What is Bond?
Bond is a debt security in which the authorized issuer owes the holders a debt and is obliged to repay the principal and the interest (the coupon) at a later date, termed maturity. In other words, a bond is simply a loan but in the form of a security.
Features of Bond
The issuer is the borrower. It may be government, financial institution or corporate. In theory, all legal entities can issue bonds to finance their operation activities subject to the approval of the respective regulations of their jurisdictions.
Primary & Secondary Market
Primary market refers to the issuance of new debt instrument. Secondary market refers to the trading of bonds / fixed income products OTC.
Nominal / Principal / Face Amount
It is the stated value of an issued security. It is also the amount over which the issuer pays interest and which has to be repaid at the maturity.
The price at which investors buy the bonds in primary market.
The date on which the principal amount becomes due and payable.
The interest rate stated on a bond when it is issued. The coupon can be fixed or float.
Yield to Maturity
The percentage rate of return paid if the security is held to its maturity date. The calculation is based on the coupon rate, length of time to maturity, and market price. It assumes that coupon interest paid over the life of the security is reinvested at the same rate.
- When a bond’s coupon rate is lower than its YTM, then the bond is selling at a discount.
- When a bond’s coupon rate is higher than its YTM, then the bond is selling at a premium.
- When a bond’s coupon rate is equal to its YTM, then the bond is selling at par.
The annual rate of return based on the price. It is calculated as (coupon rate * par amount / price) / 100
There are two major credit rating agencies to evaluate the creditworthiness of bonds, namely Moody’s and Standard & Poor’s.
A bond is regarded as investment grade if its credit rating is BBB- or higher by Standard & Poor’s or Baa3 or higher by Moody’s. Non-investment grade bonds refer to bonds with BB+ or below Standard & Poor’s credit rating or Ba1 or below Moody’s credit rating. The higher the credit rating of a bond, the more likely the issuer can meet its debt obligation.
In general, the lower the rating, the higher the yield that investors can get so as to compensate for higher risk they need to bear.
Scenario 1 (Hold to maturity)
For investor who owns a bond, collects the coupon and holds it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. Therefore, investor could get the principal amount and the interest payments if he/she holds it until maturity and assuming the Issuer does not have any default event.
Scenario 2 (Sell before maturity)
Investor who sells bonds before maturity is exposed to many risks, among others changes in interest rates. When interest rates increase, the price of bonds may fall. Likewise, when interest rates fall, the price of bonds may rise. Therefore, the investor may enjoy a capital gain or suffer capital loss when he/she sells the bond before maturity.
General Key Risks of Fixed Income Products
- Fixed income products (even for plain-vanilla bonds) are not risk free products suitable for all investors. The price of fixed income products can and does fluctuate, sometimes dramatically and may become valueless. It is as likely that losses will be incurred rather than profit made as a result of buying and selling of fixed income products. Holders of fixed income products, including plain-vanilla bonds, are subject to various risks, including but not limited to:
The value of a fixed income product is determined by the quality of the credit and the likelihood of default. As the credit risk of a fixed income product increases, any changes to that perceived credit risk tend to have an increased impact on the price of the product. The credit risk of high yield bonds (which are generally below investment grade or are unrated) is significant, and therefore, a change in the credit quality of an issuer of high yield bonds will be apt to have a significant impact on the bonds. The holder of fixed income products bears the credit risk of the issuer and/or guarantor (if applicable) and credit ratings assigned by credit rating agencies do not guarantee creditworthiness of the issuer and/or guarantor (if applicable). Investors shall beware that credit rating of guarantor should not be confused with that of the issuer or the bond / debenture.
Some fixed income products may not have active secondary markets and it would be difficult or impossible for investors to sell them before maturity or they may be forced to sell at a significant discount to market value. Liquidity risk is greater for thinly traded securities such as lower-rated products, products that were part of a small issue, products that have recently had their credit rating downgraded or products sold by an infrequent issuer.
Interest Rate Risk
Fixed income products are more susceptible to fluctuations in interest rates and generally prices of fixed income products will fall when interest rates rise. If interest rates go up, the price of the debt security will, other factors being equal, go down, thereby increasing the current yield (the annual interest payment divided by the price of the debt security) and bringing it into line with the higher coupon rates offered by new debt issues. If interest rates go down, the price of the debt security will increase, thereby reducing the current yield and bringing it into line with the lower coupon rates offered by new debt issues. The price of the debt security may be higher or lower than the original investment if it is sold before maturity.
