Now, the pertinent question arises where an investor tries to determine how much and which bond he/she should invest in. Since everyone’s needs and requirements are different, there is no single formula or process that fits all investors’ needs. However, the decision to identify and invest in bonds could basically be guided by ‘risk appetite’ or the amount of risk that individuals are willing to take to achieve their objectives.Risk appetite is typically based on the following:<ul><li>Age – A simplistic way of approaching investing is to allocate a percentage that represents one’s age into bonds. For example, if one’s age is 30, then 30% of his/her portfolio must be in bonds and the remaining in stocks. Whilst this is just a start, one can definitely deviate from the above allocation based on their net worth, assets held and several other factors based on the particular individual.</li></ul>&nbsp;<ul><li>Time Horizon – There are broadly three time horizons that one may look at investing in bonds for – short-term (up to 2 years), medium-term (2-10 years), long-term (more than 10 years). Short-term bond investments may reduce the volatility in the portfolio but may also offer lower yields in a normal interest rate environment. Long-term bonds are more volatile but may offer higher yields. The trade-off depends on the broad expected return that an individual seeks to make on the portfolio.</li></ul>&nbsp;<ul><li>Assets &amp; Liabilities - Individuals may look their upcoming expenses/liabilities and invest an amount proportional to the present value of such outlays. Also, an existing base of high value net assets may see an investor take more risk since he/she would have a bigger cushion against any potential losses.</li></ul>&nbsp;<ul><li>Alpha – Alpha refers to the excess returns that an investor wants to make over and above a benchmark index. This may see higher risk taking whereby he/she may go into lower quality bonds to enhance returns, albeit with higher credit, liquidity and other risks.&nbsp;</li></ul>After the risk appetite is determined, investors can choose how they want to allocate their funds among investment grade and high yield bonds to have a well-balanced portfolio.&nbsp;

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How much should I allocate to bonds in a portfolio?

“Bonds” have been doing the rounds in most financial discussions of late and have resurfaced as a major asset class to invest in, given the current state of financial markets and the broad economy. With interest rates at levels not seen in decades&nbsp;(see chart below),&nbsp;a major incentive to invest in bonds has taken over markets.<img src="/uploads/US_10_Y_Bond_8c8521c269.PNG" alt="">So what are bonds? Bonds are financial instruments issued to investors willing to lend money for a certain time period. In return, the borrower pays interest payments and the principal amount at maturity to the lender. While they are similar to loans, they are tradeable in the financial market like stocks and thus have a price that fluctuates. Moreover, since they offer a fixed return, they offer a safety net as compared to stocks.<img src="/uploads/what_is_a_bond_ba70fe083a.PNG" alt="">&nbsp;While there is a whole array of bonds that investors can choose from, broadly, there are two types of bonds that investors prefer to invest.The first is government bonds – these bonds are issued by the government of a country and are considered to be among the safest instruments. Without going into too much detail, government bonds can be further classified into G4 bonds (low risk), emerging market bonds (higher risk) and other region specific bonds.The second is corporate bonds. Corporate bonds fall into two broad categories: investment-grade (lower risk) and high yield bonds (higher risk). More about this in the following modules.The choice of which bond or which type of bond you may want to buy depends on your risk appetite. Hence it is always preferable to look at the risk-return spectrum to identify the type of bond that might suit your preferences.

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Why is everyone talking about bonds right now?

