Is it good to invest in bonds?
Question: My bank recently told me it was no longer accepting Special Deposit Account (SDA) investments and that my existing SDAs with the bank would soon be discontinued. There are various bond offerings lately and I am exploring if I can shift my funds from SDA to bonds. Can you advise me?—Verna Lozano by e-mail
Answer: Investing in bonds will definitely give you a higher return than SDAs. However, unlike SDAs, which keep you liquid by giving you the option to roll over your investment every month it matures, investing in bonds may keep your money tied up for many years.
Bonds are normally issued with a term of at least one year and as long as 30 years. The interest rate promised is fixed over the life of the bond. The longer the maturity, the higher the fixed interest rate is to compensate you for tying up your money for a longer period. You can get back your principal if you hold on to the bonds until maturity.
There is nothing wrong with holding on to the bonds until maturity if you do not see any use for the money in the immediate future. You may have already computed beforehand the amount of money you need to achieve certain financial goals such as paying for someone’s college education or retirement needs when the bond matures.
You can also pre-terminate your bonds anytime by selling them before maturity but there is no guarantee that you will receive your principal intact. Why? The market interest rate by that time may be higher than the interest rate your bond offers. In this case, you may have to sell at a loss to adjust the rate to current yield.
For example, you invested P100,000 in a government-issued bonds that pay 3.25 percent a year or P3,250 in interest income for 10 years. After one year, you decided to sell your bonds in the market because you needed money but the prevailing interest rate by that time was 5 percent a year. For you to find a buyer of your bonds, you need to value your bonds that assumes to pay the same interest income of P3,250 but at 5 percent interest. To value your bond, divide the fixed interest of P3,250 by 5 percent which gives you P65,000. At this amount, you will stand to lose 35 percent of your principal.
There is also the possibility that interest rate will be lower after one year. Using the same example, if you sell your bonds at a time when current interest rate in the market is 2 percent a year, which is lower than the 3.25 percent as promised, the value of your bond will be computed by dividing the fixed interest of P3,250 by 2 percent which gives you a market price of P162,500. In this case, you will gain 62.5 percent from your investment of P100,000.
You see that bond prices and interest rates move in opposite directions. When interest rates fall, bond prices go up. When interest rates go up, bond prices fall. So what are the chances that interest rates will continue to fall?
Interest rates in the United States have started to pick up on expectations that the US Fed will soon reduce money supply in the system. The rise in interest rate in the US lured back dollar funds invested elsewhere, including the Philippines. The outflow of dollar funds from our economy resulted in the temporary depreciation of the peso. If this continues, the local interest rates may also increase.
The strategy is to stay liquid at this juncture and avoid rushing to lock in your funds from SDAs into these bond offerings that offer low fixed interest rates. There will be more bond offerings not only from the government but also from corporations because they want to take advantage of the current low interest rate environment.
Global interest rates are expected to increase soon, this is the best time to stand by and look for the best opportunity to invest in underpriced assets such as bonds or stocks. If interest rates go up, you can buy bonds at discounts. The capital gain that you will earn from the discount plus the interest rate for the remaining life of the bond is what we call yield to maturity or YTM.
When you invest in bonds, make sure your YTM is higher than the expected inflation. For example, you invested in a bond that pays 3.25 percent YTM for 10 years and let’s say inflation increases to 4 percent next year, you would get negative real interest rate of 0.75 percent. Our current inflation is at historical low of 2.5 percent and with the expected increase in money supply from expiring SDAs worth at least P1 trillion in the coming weeks, inflation may pick up and find its way back to recent highs of 3.8 percent to 4 percent.
While you wait for bond prices to fall for better yields, you can use your excess funds to invest in high dividend-paying stocks. There are a handful of solid stocks in the market offering higher than 3.25 percent yield that you can buy now at bargain prices. With higher interest rates looming in the horizon, stock prices will likely fall further.
As stock prices fall, dividend yield increases. Buy stocks with dividend yields of at least 3.25 percent as your starting point. One stock that you can consider is PLDT, which has a current dividend yield of 5.7 percent. This stock pays dividends two times a year just like a regular bond. Yes, it may fall more, but you will be happy to buy more because of higher dividend yields. Are you ready?
(Henry Ong is a registered financial planner of RFP Philippines. To learn more about financial planning and how to become RFP, attend our free personal finance talk on Aug. 29 at PSE Ortigas. To reserve, email at firstname.lastname@example.org or text <name><email><RFPinfo> at 0917-3464126).