- Not all fixed income products provide for repayment of 100% of their face values. Returns on a fixed income product depends on the terms of issue and reference should be made to the corresponding prospectus or term sheet for details, and there may be circumstances that the money and/or value of the securities investors receive at maturity is substantially less than the value of their original investment. If there is any fractional share(s) or other securities or underlying assets deliverables on maturity, it/they may not be physically delivered.
- In situations where any fixed income product is a product combining note with financial or other derivatives, such as options, its return may be linked to the performance of other financial instruments, such as underlying stocks, commodities, currencies, companies, and indices. Unless such product is listed on Exchange or other regulated stock exchanges, investors will only be able to sell such product on the over-the-counter market, if at all. The prices of fixed income products in secondary markets are affected by a wide range of factors, including without limitation, the performance of the underlying stocks, commodities, currencies, companies, indices, the market view of the credit quality of the relevant company, and interest rates. Investors must be aware that secondary markets do not always exist and even where a secondary market exists, it may not be liquid. Investors must accept any associated liquidity risk.
- Transactions in options carry a high degree of risk (including products that have options embedded in them). Purchasers and sellers of options should familiarize themselves with the type of option (i.e. put or call) which they contemplate trading and the associated risks.
- High-Yield Bonds
In addition to the generic risks set out above, investments in high-yield bonds are subject to risks including:
(a) Higher Credit Risk – Since they are typically rated below investment grade or are unrated and as such are more often subject to a higher risk of issuer / guarantor (if applicable) default.
(b) Vulnerability to economic cycles – During economic downturns such bonds typically fall more in value than investment grade bonds as (i) investors become more risk averse and (ii) default risk rises.
- Bonds with Other Special Features
Some bonds may contain special features and risks that warrant attention of investors, they include:
(a) Subordinated – Certain bonds are subordinated, and investors would only have subordinated ranking, in case of liquidation of the issuer, which means investors can only get back the principal after other senior creditors are paid. Holders of subordinated debentures will bear higher risks than holders of senior debentures of the issuer due to a lower priority of claim in the event of the issuer’s liquidation.
(b) Perpetual – Certain bonds are perpetual in nature and interest pay-out depends on the viability of the issuer in the very long term. Investors should beware that such bonds do not have a maturity date, and the coupon payments may be deferred or even suspended subject to the terms and conditions of the issue. Furthermore, investors shall also pay attention to the following risks that are often applicable to Perpetual bonds:
Reinvestment risk is related to interest rate risk, but has the opposite effect on a bond’s performance. It refers to the risk that the rate at which coupon and principal cash flows from a bond are reinvested will be lower than the expected rate in effect when the bond was purchased. The risk increases for bonds with longer maturities and higher coupon payments, and decreases for bonds with shorter maturities and lower coupon rates.
Perpetual bonds are often callable, entitling their issuers to redeem them at a specified price on a date prior to maturity. Declining interest rates may accelerate the redemption of a callable bond, causing an investor’s principal to be returned sooner than expected. In that scenario, investors have to reinvest the principal at the lower interest rates.
The investors may have lower priority of claims in case of liquidation of the issuer, and will only be paid after debts to other senior creditors are satisfied.
(c) Contingent convertible or bail-in – Investors shall beware that certain bonds have contingent write down or loss absorption features and the bond may be written-off fully or partially or converted to common stock on the occurrence of a trigger event. These bonds generally absorb losses while the issuer remains a going concern (i.e. in advance of the point of non-viability). Apart from contractual bail-in mechanisms requiring the bonds to be written off or converted to common stock on the occurrence of a trigger event, they may contain statutory bail-in mechanisms whereby a national resolution authority writes down or converts bonds under specified conditions to common stock. Bail-in bonds generally absorb losses at the point of non-viability. Investors shall pay extra attention to the nature of this kind of product, the trigger events, and implications of such trigger before they invest.
(d) Basket equity-linked products – Investors of basket equity-linked products with bull structure are obliged to buy at the strike price (or suffer a financial loss with reference to) the worst-performing stock in the basket of linked stocks, if the final price of the worst-performing stock is below the strike price. Investors shall therefore aware that they are exposed to the risks of the basket of stocks especially the stock having the worst performance before they invest.
(e) Fixed rate – The coupon remains constant throughout the life of bond.
(f) Floating rate – A variable rate that resets periodically based on market interest rate before maturity date.
(g) Callable – The issuer has the right to but not the obligation to buy back the bonds from the bond holders at a pre-agreed call price before Maturity Date. The issuer will normally buy back the bond when financing cost goes down and issues another callable bond based on the latest interest rate so as to reduce the interest expenses.
