My name is Bond... what were you expecting?
When it comes to bonds, it's a fairly boring affair. However, it is very easy to understand and is a safe investment as you age. Let's crack it down and see how bonds and index funds can make a great portfolio.
I can tell you right now, in a long term investment, bonds will rarely (or probably never) make as much money as stocks or index funds. However they are much less volatile and if this is included in your portfolio, you can almost be sure that it won't hit rock bottom.
To put it simply, a bond is just money you loan to the government or a corporation. They will promise a certain amount of returns that is typically around 2%-4% annually, there are others out there that offer more, but most bonds come around this range. If this entity is able to repay your capital and interests, it's generally safe.
Bonds can be short, intermediate or long term. When you buy them, you can choose which you prefer. A short term bond can be as short as 1 year, while long term bonds can go up to 15-20 years. This means your capital is locked in for that amount of years and you will get back the same capital (if you deposited 10K, you get 10K, since interests are paid to your bank account every 6 months or 1 year) once the bond term ends, unless you sell it to a primary dealer before that (explained later).
However, different types of bonds presents different amounts of risks. In Singapore, the safest bonds are Singapore Savings Bond (SSB) and Singapore Government Securities (SGS), as they are from the government. So unless our government goes bust, you can almost guarantee your money is safe.
A good rule of thumb to see if the bonds fit your risk appetite is to know that the higher interest offered, the riskier the bond.
For Singaporeans, other than SSB and SGS, there is another common option, which is the ABF Bond Singapore Index Fund. It's an ETF of AAA-rated government bonds. Right now you're probably confused as to how bonds can be traded as ETFs, I'll get to that shortly. Let me elaborate about SSB and SGS first.
SGS: A Very Clear Explanation
SSB and SGS are very similar except in terms of liquidity and structure. They are both bonds backed by the Singapore government and is risk free as long as the government does not go bankrupt. Your capital is guaranteed for SSB and it depends for SGS. Here's why.
SGS is a traditional bond by the Singapore government. For this bond, the value of your bond increases when interest rates are low and vice versa. Let me explain why.
Assuming you bought a bond at $1000 SGD at 3% interest returns annually, that means that you're getting $30 annually. However, the next month/year when new bonds are out at an increased interest rate, say 5%, the value of your bond is now not worth as much as you paid for. Investors would rather get $50 annually than $30, so they would rather get the new bond that's just released. If they can get a 5% interest rate at $1000 SGD, why would they buy yours for the same? Of course alternatively if your bond's interest is higher than the new bond released, investors would be willing to pay more for your bond as the value is technically worth more than $1000 SGD.
In any case, note that the value of bonds only affects you if you do not plan to keep your purchased bond until maturity, be it 2,5,10 or 20 years. If you're not letting them go, the value of a bond doesn't affect you as you will just get your capital back. This applies to all types of sellable bonds, not just SGS.
I know what you're thinking. You bought bonds from the government, so who do you sell the bonds to if you wish to make a quick profit/loss (if your bonds rise in value due to lower interest rate, or if you just want to cut short your loss, which isn't a very smart move)?
Primary dealers are people who buys government securities from either a willing seller or the government directly with the intention of reselling bonds for a profit when interest rates are higher. That's who you're selling to if you intend to sell it. This is the only reason why your bonds can rise or fall in value. However, if you keep the said bonds you've purchased from the government till maturity, your capital is guaranteed, at no profit or loss, with the annual interests paid to you.
So to sum it up, bonds like SGS are loans that you give to the government or a corporation and they promise you an interest rate normally paid semi-annually or annually. If you keep it till maturity, you earn the interest rate annually until the end of the bond and when it matures, you get back your original capital. If you decide to buy or sell it, that's when the value of a bond matters, and you have to see if it's for a profit or loss.
SSB
The Singapore Savings Bond (SSB) is a newer bond released by the local government.
Firstly, it does not have a locked period. If you intend to sell it back to the government, the government will return your capital to you in 30 days. That means your bonds have much more liquidity compared to SGS. By the way, you cannot sell SSBs to Primary Dealers, it is only sellable to the government.
Secondly, the interest rates are increased over time. I.e to say, at the first year, the interest may be 1%, the second may be 1.5% and it increases every year. However, it follows the SGS market rates, therefore if you were to put the money in for 10 years in an SGS or an SSB, the overall interest gained is the same.