Bonds have different components and terminologies that investors must know before investing in them. Let’s cover these topics in simple terms and try to understand them:<ul><li>Principal: Principal refers to the amount of money that the bond investor will receive from the bond once it matures. Sometimes it is also referred to as the nominal value, face value or par value</li></ul>&nbsp;<ul><li>Maturity Date: This refers to the date at which an investor can expect to receive the principal investment from the bond, subject to default risks. Essentially on this date, the investor’s initial investment will be returned, unless the issuer declares a default at any time over the life of the bond. It is worth noting that for bonds with call options, redemption can take place well before the maturity date. Do note that there is a category of bonds known as ‘Perpetual bonds’ that do not have a maturity date, however they can be redeemed by the issuers at specific times during the life of the bond (known as call date). Do note that for perpetual bonds on the BondbloX App, the maturity year is indicated as 2049. For example, the HSBC 6.25% Perpetual bond is identified on the BondbloX App as HSBC 6.25% 2049.</li></ul>&nbsp;<ul><li>Coupon: A bond’s coupon refers to the regular payment that the issuer promises to pay the investor over the life of the bond. The payment frequency could be annual, semi-annual or quarterly and the coupon is stated in annualized terms. While most bonds have a ‘fixed rate coupon’ throughout the life of the bond, there are ‘floating rate notes’ where the coupons keep changing regularly depending on market rates. There are also ‘fixed-to-floating’ bonds that have a change in the coupon rate during the life of the bond at a particular reset date. This is more common with perpetual bonds.</li></ul>&nbsp;<ul><li>Yield: Yield aka ‘Yield to Maturity’ simply refers to the expected return that an investor would make by investing in that bond.&nbsp; There are several types of yields, each calculated in a different manner. The yield on a bond can easily be calculated on MS Excel, using the following inputs and the formula below (do try it out!)</li></ul><img src="/uploads/Yield_Calculation_016dae088b.PNG" alt=""><ul><li>Bond Price: This is the current market price of the bond that is being traded in the secondary market at which buyers and sellers trade the bond. A fundamental concept to understand is that a bond’s price is inversely proportional its yield or interest rates. Thus, if yields or interest rates rise, the bond’s price falls and if yields fall, its price goes up.</li></ul>&nbsp;<ul><li>Duration: Bond duration is a metric that measures a bond’s sensitivity to interest rates. The duration of a bond indicates how much a bond’s price is expected to rise/fall if interest rates fall/rise by 100 basis points or 1%. Thus, by knowing the duration of a bond, investors can understand the fluctuation expected in their bond investments as interest rates are a key in determining the extent of the move. To learn more about bond duration in detail with examples,&nbsp;<a href="https://bondblox.com/news/bond-duration-understanding-interest-rate-risk">click here</a></li></ul>&nbsp;<ul><li>Credit Ratings: Credit rating refers to the grading given by ‘credit rating agencies’ that indicates creditworthiness of the bond issuer as well as that particular bond. The three major international rating agencies that rate issuers are Moody’s, Standard &amp; Poor’s (S&amp;P) and Fitch. They&nbsp;analyze the financial health of the issuer by considering internal and external factors when assigning a rating. Broadly, credit ratings are classified into two main categories as shown in the image below, across the three rating agencies. As you go lower down on the credit rating scale, the perceived risk increases. It is important to note that the bond issuer can have a different credit rating as compared to the same issuer’s bond due the terms and conditions of that bond.</li></ul><img src="/uploads/Rating_Scale_14e90f7633.PNG" alt="">

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What are the basic features of bonds?

Bonds are an essential part of any portfolio and offer several benefits as listed below:i.&nbsp; &nbsp; Income Generation - Bonds provide a fixed amount of income at regular intervals in the form of coupon payments.&nbsp;ii.&nbsp; Capital Preservation – Bonds protect the absolute value of your investment by promising the return of principal and are thereby less risky than stocks.&nbsp;iii. &nbsp;Capital Appreciation – Although bonds are viewed as a capital preservation tool, they also offer opportunities for capital appreciation. Investors can take advantage of rising bond prices by selling their holdings prior to maturity in the secondary market, akin to booking profits on stocks as prices rise&nbsp;iv.&nbsp; Diversification - Stocks and bonds have an inverse relationship when slowdowns occur. Slower growth tends to lead to lower inflation, leading to lower interest rates and thereby price increases in bonds. An slowdown may also hurt corporate profits and stock market returns, making bond coupons compelling. Thus as the adage goes, “don't put all your eggs in one basket”&nbsp;v. &nbsp; Inflation Protection - Certain bonds known as inflation-linked bonds (Linkers) add the ongoing inflation rate to their payments, which protects against rising prices/inflation.&nbsp;Currently, several analysts have come out with calls to buy bonds and make them a key part of the portfolio. This is because bond yields are at levels not seen in over a decade where investors can lock-in these rates to enhance their returns especially in the case on an oncoming recession.

