Bond Pricing – How Does it Work and What Impact Does it Have on Investors?
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For most people who are new to bond investing, issuers that appear on mainstream media such as the Monetary Authority of Singapore (Singapore Savings Bonds), Azalea (Astrea IV and V) and Temasek Holdings will resonate well with such investors. However, such bond offerings only scratch the surface of what is available in the fixed income market.
In fact, our entire understanding of how to invest in bonds is usually just a shadow of what is actually available to us. For instance, new bonds are issued and distributed on the primary market and subsequently traded on the secondary market where bonds can exchange hands between buyers and sellers. Not too complicated, right? But the actual mechanics of investing in bonds are, for the average consumer, quite different from equities. Let’s find out more.
What exactly is the OTC (Over The Counter) market?
Most financial investors know equities are traded on designated exchanges, depending on where the company lists their shares. Bonds on the other hand, generally do not trade on exchanges. They are traded over the counter with various market makers or counter parties. What does this mean?
Let us use an illustration. Imagine you are going on a holiday to Malaysia and you need to exchange your Singapore Dollars for Malaysia Ringgit. You will proceed to a money changer and find out the rates today. However, most people won’t exchange their money upon receiving a quote from the first shop. What do you do? You will find another money changer and compare the rates. Ultimately you will find a rate you deem to be favorable and execute the transaction.
Now replace the various money changers with banks (like DBS, OCBC, UOB, etc.) who may offer different prices for the same bond, and voila, the fixed income market in a nutshell! Most people do not realize exchanging currency for your holiday is already an OTC market, and you are actually doing price discovery while shopping for the best rates. A bond transaction is no different from changing currency but in this case, companies such as CGS-CIMB Securities (Singapore) Pte. Ltd. will help you find favorable and competitive quotes from different banks.
What impacts the price of a bond and how does it move?
As an investor, one of your key concerns is the yield when you invest in a particular bond. The Yield to Maturity (YTM) is the annualized rate of return an investor can achieve, assuming the investor holds the bond to maturity. If you buy the bond at par or 100% and the coupon is 5%, your YTM is 5% for the bond tenure. When you buy the bond at a premium, say at 101%, your YTM will be below 5%. Vice versa, when you purchase it at a discount, say at 99%, your YTM will be greater than 5%.
Source of graph: MoneySmart
Even though most issuers will issue their bonds at 100% and are expected to redeem them back at par during maturity, the prices of bonds can fluctuate between the issue date and the maturity date. Bond prices move for several reasons due to market forces.
Interest rate movements
Interest rates and bond prices have an inverse relationship. So when interest rates go up, bond prices fall. Conversely when interest rates fall, bond prices rise.
Why is this so? To put it simply, the current price of a bond is the present value of all its future cash flows discounted at a rate. When rates are expected to go up, your future cash flows get discounted with a higher rate, thus your current value of the bond decreases.
Depending on the type of bond, investors will observe different price movements:
The lower the coupon rate, the more sensitive the bond is to interest rate movements, all else equal. The longer the maturity, the more sensitive the bond is to interest rate movements, all else equal.
Credit or default risk
The returns received by bond investors are dependent on the credit quality of the issuers of the bonds they hold. Issuers deemed more creditworthy will have lower yield on their bonds than risker issuers. The creditworthiness of an issuer can be measured by something called credit spread in the market. Credit spread is the difference between government risk-free rates and corporate bond yields. This is the premium that investors require for investing in the corporate bond against a government bond.
When a company performs well and the ability to repay its bonds increases, the credit spread premium may decrease. As a result, the issuer’s bond price increases. The reverse is true if a company’s business performs poorly.
How can people invest in bonds?
For most individuals, it is not possible to invest in the majority of bonds on the Over-The-Counter (OTC) market as there are high barriers in place—you need at least $250,000, which is prohibitive for most.
There are some exceptions in the Singapore Government Bonds space. There are a handful of retail bonds that can be traded on SGX in minimum lots of $1,000. However, this dramatically narrows the selection of bonds.
CGS-CIMB Securities (Singapore) Pte. Ltd. has a solution to this problem. They now offer a Bond Contract For Difference (CFD) product which will enable you to invest in bonds at a much lower starting capital.
Bond CFDs work by letting you invest in a bond’s performance without having to buy the actual bond. It does this by mimicking the prices and performances of the underlying bond and you get to trade at roughly the same prices as the actual bond. You will also receive cash flows mimicking the coupon payment of the bond.
Since you are not buying the actual bond, you are not limited by the minimum cash outlay imposed by the Over-The-Counter market. Bond CFDs can be purchased in contract denominations of 50,000 notional.
But that doesn’t necessarily mean you need to fork out $50,000 in cash. CGS-CIMB Securities (Singapore) Pte. Ltd. lets you trade on up to 20% margin, so you can buy the bond for a lot less upfront. For instance, if you buy a bond on 20% margin, you only have to put up $10,000 in cash in order to satisfy the 50,000 notional minimum contract (excluding commissions, financing and miscellaneous cost).
Invest in Bond CFDs with CGS-CIMB
Bonds offer a great way to diversify your portfolio and hedge against economic turbulence. But they are not immediately accessible to individual investors due to high minimum outlays on the OTC market.
The solution to this is to invest in Bond CFDs instead. Bond CFDs mimic actual bonds and let you benefit from coupon rates and price movements without having to buy the actual bond. Most importantly, Bond CFDs enable investors to overcome the higher barriers to entry while at the same time benefit from the bond market. This article explains Bond CFDs in a bit more detail.
Find out more about how you can start investing in Bond CFDs with CGS-CIMB here.
Do you have any questions about investing in Bonds CFDs? Leave them in the comments!
Any examples shown are for illustration purposes. This article does not constitute an offer or solicitation to buy or sell any security or instrument, or an invitation or a recommendation to enter into any transaction. All capital market products contain risks and may not be suitable for everyone. Please refer to the Risk Disclosure Statement in the General Terms and Conditions of CGS-CIMB Securities (Singapore) Pte. Ltd. (Co. Reg 198701621D) for more details.
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