Gradually up exposure to Investment Grade bonds amid slowing economy
- Slower and longer: Interest rate is now approaching to the recent high and we expect that such level will maintain. There should be a lower volatility for the short and medium term bonds due to lower sensitivities towards the interest rate.
- Economic activities and sentiments of the U.S. and Europe are expected to undergo downtrends. Contracting growth accelerates the elimination of the weak; default risk therefore increases. Bonds with good credit quality are more desirable.
- In 2022, Fed raised rate by 4.25%, during which bond yields also rose; this makes investment grade bonds even more favorable.
- Since the interest rate hike cycle is yet to end, bond yields could climb further, and the yield curve is still inverted. It is recommended that investors give priority to short-term bonds, and wait until the Fed’s rate hike roadmap becomes clearer, or when the risk of a U.S. recession rises significantly, before progressively upping the allocation to longer duration bonds to increase long-term potential returns
Above information as of Feb 2023
How to generate potential gains through bond investments?
Investors receive interest payments^ regularly regardless of the price movement.
Potential capital upside by capturing the price movement
Investor may also make profit by capturing price movement and trade them in the secondary market.
If investors buy the bond at a discounted price, investors may enjoy capital gain from the price difference as the bond issuer will repay the principal at par value to them at maturity.
^ Except zero coupon bonds
Bond Price: 103%
Bond price is higher than the par value, known as “Premium Bonds”
Yield < Coupon
Investor may sell the bond at 103% at the market, and receive accrued interest.
Capital Upside + Coupon received + Accrued interest
Bond Price: 99%
Bond price is lower than the par value, known as “Discount Bonds”
Yield > Coupon
There is a capital loss if you sell the bond at this level, yet it can be partially offset by the coupon and the accrued interest entitlement.
Capital Downside + Coupon received + Accrued interest
You will receive 100% of principal and last coupon payment at the maturity date.
Principal + last coupon payment = $200,000+5,000 =$205,000
Coupon received during your holding period
Early Redemption Feature
Callable option may be embedded in some bonds and the actual duration may be shorter than what the investors expect. As such, investor should also take the Yield to Call (YTC) into account so as to manage their expected return.
Ranking of claim may differ from the across different in the event of default/liquidation, Claiming rank can be different for each bond even they are issued by the same entity, there can be premium for the bond with lower claim ranking.
Notes – Bond Investments
- Several credit agencies assign rating to assess their credit risk, such as Moody’s , S&P Global Ratings and Fitch.
- Bonds can be either rated as investment Grade bonds or High Yield bonds. As a nature of risk-reward, high yield bonds usually bears a higher coupon/yield than the investment grade bonds, however with higher credit risk.
- Bond issuers may not obtain credit ratings from the credit agencies.
|Moody’s||S&P Global Ratings||Fitch|
Bonds involve default risks from the issuer. Credit ratings is not as a guarantee of the issuer’s creditworthiness.
Investor may not sell the bonds before the maturity date as the liquidity can be limited in the secondary market for some bonds.
Interest Rate Risks
Bonds can be sensitive to the interest rate movement. There can be a negative impact on the bond price when the interest rate increases in general.
Investors may face re-investment risk if the issuer redeems the bonds prior to the maturity date.
Additional risk for High Yield Bonds Investments
Those bonds are usually assigned to a lower rating, or they are not rated by any credit agencies, and usually involving higher credit risk
Subject to the change of the economy cycle
There can be bigger negative impact on the high yield bonds comparing to the investment grade bonds when the economy downturns, because (i) investors may be more prudent and unwilling to bear risk exposures and (ii) higher default risks.
- Yield to Maturity (YTM) means the expected rate of return when the investor holds the bond till maturity, expressed as an annual rate of return
- Yield to Call (YTC) means the expected rate of return when the investor holds the bond till the next callable date, expressed as an annual rate of return
- Yield to Worst (YTW) means the lowest return in all possible scenarios, such the return between YTM and YTC, whichever is lower.
|1||Issuer||It refers to the institutions which borrow funds from the investors, they can be corporate, government or supranational bodies|
|2||Principal||The amount the issuer repays to the bondholder. Typically it is 100% of the face value.|
|3||Guarantor||Some bonds are guaranteed by the third party (as known as guarantor). In the event that the bond issuer defaults, the guarantor repays the principal and/or interest to the bondholders#|
|4||Ranking||Bonds can be categorized by their seniority. Some bonds are back by the collaterals, known as secured bonds. There are no collaterals for the senior unsecured bonds. In general, senior bond holders has priority compare to the subordinated bondholders for claiming.|
|5||Coupon||Issuer pays the bondholders at a predetermined interest rate, either fixed or variable. Some bonds bear zero percent coupon, they are normally issued at a discount price and bondholder will receive the principal in full at the maturity date.|
|6||Coupon Frequency||Typically, coupons are paid annually, semi-annually or quarterly.|
|7||Maturity||The predetermined date when the issuer repays the principal to the bondholders. Bonds with no specific maturity date are known as perpetual bonds.|
|8||Credit Rating||One of the consideration factors for assessing credit risks, which are assigned by the credit agencies. Generally speaking, higher credit rating will be assigned in the opinion that the bond issuer has a better capability for the repayments.|
|9||Accrued Interest||Investors need to pay the interest incurred between the previous coupon payment and the settlement date when the investor purchases bonds in the secondary market, apart from the principal.
Investor will receive the coupon in whole if they hold the bond till the next coupon payment date.
# Guarantors may not repay the principal and coupon in whole in the event of the issuer defaults, subject to the claiming priority and they are on case by case basis.
All investments involve risks. The prices of securities fluctuate, sometimes dramatically. The price of a security may move up or down, and may become valueless. It is as likely that losses will be incurred rather than profit made as a result of buying and selling securities.
Bond investment is NOT equivalent to a time deposit. It is NOT protected under the Hong Kong Deposit Protection Scheme. Bondholders are exposed to a variety of risks, including but not limited to: (i) Credit risk – The issuer is responsible for payment of interest and repayment of principal of bonds. If the issuer defaults, the holder of bonds may not be able to receive interest and get back the principal. It should also be noted that credit ratings assigned by credit rating agencies do not guarantee the creditworthiness of the issuer; (ii) Liquidity risk – some bonds may not have active secondary markets and it would be difficult or impossible for investors to sell the bond before its maturity; (iii) Interest rate risk – When the interest rate rises, the price of a fixed rate bond will normally drop, and vice versa. If you want to sell your bond before it matures, you may get less than your purchase price. Do not invest in bond unless you fully understand and are willing to assume the risks associated with it. Please seek independent advice if you are unsure.
You are advised to exercise caution and undertake your own independent review, and you should seek independent professional advice before making any investment decision. You should carefully consider whether investment is suitable in light of your own risk tolerance, financial situation, investment experience, investment objectives, investment horizon and investment knowledge.
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