially those operating in Emerging Markets like Latin America and Asia.

Case in point, following the 2001 dot com crash and the 2008 financial crisis, default rates for emerging market bonds exceeded 10%.

Closer to home, a string of collapses in 2016 - a first since 2009 - led by Trikomsel, Pacific Andes Resources Development, Swiber, Perisai Petroleum Teknologi, Swissco and Rickmers Maritime raised concerns over such risks in the Singapore dollar high yield space. Many of these stressed issuers were operating in the oil and gas sector, which itself was battered by the persistent decline in oil prices due to OPEC’s “price war” against U.S. shale producers.

While solid credit underwriting can reduce default risks, it will never eliminate them entirely. After all, it may not always be the case that a company was badly run, but that the macroeconomic circumstances and sector-related pressures may push companies to the brink of default. Inability to access funding due to the size and scale of the company’s operation during periods of stress might be another factor to be mindful of.

The inconvenient truth is defaults have been and will remain part and parcel of investing in any bond, and this is a risk that investors need to understand and accept once they sign on the dotted line.

Liquidity risk is the other key risk to bear in mind. This is especially pertinent among high yield bonds. In times of heightened financial market volatility, this market can potentially run into some liquidity issues.

We saw this happening in the Singapore dollar bond market in 2016, which largely affected the oil and marine sectors where increased volatility resulted in a lack of liquidity for such bonds.

In financially precarious situations, investors may be hard-pressed to find buyers for these stressed assets and may therefore find it difficult to trim their positions quickly, resulting in bigger losses later should they not be able to offload these securities.

Liquidity risks adds another dimension of uncertainty and may require investors to be responsive and agile in their bond allocations to changes in market conditions. Slow reactions may become particularly costly for investors.

Consider bond funds to reduce investment risk

Diversification is one way to reduce risk, However, with bonds, the investment outlay can be substantial as you need at least $250,000 to buy most bonds. This makes buying a diversified pool of bonds very costly.

The alternative is to consider bond funds or multi-asset funds with exposure to bonds, which offers diversification benefits and allows investors to tap into the expertise of fund managers.

The outlay to purchase a bond fund is much lower than buying individual bonds and is one way to reduce investment risk.

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