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What is the role of bonds in a portfolio?

Whilst bonds are less risky as an investment as compared to equities, they also have certain risks inherent in them. Below are important risk factors that investors must be aware of while investing: i. Interest Rate Risk - As bond prices move inversely with respect to interest rates, rising interest rates can cause bonds to fall. Thus, &nbsp;a bond investor will see bonds lose value in a period of rising interest rates. In particular, high duration bonds like investment grade bonds witness the largest losses during a rising rate environment. The price changes seen in 2022 is one such example (see chart below).<img src="/uploads/IG_Bond_Returns_76e4006f45.PNG" alt="">ii. Inflation Risk - Higher inflation tends to see central banks raise rates to curtail the existing high demand and attract savings. Thus, rising interest rates due to inflation leads to a bond’s price losing value.&nbsp;iii. Credit/Default Risk - Bonds carry the risk of an issuer defaulting i.e., not being able to make pay coupons and/or the principal amount. This would mainly occur due to insufficient financial resources on part of the issuer.iv. Liquidity Risk - In secondary markets, bonds are traded over the counter (OTC) and not as frequently as stocks due to their large ticket sizes. Thus, they tend to have lower liquidity. Also, the most recently issued bonds known as on-the-run bonds tend to have more liquidity than older bonds of the same issuer (off-the-run bonds).v. Optionality Risk - For bonds with a call option, there is a risk that the issuer may not exercise the call option on the call date. This leaves the investor with an unredeemed bond and extends the duration of the investment.vi. Reinvestment Risk – This refers to the probability that an investor may be able to reinvest the bond’s cashflows i.e., coupons at a rate equal to the bond’s current yield. The yield to maturity (YTM) of a bond at the time of the original investment has an inherent assumption - that the coupons received from the bond are reinvested at the same YTM. However, if interest rates decrease during the life of the bond, then the final yield on the investment automatically reduces.While these are the primary risks that exist in bonds, there are others too that may be specific to each bond given their nature and such risks must be considered by reading the bond’s prospectus including cross default, accelerated payments, keepwell risks, trigger event risks etc.

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What are the risks associated with investing in bonds?

Bonds and stocks have similarities, yet they are so different! Bonds are issued in the primary market with the help of banks just like equities are issued via an IPO. Both, bonds and stocks are then traded in the secondary market where investors either bet on the price and/or rely on cashflows from these securities.However, buying and tracking bonds has historically been a cumbersome process for individuals. This involves a manual voice call to their banker/broker to check the price, after which they decide to proceed with a buy/sell order. Price transparency is a problem. Besides, there are the extra costs that accrue due to the number of intermediaries involved between the end investor and the actual market due to OTC trading. In times of a crisis, settlement risk becomes a major concern. Moreover, a large chunk of the dollar bond market has a high minimum ticket size of $200,000 that automatically acts as a disincentive for even wealthy individual to dip their toes.In comparison, the equity, FX, and all other major markets have become fully electronic with minimal costs, high transparency of prices and convenient minimum ticket sizes. Bond markets thus still function just like they did in olden times.BondbloX is now redefining bond investing by allowing investors to buy dollar bonds in the secondary market via the BondbloX Bond Exchange (BBX). We allow you to buy bonds online at your convenience. Moreover, you can now buy bonds both, in its full size of $200,000 and in fractions of $1,000 using the help of BondbloX. We also remove settlement risk from the existing T+2 cycle to ‘<a href="https://bondblox.com/all-featured-articles/the-alchemy-of-atomic-settlement">atomic settlement</a>’ i.e., instant settlement.To start your investment journey online, login to the <a href="https://onelink.to/tzzxev">BondbloX App</a>

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How Do You Buy Dollar Bonds?