(h) Putable – The bond holder has the right to sell his/her bond to the issuer prior to the bond’s maturity date. The holder of the bond can sell the bond back to the issuer when the interest rate goes up so that the sales proceeds can be used to make other investment earning higher profit. As the terms on putable bond are favorable for investors, they are often willing to accept a lower coupon rate.
(i) Convertible – It is unique from other bonds or debt instruments because it gives the bond holder the right, but not the obligation, to convert the bond into a predetermined number of shares of the issuing company. Therefore, convertible bonds are a hybrid form of bonds and shares. When investors are not sure on the potential upside and prospect of the company, they can invest in convertible bond. When the share the company goes up, the bond holder can convert the bonds into shares in order to benefit from the company’s development. Convertible bonds provide an investment choice for investors.
Bonds that have variable and/or deferral of interest payment terms and investors would face uncertainty over the amount and time of the interest payments to be received.
Bonds that have extendable maturity dates and investors would not have a definite schedule of principal repayment.
Bonds that are convertible or exchangeable in nature and investors are subject to both equity and bond investment risk.
Key Risks associated with RMB Products
- RMB currency risk – RMB is not freely convertible at present and conversion of RMB through banks in Hong Kong is subject to certain restrictions.
For RMB products which are not denominated in RMB or with underlying investments which are not RMB denominated, such products will be subject to multiple currency conversion costs involved in making investments and liquidating investments, as well as the RMBi exchange rate fluctuations and bid / offer spreads when assets are sold to meet redemption requests and other capital requirements (e.g. settling operating expenses).
The PRC government regulates the conversion between RMB and other currencies. If the restrictions on RMB convertibility and the limitations on the flow of RMB funds between PRC and Hong Kong become more stringent, the depth of the RMB market in Hong Kong may become further limited.
- Exchange rate risks – the value of the RMB against the Hong Kong dollar and other foreign currencies fluctuates and is affected by changes in the PRC and international political and economic conditions and by many other factors. For our RMB products, the value of Customer’s investment in Hong Kong dollar terms may decline if the value of RMB depreciates against the Hong Kong dollar.
- Interest rate risks – the PRC government has gradually liberalized the regulation of interest rates in recent years. Further liberalization may increase interest rate volatility. For RMB products which are, or may invest in, RMB debt instruments, such instruments are susceptible to interest rate fluctuations, which may adversely affect the return and performance of the RMB products.
- Limited availability of underlying investments denominated in RMB – For RMB products that do not have access to invest directly in Mainland China, their available choice of underlying investments denominated in RMB outside Mainland China may be limited. Such limitation may adversely affect the return and performance of the RMB products.
- Projected returns which are not guaranteed – For some RMB investment products, their return may not be guaranteed or may only be partly guaranteed. Investors should read carefully the statement of illustrative return attached to such products and in particular, the assumptions on which the illustrations are based, including, for example, any future bonus or dividend declaration.
- Long term commitment to investment products – For RMB products which involve a long period of investment, if investors redeem their investment before the maturity date or during the lock-up period (if applicable), investors may incur a significant loss of principal where the proceeds may be substantially lower than their invested amount. Investors may also suffer from early surrender / withdrawal fees and charges as well as the loss of returns (where applicable) as a result of redemption before the maturity date or during lock-up period.
- Credit risk of counter parties – For RMB products invest in RMB debt instruments which are not supported by any collateral, such products are fully exposed to the credit risk of the relevant counter parties. Where a RMB product may invest in derivative instruments, counter party risk may also arise as the default by the derivative issuers may adversely affect the performance of the RMB product and result in substantial loss.
- Liquidity risk – RMB products may suffer significant losses in liquidating the underlying investment, especially if such investments do not have an active secondary market and their prices have large bid / offer spread.
- Possibility of not receiving RMB upon redemption – For RMB products with a significant portion of non-RMB denominated underlying investments, there is a possibility of not receiving the full amount in RMB upon redemption. This may be the case if the issuer is not able to obtain sufficient amount of RMB in a timely manner due to the exchange controls and restrictions applicable to the currency.
- The above key risks statement does not disclose all the risks and information in relation to investment in RMB products. For example, selling restrictions may be applicable to certain investors in accordance with the restrictions as stipulated in the relevant prospectus of the RMB products. Investors must therefore read the relevant prospectus, circular or any other documents in respect of each RMB products and carefully consider all other risk factors set out therein before deciding whether to invest.