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23rd January 2019 | Jacek Starobrat | Deputy Head of Portfolio Management

When to invest in fixed income? When to buy bonds?

There is no simple answer on this question, no simple solution, algorithm or rule. General rules can deviate or inverse. General “buy” or “long” bias can mean buying bonds from a long end part of the curve and selling a short end part of the curve.

Let’s start from the beginning

There are many factors, events, reasons for fixed income instruments and particularly bonds to be bought or traded. Return on investment is an important one but not the only reason for investors to invest their money.

Fixed income investment carries 3 major reasons to invest:

  • Capital protection,
  • Liquidity,
  • Profits.

Capital protection

Capital protection should be understood as protection of the nominal invested value when ensuring a stable current income while taking on low risk. If we compare different asset classes like equity and commodities, it seems that fixed income might be the safest investment. However, fixed income does not only mean the safe investment and capital protection. Everything depends on the level of risk assumed. More risk – less protection.

Among fixed income instruments, there are both riskier ones like corporate bonds and less risky like treasury bonds. Among both sovereign and corporate bonds, they may be more risky instruments from the long end of the curve, more sensitive to the risk of changes in interest rates, inflation or credit risk of the country risk and those from the short end of the curve less risky in terms of interest rate risk but faster reacting in a short time to market fluctuations and interest rates turbulences. 

Fixed-rate treasury bonds may have a high interest rate risk but low credit risk. Meanwhile, corporate floating rate bonds may have a very small interest rate risk, but high credit risk. The measure of the risk taken requires advance tools to calculate a risk level, including all types of risks. Successful investing requires theoretical investment skills and practical experience. This is why a professional portfolio management service increases the investor's chances of protecting capital and achieving profits from the investment.

Liquidity

Liquidity refers to the ability to sell or buy a given instrument. Some definitions describe liquidity as the possibility of selling or buying the financial instruments without affecting the asset’s price.

Some general rules for liquidity:

  • the more liquid asset, the easier it is to sell or buy it,
  • the more risk taken when trading the financial instrument, the lower liquidity it has,
  • the more instruments available on the market, the greater liquidity should be expected etc.

Cash is considered as the most liquid asset, while bonds with 30 years to maturity are relatively illiquid. Three months bond will have a much bigger outstanding value and should be much more liquid than a small private company which issued the short-term bonds to a private investor.

In general, short-dated fixed income instruments should be much more liquid than long dated bonds or other asset classes such as e.g. equities. For example, with the high probability, the Shelter Model Portfolio Strategy investing in short maturity bonds, mostly in treasury bonds, will be much more liquid than the Aggressive Bond or Equity Fund investing in a very risky and volatile instruments.

Profits

The major purpose of investing is to achieve profits from your capital. The fact of how much money you earn will always depend on how much risk you take. Fixed income investments may also provide profits to investors proportionally to the level of risk assumed. 

The main measure of the rate of return on an investment, in the case of interest rate instruments is yield. Yield refers to the earnings generated and realized on the investment over some period of time and it is expressed as a percentage of the invested amount according to the market valuation.

Setting the bond yield equal to its coupon rate is the simplest definition. But the current bond yield is the function of the coupon rate (interest rate) and market price which influence the value of the bond. The simplest way to calculate a bond yield is to divide its coupon payment by the face value of the bond. It is necessary to remember that the yield of the bonds is inversely proportional to its price. This means, that if the bond yield falls, the price grows and vice versa. 

Summarizing the above, the short-dated, high quality assets will provide rather smaller returns on the investment but also a low risk of losing the nominal capital value.

Again, the long-dated instruments with higher credit risk may provide better returns but also a higher risk of bigger loses. 

Positive sentiment on the bond market does not always mean that you need to buy bonds. It is sometimes worth buying bonds from one end of the curve and sell from the end of the curve. An example would be to buy corporate bonds and sell treasury bonds. 

When considering one of the three major reasons for investing in financial assets, such as capital protection, liquidity, and profits, an investor should take into account investments in fixed income products. However, investor should also take into account the level of accepted risk based on his/her risk profile which might be defined by the scoring received from the investor profile questionnaire.

As the choice of an investment strategy when investing in fixed income securities should be supported by a large theoretical knowledge and market experience, it is a good solution to use the professional services of a portfolio manager.

Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication.

All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.

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