Bond duration is used as a key measure of interest rate risk. With the US Fed, Bank of England and other global central banks raising interest rates, understanding the concept of duration is critical for bond investors and advisors. Duration is a key metric used by professional investors to help manage risk and it forms the building block for any bond investor. In this piece, we cover all essential concepts regarding duration with examples. Investors can view bond duration on the BondbloX App and use it as a tool to compare bonds that suit their investment objectives.&nbsp;<h2>What is Duration and How do you Define It?</h2>We know that bond prices are inversely related to interest rates. If interest rates rise, bond prices fall and if interest rates fall, bond prices rise. That said, bond duration is a metric that quantifies:<ul><li>How much a bond's price is expected to change by, if interest rates change by 100bp - known as Modified Duration (more on this below)</li><li>The time it takes for the bond to repay all of its coupons and principal factoring in the time value of money - known as Macaulay's Duration (more on this below)</li></ul>&nbsp;<h2>A Detailed Understanding of Duration</h2>Duration (as in Macaulay's Duration) gives us an estimate of how much time it takes to recoup the cost/price of the bond before maturity. Since each cash flow from the bond is given a time-weighted importance, the first cashflow helps recoup a portion of the cost of the bond in lesser time than subsequent cashflows. The same applies to the second and later cashflows, that help recoup a portion of the bond's cost in lesser time than the cashflows that follow them.The concept of bond duration can be understood via the example of a fulcrum as shown below:<img src="/uploads/Duration_Fulcrum_6c48f714ba.PNG" alt="">&nbsp;<h2>Rules of Duration</h2>Now that we have an intuitive understanding of duration, below are the inferences that can be made:<ul><li>For an interest paying bond, the duration will always be lesser than the maturity</li><li>For a zero-coupon bond/non interest paying bond, the duration will equal the bond's maturity</li><li>Duration decreases as coupons increase; duration increases as coupons decrease</li><li>Duration decreases as yields increase; duration increases as yields decrease</li><li>Perpetual bonds have a finite duration</li></ul>&nbsp;<h2>Types of Duration</h2>Duration is a mathematically calculated measure. Whilst we now have an understanding of the concept, let us look at the different types of duration measures.<h3>Macaulay's Duration</h3>Macaulay's Duration measures the time it takes to recoup the cost of the bond giving a weight to each cash flow. Akin to a bond's maturity, this is also measured in years. Thus, a bond trading at par with a 5 year maturity and Macaulay's Duration of 4.55 years tells us that the investor who invests $100 in a bond will recoup his/her investment in 4.55 years. See the appendix below for an example with the calculations on MS Excel.In the colloquial sense, the word duration is thought of in terms of time and people are susceptible to mistake this measure as the bond's maturity. A bond's maturity is simply the time taken until a bond's interest payments cease and its principal is paid back. However, a bond's maturity does not factor in the time value of money where $1 today is worth more than $1 tomorrow and thereafter!<h3>Modified Duration</h3>Modified Duration tells us how much a bond's price will change with respect to a change in yield. Thus, a bond trading at par with a modified duration of 4.33 years tells us that the bond's price will rise by 4.33% if interest rates fall by 100bp (1%). It also indicates that the bond's price will fall by 4.33% if interest rates rise by 100bp. The calculation of Modified Duration is an offshoot of Macaulay's Duration. Here, we divide Macaulay's Duration by (1 + yield to maturity) due to differentiation formulas in calculus. The appendix below shows the calculation of Modified Duration on MS Excel.