For a SGS, you get a fixed interest every year, and for SSB the interest increases over time. You will get lesser interest back at the start for SSBs, but at the advantage of liquidity if you need the money. If not, keep it till maturity and you will enjoy the same rate as the SGS.
The minimum amount to invest is SGS is also slightly more affordable, at a minimum of $500 SGD compared to $1000. However, there's a total limit of 100K for SSBs, and you can no longer invest if you have maxed the amount.
SGS or SSB? Why not both?
This is a common strategy. If interest rates are high, get SSBs to enjoy the higher interest coupons. Do not make the mistake of getting SGS as it will not benefit from a high interest rate (unless you want to keep it until maturity, then get it by all means). When interest rates gets lower, that's when you should get SGSs as you will be able to resell them for a higher value when you've waited till interest rates are high again. Some people I know do adopt this strategy, but I'm not very supportive of it.
In my personal opinion, I'm a fan of maintaining my bonds in SSBs due to the liquidity and to fulfil my main objective, to maintain a balanced portfolio the 'lazy' way. By having to buy and resell my SGSs and SSBs at different times according to interest rates, it's a hassle that I may not strongly favour. SSBs are designed to buy and hold, and if you wish to take advantage of higher interests, apply periodically instead of one lump sum of 100K.
The Third Alternative: Bond Index/ETF
That's right, bonds can be bought as index funds and ETFs. Since you probably know what an index fund is if you read my previous post, it's easy to explain. A bond index is simply the same as an index fund, except that instead of the top companies, it's a basket of high quality bonds (or whatever bond that advisor deems fit). When one bond expires or matures, another bond will simply take it's place. This can be bought as an ETF, which makes your portfolio way easier than having to switch between SSBs and SGSs. Just take it that you are now loaning money to a buttload of corporations and government entities instead of just the government or a single corporation, the theory is the same.
A great bond index in Singapore is the ABF Singapore Bond Index Fund, also by Nikko AM. They track the iBoxx ABF which comprises of high quality government bonds and government entities. They have generated annualised returns of 2.65% since inception (with compound interest in effect, that's a good lot of money if you've been investing since 2005), and has proven to have a steady track record thus far. I'm currently invested in this via POSB Invest Saver.
Since bonds are promised interest rates, you will discover that their returns will be generally lesser than index funds / ETFs (2.65% compared to 11.48%) which fluctuates based on market performance. Therefore, it is advisable to invest a lesser proportion of your money into bonds unless you are very conservative.
Why Should I Invest In Bonds Then?
Since index funds perform so much better than bonds, why shouldn't I invest all of my portfolio in it?!
That sounds logical at first, but...
Firstly, what is your original goal? To be mega-rich, or to retire early and live a comfortable life? The main purpose of passive income and dollar cost averaging is to generate returns for you to have a comfortable retirement without worries. If you need to liquidate your ETFs when you get old and the stock market is at an all time down, how much of your returns would you have lost?
With bonds, at times of emergencies you are able to liquidate without touching your index funds, and you can wait for a suitable time before selling the units at a much better price. When you reach an old age, your portfolio should primarily consist of bonds in order to be able to withdraw the dividends without touching the units inside, that is our ultimate goal.
That's right, never lose sight of your final goal. We want to generate a save passive income that allows us to not have to touch our units and let the money work for us. At the time of retirement, you cannot afford to wait ten years for the market to recover after a drastic market crash like you are able to now.
At the age of 23, I am able to handle 3-4 decades of market crashes (I would cheer for crashes as I can get units dirt cheap). However when I'm 60 and in need of a stable passive income, one market crash can ruin my entire annual income if I don't have a primary allocation of bonds in my portfolio.
In my next post, I will share about the portfolio strategy that is safe and effective. As an introduction, just know that young = index funds and old = bonds. It's the risk that you can take and the risk you cannot afford to take.
Till then, remember not to be greedy and aim for pure index funds unless you think you're lucky enough!
-WC
P/S: After I've gotten around how I'm planning my portfolio in the next post, I'm going to write a series of posts that educated me about numbers, good and bad investments, and also some terminology that you should know! So after the 'boring' stuff, let's learn little by little to make yourself more financially savvy! Don't just know what to invest, know how to invest!
