• Investing in Bonds may improve your return than sitting on cash.
  
  
  (Date: as of May 2010)

• Bonds deliver stable and predictable coupons as streams of income. Bonds also offer predictable repayment of principal at maturity.
  
  

• Bonds exhibit low correlation to other asset classes, hence the inclusion of bonds can bring relative stability to a portfolio.
• Bonds often demonstrate comparable performance against equities over time, however with a lower volatility! The following chart shows 10 year performance of bonds (Represented by HSBC Asian US Dollar Bond Index ) and equities (Represented by Hang Seng Index).
  
  
  Equity: Represented by Hang Seng Index
  Bond: Represented by HSBC Asian US Dollar Bond Index which consists of non-Japan Asian bond portfolio with US dollar-denominated, fixed-rate, straight bonds

• The market price of a bond is affected by market interest rates, and perceived creditworthiness of the issuer.
• Potential for capital gain from price appreciation occurs when market interest rates fall or when perceived creditworthiness of the bond's issuer strengthens
   

  Credit Worthiness	Bond Price
  Stronger
  Weaker

  Interest Rates	Bond Price
  Higher
  Lower

  Demand & Supply	Bond Price
  Strong demand / Weak Supply
  Weak demand / Strong Supply

  
   

• Categories of bonds are mainly classified based on the nature of issuers - common categories known to HK investors include:
  • Government Bonds - e.g. US Treasury Bills / Notes / Bonds, HK Exchange Fund Bills / Notes
  • Corporate Bonds, e.g. bonds / notes issued by financial institutions or companies
• Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects

• A bond's credit rating indicates its credit quality and is based on the issuer's financial ability to make regular interest payments and repay the loan in full at maturity. Credit rating agencies help to evaluate the creditworthiness of bonds. Two major independent credit rating services are Moody's and Standard & Poor's.
  
   

  	Moody's	Standard & Poor's	What the Ratings Means
  Investment Grade	Aaa	AAA	Highest quality
  	Aa1,Aa2,Aa3	AA+,AA,AA-	High quality
  	A1,A2,A3	A+,A,A-	Upper-medium quality
  	Baa1,Baa2,Baa3	BBB+,BBB,BBB-	Medium quality
  Non-Investment Grade	Ba	BB	Speculative
  	B,Caa	B,CCC,CC	Highly speculative
  	Ca,C	D	Default

   
  • Moody's applies a numerical indicator 1, 2, and 3 in each generic rating. For examples, A1 is better than A2. Standard & Poor's use a plus or minus indicator. For example, A+ is better than A, and A is better than A-.
  • Ratings affect a bond's yield. The lower the rating, the higher will be the yield as investors will need extra incentive to compensate for higher risk.
  • Investment grade bonds are of relatively high quality with a minimum S&P rating of BBB- or a minimum Moody's rating of Baa3.
  • Non-investment grade bonds, on the other hand, are of lower quality, and carry a higher risk of default. S&P rates these BB+ and below, while Moody's rates them Ba1 and below.
     

Fixed rate bond

• A bond that pays a fixed rate of interest over its life.

Floating rate bonds/ notes (FRNs)

• FRNs are bonds that have a variable coupon, adjusted according to the market interest rates and therefore reflect changes in a market interest rate, like the USD LIBOR, RMB SHIBOR, AUD BBSW, etc.
• The variable coupon is reset regularly (e.g. every3 months), determined by the market interest rate plus a "spread". The spread is fixed when the bonds are issued.
• The variable coupon rate adjustment means that FRNs have relatively stable bond prices due to limited interest rate risk. FRNs provide capital preservation and higher income as interest rate rises.

Zero coupon bonds

• Zero coupon bonds do not pay out any interest prior to maturity. These bonds are sold at a deep discount because all of the value occurs at maturity when the principal is returned to the investor.
• The main benefit of zero coupon bonds is for saving for an objective on a specific date. The drawback of zero-coupon bonds is that they are more volatile than bonds that make regular interest payments. But interest rate movements do not matter if bonds are held to maturity.
  
  
  
  
   

• Also known as "Hybrids". Companies issue "Hybrids" to diversify their funding sources, and better manage the capital costs since "Hybrids" is a cheaper form of capital than equity.
• It is important to note that "Hybrids" are structured differently that some behave more like fixed interest securities and others behave more like the underlying shares.