<h3>Effective Duration</h3>A limitation of both Macaulay's Duration and Modified Duration is that they do not incorporate the impact of options. For example, bond with a call option can be called back before its maturity date. Effective Duration accounts for the optionality in a bond. Effective Duration thus takes the price of the bond if yields increase or decrease by a certain quantum. See the appendix below for the formula to calculate effective duration.&nbsp;<h2>How Can Investors Use and Interpret Duration?</h2>Now that we have a good understanding of duration (modified duration), we can agree that it is a measure of price risk. As we established earlier, it is the price sensitivity of the bond with respect to a change in the underlying interest rate. One of the simplest way to use duration while investing in a bond is to multiply the duration with the change in yield. Let's look at examples below from the BondEvalue App.We first consider&nbsp;Vedanta's 9.25% dollar bond maturing in April 2026. The bond's price is about $84 for a par value of $100, a yield to maturity (YTM) of 14.92% and a duration of 3.09 as of May 9, 2022. Let's assume that an investor buys the bond at $84 and expects the yield to rise by 100bp to 15.92%. In this case, the bond's price would fall by 3.09% to $81.4. Similarly, if the yield is expected to fall by 100bp to 13.92%, then the price would rise by 3.09% to $86.6. This is the simplest interpretation.However, another crucial way an investor can use duration is to calculate how much would the yield/interest rates need to rise to lose all of the bond's yield/return. Dividing the yield by the duration, you would get the change in yields that would wipe out your bond's 14.92% yield/returns. Thus, a 483bp or 4.83% (14.92% ÷ 3.09) change in the yield/interest rates would essentially wipe out the investor's return from the bond.<img src="/uploads/Vedanta_a91395b111.PNG" alt="">Let's take another example of Amazon's 1% bond due May 2026 shown below. The bond has a similar maturity to Vedanta's bond above. In this case, dividing the yield by the duration, a 1bp or 0.01% (3.48% ÷ 3.84) change in the yield/interest rates would essentially wipe out the investor's 3.48% yield/return from the bond.<img src="/uploads/Amazon_0c1b5f33a1.PNG" alt="">As you can observe, while Amazon (A1/AA-/AA) might be a safer bet than Vedanta (B2/B-) in terms of credit ratings, a smaller/minor change in yields could hurt their investment in Amazon a lot more than in Vedanta. This reiterates our earlier conclusion, where a higher yield benefits an investor as the duration is low, implying less price risk for Vedanta's bond. It also emphasizes that Investment Grade (IG) bonds have a higher duration risk than High Yield (HY) bonds.&nbsp;<h2>Limitation of Duration as a Metric</h2>Duration, despite its simple conceptual understanding is not a perfect metric. If you look with a keen eye on duration, you will notice that there is a flaw. Duration assumes that a bond's price rises/falls by the same amount for a given change in yields. In other words, it is a linear metric. A bond duration of 5 years would imply that the bond's price changes by 5% if yields go up or down by 100bp. In practice, bond prices do not move linearly but are convex by nature. Bond prices gain more than they fall for the same change in yields i.e., the price gain for a 100bp fall in yields is more than the price loss for a 100p rise in yields. This incremental benefit on the upside for bond prices is known as 'bond convexity'.&nbsp;<h2>Appendix</h2><h4>Macaulay’s Duration and Modified Duration Calculations</h4><img src="/uploads/excel_calc_79998b5bc3.PNG" alt=""><h4>&nbsp;</h4><h4>Effective Duration Calculation</h4><img src="/uploads/effec_dur_formula_df2a97d9c1.PNG" alt="">

