InsideINVESTOR: Investing in Bonds

By ShareInvestor

Many people like yourself are familiar with the terms stocks and shares. However, chances are most of us are likely to be clueless when the topic veers towards investing in bonds.

There is no need to avoid bonds or fear them – they are nowhere near as complex as you may think. Read on and you will find yourself agreeing on this!

How do bonds work?

We should start off with explaining what bonds are.

Bonds are essentially loans. If you buy a bond, you are effectively loaning money to the company issuing the bond.

To provide you an incentive for the loan, the company would propose something along these lines: “For lending me $1,000, I will pay you back the amount in a year with an interest of 2 per cent.” That means you get $1,020 back after a year.

You will then sign a document with the company with these terms clearly stated so that it is legally binding, which the company is still obliged to meet its promised pay-outs even if it is not making profits.

If the company continues to do badly over an extended period, it may need to sell its assets or liquidate. If this happens, those who hold bonds will receive priority to get paid over those who own shares.

Different bonds come with different interest rates and different time frames.

A bond can be as short as a year or as long as 10 years, however, longer period bonds would tend to offer higher interest rates.

About Government bonds

Bond offered by the Singapore Government are especially popular with investors as they allow a low entry level of just $500.

These bonds guarantee the investor’s principal amount invested and is backed by the Government itself.

Another feature is that they allow investors to withdraw their investment at a time without any penalty. You get to withdraw your full principal amount and keep whatever interests that have been paid to you previously.

Are bonds suitable for you?

Overall, these are the wonderful things about bonds:

  • They are comparatively stable and offer a steady flow of returns;
  • They are almost guaranteed to give you your promised returns and capital back
  • They are not tied to how much a company makes so even in tough times, investors still get their promised returns

Do these qualities appeal to you? If so, bonds may be something you want to seriously consider, no matter what stage of life you may be in. Bonds are especially attractive to those who are risk averse or have a preference to “play it safe”.

You could be a young adult who have just started working and are trying to build up their savings at a higher interest rate than a bank’s savings account, but do not want the risks that come with investing in stock markets.

Or you could be a middle-aged salaried worker, saving for your retirement and want to avoid the situation of your savings being wiped out by a sudden market crash.

Retirees who have enough saved up would also find the bonds option attractive as it increases their retirement pool without the risk of losing their savings.

Bonds are a stable form of investment. Like those who get sick on planes or boats, some people just don’t have the stomach for the turbulence of stock markets and prefer bonds - no one should laugh at you for that as financial planning is unique to individuals and their goals.

On the other hand, if you have already built up a fair amount of savings for rainy days, you may want to consider investing in more high-risk instruments like stocks. Because this amount is the “extra” you can afford to lose, you may be willing to take more risks with it in the hope of better returns.

The approximate rate of a one-year bond is about 1.5 per cent. Stocks, on the other hand, may earn investors between 5 and 10 per cent when invested prudently.

You should also consider that the returns from bonds can get diluted due to inflation. The Monetary Authority of Singapore (MAS) puts the average annual increase in inflation at 2 per cent.

For those invested in longer-term bonds, the interest you collect may not necessarily help you combat the inflation rate if things end up becoming more expensive.

Is it ‘either-or’ when it comes to stocks and bonds?

Does this mean that people who buy stocks would not buy bonds, or vice versa?

Not at all – you may have heard of the adage ‘Never put all your eggs in one basket.’ This is to balance out the volatility of the stock market with the stability of bonds.

Take for example someone who invested $1,000 in stocks and another $1,000 in bonds.

After a year, assuming the person needs his money back, the stocks they bought may have dropped in overall value by 1 per cent, meaning they get only $990 back if they sell them.

But the bonds they bought would have made them 2 per cent and they get $1,020 in return.

Overall, this investor would still have made $10 after a year. In this example, the investment in bonds is used to cushion potential losses in the stock market.

This is the reason why you may have heard of the term “diversification” from your friends who invest – have some bonds in your investment portfolio for more secure returns but use some of your savings to invest in stocks for potentially higher returns. The proportion of bonds to stocks should depend on the amount of risk you are willing to take.

Now that we’ve explained the concept of bonds and their pros and cons, while you won’t turn into a pro overnight, equipped with this knowledge you should at least feel more at ease with them.

The next time you have that little extra in your savings that you may not need for a year or two, consider ‘loaning’ it to a company.

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