Should I invest in bonds?

Question: I often read about investing in stocks and bonds. I get to read a lot of discussions on stocks but not much on bonds. What are bonds and should I invest in them?—Name withheld upon request, asked via e-mail

Answer:

With all the attention the stock market gets lately, you would think it is getting the bulk of the investments being made in the Philippines, right? Not really. The bulk of the investments are usually placed in credit instruments like bonds.

What are bonds? Bonds are contracts in which an investor lends money to a borrower. As compensation to the lender, the borrower agrees to pay interest, often twice a year, and, generally, at a fixed amount. The borrower also agrees to repay a stated sum at the end of a fixed period. The date that the loan is to be repaid is called the maturity date.

Bonds issued by a sovereign state are known as government securities. It is usually considered zero or minimal risk because the government backs the indebtedness (they only need to print more money to pay you!). In the Philippine investment scenario, the majority of fixed income investments are placed in government securities. However, there are some investment grade bonds issued by top corporations including PLDT, Ayala Corp., San Miguel Corp. and SM. The risks associated with corporate bonds are higher than those issued by the government, hence one can expect higher yields from corporate bonds.

Bonds of high-quality companies are considered safer than most investment alternatives for the following reasons:

The annual income to be received is generally fixed in advance.

The contracted loan principal is likely to be repaid in full at the stated due. In the event of financial difficulties, the borrower still has to comply with the terms of the contract. Interest and principal will be repaid on time or the company will be facing bankruptcy. Should bankruptcy occur, bondholders have priority in receiving the proceeds from liquidation of the business’ assets and are therefore repaid before stockholders receive any material proceeds.

Here are some terms that may help you understand bonds and notes:

Bonds are debt securities issued by borrowers. They are also referred to as fixed income securities since they give coupon or interest payment on a regular or a fixed basis. Basically, these are “IOUs.”

Technically, the term “bond” is used for securities with tenors of more than 10 years while “note” is used for securities with tenors of less than 10 years.

Treasury bills are government securities traded at discount to FV, one year or less.

Commercial papers are similar to T-bills, except the issuer.

Bond prices will vary throughout its lifetime and are largely dictated by market prices. Generally, bond prices are affected by supply and demand, prevailing interest rates, credit standing of the issuer, the economy and other factors.

If bonds are deemed as fixed-income securities, why do prices fluctuate? Basically, bond prices fluctuate because they are traded in the secondary market, which ultimately determines the value of a bond based on supply and demand, and market forces.

Bonds are for those who are risk-averse. Although its value fluctuates over its lifetime (tenor), your capital will be principally protected if you will hold out to maturity. Bonds are actively traded just like stocks and many investors, particularly institutional investors like banks and large corporations, can get good yields from trading bonds.

You can invest directly in bonds by buying them or through managed funds like UITF and mutual funds that invest primarily in bonds like “bond funds.” Buying bonds directly can be done through the trust departments of banks but it requires substantial capital unless you are purchasing the government’s retail treasury bonds. An alternative to investing in bonds directly is buying through bond funds offered by UITFs or mutual funds at a much lower initial investment, usually P5,000 to P10,000 only.

It is a good idea to consider including bonds in your portfolio because when it comes to capital protection, bonds fare better than stocks. Be mindful, however, that yields are always a function of risks so while bonds are good for capital protection, their returns will not compare with what you’ll get from equities. The key to balancing your risk and return objectives is to have a properly diversified portfolio. Have some stocks, have some bond and a few other stuff you can get your hands into.

I hope this helps.

Learn comprehensive investment ideas, attend “Wealth Strategies for Everyone” featuring me and Mr. Stock Smarkts, Marvin Germo, RFP on Nov. 23, 2012, at the RCBC Plaza. For inquiries, call (02) 852-7377 or 0915-8986495 (look for Greg Pimentel) or send an e-mail to [email protected]

Randell Tiongson 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 November 28, 7 p.m., at PSE Center Ortigas. Reserve now at [email protected] or visit www.rfph.ph.