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Bond Duration – Understanding Interest Rate Risk

What are perpetual bonds?Perpetual bonds, also called perpetuals or perps, are fixed income securities that have no maturity date, or where the agreed-upon period of time over which interest will be paid is forever (in perpetuity). Unlike fixed tenor bonds that have a fixed maturity date and hence a predictable return of principal, <a href="https://bondevalue.com/bond-market/list-of-bonds/perpetual-bonds">perpetual bond</a> do not have a fixed maturity date and hence no predictable return of principal. The only source of cash flow for perpetual bond investors is the scheduled coupon payments.This makes perpetual bonds similar in nature to equity investments that pay dividends, rather than fixed-income or debt investments. Thus, perpetual bonds are often termed as hybrid investments as it has features of both debt and equity.While most perpetual bonds do have a call feature, thereby allowing the issuer to redeem the perpetual bonds according to a fixed schedule, some perpetual bonds do not.&nbsp;Why do investors buy perpetual bonds?• Higher yield: Given the uncertainty with respect to return of principal, perpetual bonds tend to offer a higher coupon and hence a higher yield when compared to similar fixed maturity bonds. Thus, investors seeking higher yields flock to perpetual bonds.• Coupon step-up: A coupon step-up feature in perpetual bonds enables the investor to receive an increase or step-up in the coupon rate as per a pre-set schedule. Coupon step-ups can be one-step or multi-step. One-step bonds have their coupon increased once throughout the bond’s lifetime. Multi-step bonds have multiple increases through their lifetime, as per a fixed schedule.This feature compensates investors by reducing interest rate risk, particularly in a rising interest rate environment. At the same time, a step-up feature incentivizes issuers to call the bond before the step-up kicks in to avoid increased borrowing costs, allowing investors to take back their bond principal.• Fixed-to-floating coupon: Some perpetuals have a feature whereby the coupon changes from a fixed rate to a floating rate during the lifetime of a bond. The floating rate is often quoted as a fixed spread over an index. Commonly used indexes include 3-month LIBOR and 3-month Mid Swaps rate.This feature, once kicked-in, mitigates the interest rate risk for investors as their coupon payments are linked to a benchmark. This feature is particularly attractive for bond investors if interest rates are expected to increase in the future.• Call feature: Most perpetual bonds have a call feature, thereby allowing the bond issuer to redeem the bond at a fixed date and price, as per the bond’s call schedule. For many of the perpetuals, the first call date is also the date of coupon reset (either step-up or fixed-to-floating).When comparing two perpetual bonds, the bond with an earlier call date will have a shorter duration, all else remaining constant. Duration measures the interest rate sensitivity of a bond. “Generally, the higher a bond’s duration, the greater its sensitivity to interest rate changes. High duration bonds will fall in price by a greater magnitude as compared to lower duration bonds, if interest rates increase.”The call date of a perpetual bond is a key factor that contributes to a perpetual bond’s duration. To understand this, we take two perpetual bonds issued by HSBC – both with a coupon of 6.375% but with different call dates. One perpetual bond has a call date of 17-Sep-24 has a lower duration than the perpetual with a later call date of 30-Mar-25. This is because investors stand to get back their principal at an earlier date if the issuer chooses to exercise the call option.&nbsp;Why do issuers issue perpetual bonds?• Fulfil funding needs: Similar to other debt or equity instruments,&nbsp;corporate perpetuals are issued by non-banking corporations to meeting their business funding requirements. &nbsp;Although the company would have to pay investors a yield premium for the perpetual nature of the bonds, it can potentially not have to repay the bond’s principal for many years or into perpetuity. &nbsp;An example of a corporate perpetual is&nbsp;<a href="https://bondevalue.com/bond-market/general-electric-co-us369604bq57">General Electric’s 5% perpetual bonds.</a>• Meet regulatory capital requirements: Banks or related financial institutions who need to fulfil their capital requirements can do so with the issuance of hybrid securities including perpetuals. &nbsp;An example of a corporate perpetual is <a href="https://bondevalue.com/bond-market/US404280BL25">HSBC’s 6% perpetual bonds.</a>&nbsp;<img src="/uploads/Perps_AS_5246a97d22.png" alt="">&nbsp;

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Perpetual Bonds – Understanding the Basics