Perpetual Securities

• Some "Hybrids" are in form of Perpetual Securities which do not have a maturity date. They are likely to include a call date where the issuer has the option to repay the principal. Some Perpetual Securities may also include an option for the issuer to exchange the perpetual securities to Preference Shares.
• It is important to note whether the Preference Shares that are being exchanged into are cumulative or non-cumulative. Cumulative Preference Shares have a provision which allows dividends not paid in a particular year or period to be accumulated and carried forward to a later date whereas non-cumulative Preference Shares do not. Preference shares dividends must be paid before a dividend can be paid on the ordinary shares. In other words, if there is dividend declared for ordinary shares, both the cumulative and non-cumulative preference shares dividends will be paid as well.
• Unlike a share, Perpetual Securities have a "known" cashflow, and unlike a plain vanilla bond, there is a chance that they may be exchanged into shares. Therefore from a risk perspective, they are more risky than debt, yet not as risky as equity-a risk profile sitting in between debt and ordinary equity.

• Interest rate per annum that will be paid by the issuer.
• For Fixed Rate Bond, coupon rate is determined on the issue date.
• For Floating Rate Bond, the coupon is reset regularly (e.g. every 3 months), determined by the market interest rate plus a "spread". The spread is fixed when the bonds are issued.

• Date when face value of the bond will be repaid by the issuer. Face value is typically 100%.

• Remaining time to maturity.
• The longer the bond's maturity, the more it is affected by changing interest rate.

• A bond's credit rating indicates its credit quality and is based on the issuer's financial ability to make regular interest payments and repay the loan in full at maturity.
• The higher the rating, the lesser the risk, the lower the yield of the bond

Represents the seniority of claims in the case of a default event.

Senior / Subordinated Debt

• Senior Debt refers to debt obligations that have higher claim priority to Subordinated Debt and Equity on the issuer's assets in the event of liquidation. Senior Debt commonly includes funds borrowed from banks or other financial institutions and creditors. Specific deposits not covered by Government / Industry Deposit Protection Schemes are also generally included in the Senior Debt rankings.
• Subordinated Debt refers to debt obligations that places the investor in a lien position behind or subordinated to a company's senior creditors. Securities issued as subordinated debt will pay interest and principal but only after all interest that is due and payable has been paid on to all senior debt and creditors in the case of bankruptcy or liquidation.
• To compensate for the higher risks taken by Subordinated Debt investors compared to Senior Debt investors, the former often are traded at higher yields than the latter. Yet for investors, it is necessary to recognise that while the returns are higher the risks are also higher.

Secured / Unsecured Debt

• Secured Debt is debt obligation backed by specific assets or revenues of the borrower. In the event of default, secured lenders can force the sale of such assets to meet their claims.
• Unsecured Debt is debt obligation with no collateral by any assets of the borrower in the case of bankruptcy or liquidation. Senior debts in the market are mainly Unsecured Debts.
• You can see that the concept of "secured" in bonds is different from "safe" in common terms.

• The price at which customer pays for buying a bond in the secondary market
• Bond prices are expressed in % terms

• The rate of return of the bond.
• Yield to Maturity (YTM) is the most commonly used term to describe the yield of a bond, which assumes the bond is held to maturity and all received coupon can be reinvested at YTM.
• YTM is inversely related to bond price
   

  Offer Yield / YTM	Offer Price

  
   

Bullet bonds

• Bonds with repayment of the principal on a fixed maturity date.

Callable bonds

• Bonds with a call date where issuer has the option to repay the principal earlier than the final maturity.

Perpetual bonds

• Bonds with no maturity date. The issuer will not specify a maturity date where it repays the principal like bullet or callable bonds. Rather, a perpetual bond pays the investor a fixed coupon indefinitely. Most perpetual bonds are callable, where the issuer has the option to repay the principal on a pre-specified date when it was issued.

• Refers to the potential loss in the bond value as a result of a rise in term interest rate. However, there is no impact if planning to hold bond to maturity.
• Causes of term interest rate increase can be central bank policy hike to manage inflation, increase in issuance size in a particular tenor and reduced demand in that tenor.
• The longer the maturity of a bond, the higher the interest rate risk.
• Bond investors can consider mitigating interest rate risk by investing in floating rate bonds/ notes.

• Refers to the potential loss in the bond value as a result of either a downgrade of the issuer's credit rating or the market's perception of the issuer's credit worthiness and its ability to meet its financial obligations. However, there is no impact if planning to hold a bond to maturity.
• Bond investors can consider mitigating credit risk by investing in bonds of higher risk rating.

• Refers to the potential total loss in the bond value as a result of the issuer going bankrupt.
• Bond investors can consider mitigating credit risk by investing in bonds of higher risk rating.

• Refers to investors may have difficulty finding a buyer when they want to sell and may be forced to sell at a significant discount to market value.v
• Liquidity risk is greater for thinly traded securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid during the period right after issuance when the typical bond has the highest trading volume.
• It is often reflected in wider spread between the bid and offer price of the bond.