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Bond funds / ETFS are NOT Bonds!

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With the rise of robo-advisors in Singapore, there’s been an increased allocation into US listed bond ETFs that most investors would probably not have known about or invested in otherwise.

This article, I cover the key difference between bonds and bond ETFS and explain why they are quite different things.

Bonds in a nutshell

Bonds are essentially debt obligations.

You can think of them as IOUs.

You are essentially lending money out to a company in exchange for interest for a fixed duration of time.

Bonds are normally regarded as safer because they rank higher than equity holders.

That’s really just a fancy way of saying that in the event of a default or liquidation, you are more likely to get back your money than shareholders.

The problem with bonds in Singapore

There are two main problems.

Firstly, the retail bond market for Singapore bonds are woefully small and its very hard to build up a diversified portfolio.

If you are an accredited investor, you have more options. The only problem is that each bond is normally has a minimum investment size of $250,000.

Unless you have a very big portfolio, building up a diversified portfolio is hard.

This issue was very real for bond investors who were heavily overweighted into oil and gas bonds in 2016.

They had some spare cash, bought one or two bonds like the Swiber bonds and saw it go up in flames.

The thing is that bonds are “guaranteed” – but the guarantee is only as good as the underlying company that guarantees it.

If the company isn’t making money or doesn’t have assets, it won’t be able to pay off bondholders either.

Bond ETFS / Funds

So in that regard, bonds funds / ETFs seem like a good alternative.

You pay a management fee – but in exchange you get a diversified portfolio of bonds.

So what’s there not to like?

The problem is that bond ETFs / funds do not actually mature.

Let’s unpack this further.

OHLSP 5.150% 18May2020 Corp (SGD) – Retail (from Bondsupermart)

Bonds prices like stocks do actually fluctuate.

There’s an active market for the buying and selling of bonds (although less liquid).

Although bond prices may fluctuate, as long as the underlying company has the ability to pay it back, they eventually “snap back” to par value on maturity.

Example:

$1000 (par value) paying an interest of 5% over 5 years

The par value is just the face value of the bond. Bond prices may vary for many reasons such as interest rates fluctuation, worries about the company’s financials etc.

Bond prices move in an opposite direction from interest rates.

So in an environment when interest rates rise, bond prices fall.

The key thing is that they do eventually mature.. and you get back the money you borrowed in the first place so as long as you wait to maturity, that loss is not crystallized (i.e. you get back your $1,000).

Bond ETFS / Funds do not mature

The big problem is that bond funds / ETFs do not mature.

Unlike individual bonds, bond ETFs or funds have no maturity date.

Remember all they are are a portfolio of different bonds.

Your return will dependent on the price you pay and the price you sell your bond fund.

In an extended environment of rising rates and falling NAVs for bond funds, investors would typically suffer losses if you sell early.

Not all bond funds are the same

It is important here to note that the quality and the duration risk (i.e. how long the maturity of the bonds are) play a big part in how the bond fund will react.

For an answer, start with 2008. True, it was an extraordinary year, with the S&P 500 losing 37%, even with dividends reinvested. Still, one reason you own bond funds is to protect you in a year like that—and yet many didn’t.

Emerging-market debt funds plunged 17.6%, high-yield municipal-bond funds fell 25.3% and bank-loan funds tumbled 29.7%. It wasn’t just riskier funds that took a hit. Even short-term bond funds, which invest partly or entirely in corporate bonds, slid 4.2%.

– Why many bond funds are as volatile as stocks (LINK)

An important thing to note is that the longer the duration of the bonds, the more sensitive they are to interest rate movements and this equally applies to bond funds.

Ending thoughts:

Bond funds have a place to play for many investors. A bad year for bond funds is not nearly as bad as a bad year for stocks.

At the same time, it is important to note the key differences between bonds and bond funds as highlighted above.

 


 

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