What is a bond?
The corporation’s capital structure is a combination of debt and equity which the company uses to finance its growth and operations.
Bond is a tradable debt or loan. It is a fixed income financial instrument that pays a fixed interest rate (coupon) to debtholders/lenders. Also, it is called a promise to pay you. Who promises? The issuer or borrower which could either be a corporation or the government. On the other hand, regions and municipalities including special projects [Special Project Vehicles of SPVs] like the infrastructure programme of a government can issue bonds.
For example, San Miguel Corporation issued a bond for Php 15B in March 2020 to fund the redemption of the outstanding preferred shares of SMFB.
Recently, the government issued bonds called Premyo Bonds para sa Bayan for Php 3 B to fund the government’s infrastructure projects. The minimum investment is Php 500.00. It’s called premyo [prize] bond because for every placement of Php 500.00, it entitles a bondholder of 1 electronic reward number which will be drawn and winners can take home a prize anywhere between Php 20 K and Php 1 M.
How to make money in Bonds?
1) You can hold these bonds until their maturity date and collect interest payments on them.
2) Sell them at a price that's higher than what you pay initially. For example, if you buy Php 500K worth of bonds at face value -- meaning you paid Php 500K-- then sell them for Php 550K when their market value increases, you can pocket the Php 50K difference.
Bond prices are inversely correlated with interest rates - when interest rates drop, bond prices go up and vice-versa.
This is illustrated in this example, let’s say a Php 1000 bond with a 5% coupon pays Php 50 in income each year. If the price rises to Php 1500, the yield falls because Php50/Php 1500 becomes 3.33%. As you can see, when the bond price rises to P1500 from P1000, the yield drops from 5% to 3.33% and vice versa.
Bond prices are affected by interest rate as discussed. Also, inflation and credit ratings affect bond prices. A rise in inflation erodes your purchasing power as well as your bond investment.
A credit rating measures the ability of the bond issuer to meet interest and principal payments. A higher credit rating for the bond issuer will drive bond prices higher and vice versa.
What is the role of Bonds in your investment portfolio during the pandemic and in the next normal?
Whether in pandemic or not it is important to create a diversified portfolio to reduce volatility. During the pandemic, bonds performed well unlike equities and might play a defensive role in the next normal going forward.
Bonds had a boost because Banko Sentral ng Pilipinas [Central Bank of the Philippines] infused liquidity to pump prime the economy. It lent the Philippine government of about Php 300 B, entered into repurchase agreement* and reduced the reserve requirement for banks by 200 basis points. Also, the interest rates were likewise reduced.
In the next normal, a well-designed portfolio that includes bond will not just boost income but will provide a defensive income in the long run and it will limit or spread the risk across different investments in the volatile and uncertain economic environment in the future including offsetting volatile investments.
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