A Closer Look at Bonds

Bonds are safer than stocks, but they still have risks.

Among the most common forms of investment in Thailand: bank deposits, finance companies’ promissory notes and negotiable certificate of deposits (NCD), we should realize that they have the lowest investment risks and should not expect a high yield.

So what other products can we invest in if we are not satisfied with the current yield of 2-4% a year offered by those instruments? To most people, the reply would be “stocks”. But not everyone is comfortable with the wide fluctuation of stock prices, which can wipe out most of our principal in a few days if we pick the wrong stock(s).

A number of investment products have investment risks ranging bank those of bank deposits and stocks. Some retail investors in Thailand just started to be more familiar with is “fixed income securities”. There are IOUs which a borrower, or an “issuer”, promises to pay a lender, or a “holder”, the principal plus interests after a certain time – usually more than a year. Interests, or “coupons”, are mostly paid in a fixed amount every six months; hence the name “fixed income” securities.

Unlike the normal IOUs like bank loans, these instruments can be and are often traded among professional investors like banks, government agencies, insurance companies and mutual funds. That is, before these instruments reach their maturity dates, they can be bought and sold many times.

The most common fixed income securities in Thailand are bonds and debentures. Bonds are often referred to the instruments issued by the government or government agencies such as the Bank of Thailand, the Financial Institution Development Fund and state enterprises. Debentures are issued by well-known public companies and financial institutions. Almost all other features of bonds and debentures are the same, so in this article, I will use the word “bond” to mean both types of fixed income securities interchangeably.

What to look out for?

Prior to buying a bond, you should acknowledge and understand the investment risks associated with it. There are four major risk categories: default risk, interest rate or price risk, liquidity risk and event risk.

Since a bond is a form of an IOU, your most concern should be the borrower/issuer. Obviously, if the issuer is the government or government agency, you will feel safer to buy it than if the bond’s issuer is a company – you know that they will keep their promise to give you back the money when the bond matures. That is, the default risk is low for government bonds.

By comparison, the default risk for corporate bonds are higher. There have been cases where the companies ran into financial problems and could not repay the money to the bond investors. Some of you, unfortunate investors, may remember these bonds which were issued by various financial institutions and property companies in 1993-1995 and were defaulted. To date, investors have received very little back from such high-interest instruments.

Some defaulted corporate bonds

Issuer	Industry
Finance One CMIC Finance and Securities General Finance One Holding Property Perfect Modern Home Thai Petrochemical Industry	Finance Company Finance Company Finance Company Holding Company Property Development Property Development Chemicals and Plastic

Source: Thai Bond Dealing Centre’s web site

Since there are many companies issuing bonds now, a retail investor may find it difficult to evaluate how much default risk you are taking on for a particular issue. To help investors evaluate risks, the government and the public sector have jointly set up a company to evaluate the financial health of an issuer. The company, TRIS, rates most of the corporate bonds that are sold to the public. An issuer with an “A” rating is deemed to be financially stronger than one with a “B” rating.

A second category of risk, interest rate or price risk, is involved with a fluctuation of market interest rates. As I mentioned earlier, bonds can be traded before the maturity date. So, if you do not hold the bond until maturity, where you will receive the principal and the last interest payment, you will have to worry how much you can get from selling it.

As bond prices are dictated by the market interest rates, there is no guarantee that you will always sell the bonds with a profit. That is, the more volatile the interest rate is, the more volatile the bond prices are. As a general rule, bond prices rise when the interest rate declines, and vice versa.

So, when you need to sell the bond that you bought when the market interest rate was 8% per annum, it is likely that you will lose some money if the future market interest rate is 12% per annum. Please note that the coupon rate – the rate that gives you semi-annual interests – has nothing to do with the bond prices.

You may remember the liquidity risk from the last week’s issue. This is measured by the ability to turn the bond into cash when you need to sell it before its maturity. As you would expect, “high-quality” bonds (i.e. the government/state agency bonds) are more liquid than the lower-quality ones such as corporate bonds. This is because many investors, particularly banks and insurance companies, are required by law to hold government bonds as part of their reserves or investment. So, the “demand” always exceeds the “supply” for these types of bonds. Obviously, the bonds that have the highest liquidity risk are the ones that have defaulted or are “rumored” to become defaulted shortly.

The last risk category, the event risk, has to do with special circumstances that can affect the ability of the bond issuer to services the debt. The risk can strike suddenly. The closest example in Thailand is when the Bank of Thailand shut down finance companies in 1997. Overnight, their bondholders were left with the bonds with no value. Examples in other countries include a major accident for an oil-producing company or a sudden change in government policy relating to concession for a telecommunication company.

Conclusion

You may agree that fixed income securities can be another attractive investment alternative. They, especially the government bonds, can offer higher yield and provide you with more liquidity than banks’ fixed deposits. However, do not forget that this opportunity (to gain higher return) requires that you fully understand the characteristics of the bonds. Before you buy them, you should ask the distributor/seller to explain and compare the four major risk categories with other issues in the market.

Reprinted with modification from 'Money Matters', a weekly column written by Reungvit Nandhabiwat, former managing director of AYF, for the Bangkok Post.

September 6, 2000