Perpetual bonds have became very popular among individual investors, but the question is do you know what you are buying?Here are some of the key risks that you should keep in mind before investing in perpetuals.1. Redemption Uncertainty Perpetual bonds are a unique investment that differ from other types of fixed income products in that their redemption has an element of uncertainty and typically happens at the option of the issuer. Most perpetual bonds have a structure that allows the issuer to call back the bonds or redeem them starting from a stipulated date e.g. 5 years after the issue date, and periodically e.g. 6 months thereafter. Nevertheless, redemption is dependent on market factors such as the level of interest rates, current price of the bond, the structure of the bond such as the step-up amount, as well as company-specific considerations such as the funds available for repayment.In a market environment where interest rates have declined to levels that allow companies or banks to borrow more cheaply if they were to issue new debt, the probability of issuers exercising their option for redemption is higher. The likelihood that issuers will repay their perpetual bonds is increased when the bond terms include a step-up interest rate which comes into effect after a call date when the issuer does not exercise their option to redeem the bonds. In this case, issuers would prefer to redeem and issue new debt, which would cost them less.It is common to see issuers call their bonds at the first call date when there is a significant step-up in coupon after, which leads many investors to assume that their bonds will always be called. Unfortunately, this is not true.It is possible that if an issuer decides to never call their bonds, investors will only be repaid in coupons for eternity. Alternately, they can get their principal back by selling their perpetual bonds in the secondary markets, subject to market liquidity. It is important for investors to understand that the option lies with the issuer and that there can be a possibility where the perpetual will not get called on the first call date. This was the case in February 2019 when Spanish bank&nbsp;<a href="https://www.bloomberg.com/news/articles/2019-02-12/santander-skips-coco-call-in-nasty-surprise-for-bond-investors">Banco Santander chose&nbsp;not&nbsp;to call its 6.25% contingent convertible (CoCo) perpetuals</a>&nbsp;with an amount outstanding of EUR 1.5 billion. While this move took investors by surprise, it made economic sense for Santander as the floating rate coupon that kicked-in post first call date was lower vs. if it had redeemed the bonds and issued new ones.&nbsp;2. Lack of Voting RightsMost perpetual bonds are treated under accounting standards as equity in their company’s financial statements, since the structure of these bonds imitate&nbsp;the payment schedule of a dividend-paying stock where coupons are paid out periodically with a deferment option, and redemption is neither fixed at a certain date nor guaranteed. However, whereas holders of a company or bank’s equity have the right to vote on certain issues which require shareholder input, this privilege does not apply to bond holders including those who own perpetual bonds.&nbsp;3. Subordinated&nbsp;Nature of Perpetual BondsThe seniority of a bond determines the priority in which investors get repaid in the event that an issuer defaults or goes into liquidation. Fixed income and equity products can be classified according to their repayment priority, with senior secured bonds having the right to receive payment first in the event of a bankruptcy or liquidation. The priority of repayment then goes down the pyramid as seen below, until the issuer’s asset base is depleted.<img src="/uploads/Perptl_bonds_225b8ecb9c.png" alt="">Perpetual bonds typically fall under the category of subordinated bonds, such as that of CoCo bonds. CoCo bonds are classified as Additional Tier 1 (AT1) capital and are junior to Tier 2 capital, which in turn are subordinated to senior and/or secured bonds. &nbsp;CoCos are particularly popular among bank issuers for the purpose of adding to the capital base of the bank, helping to cushion the capital structure when leverage is high by potentially absorbing losses if there were to be a crisis situation.What is so different about CoCo bonds?As the name suggests, CoCo bonds can be converted into equity upon a contingent event where certain triggers are met. Currently, the most typically seen trigger is a conversion of&nbsp;some or all of an issuer’s perpetual bonds into its stocks at a stipulated ratio, in the event that&nbsp;its common equity tier 1 (CET1) capital ratio falls below a specific number.Take&nbsp;<a href="https://bondevalue.com/bond-market/Hsbc-Holdings-Plc-US404280BN80">HSBC 6.25% PerpNC5</a>&nbsp;as an example. Its Capital Adequacy Trigger Event is when the CET1 ratio falls below 7% and conversion is set to be within a month of the event occurrence.HSBC 6.25% Perpetual – Bond Pricing Supplement<img src="/uploads/hsbc1_b6f248ed80.png" alt="">&nbsp;CoCo Conversion Trigger<img src="/uploads/hsbc2_1709298ecf.png" alt=""> &nbsp;CoCos have increased risk from equity conversion and&nbsp;the fact that they also sit lower on the repayment priority in events of liquidation. This explains why investors would demand higher yields from CoCos. Risks are compounded by the fact that conversion only occurs when the issuer has an overweight debt to equity ratio, which decreases the likelihood of repayment.Extra precaution should be taken in evaluating the risks of perpetual bonds in light of its subordinated nature, and investors should look beyond the higher coupons and the promise of receiving coupon payments to perpetuity. Investors should analyse and understand an issuer’s cash flow position and the ability to meet financing requirements, before investing.&nbsp;4. Discretionary CouponsA feature that is often seen in CoCo perpetuals is discretionary coupons. This feature gives bond issuers the right to pay coupons at its sole discretion or choice, without being an obligation. Investors that buy into a bond with this feature have the additional risk of not receiving a coupon payment during the life of the bond. Cancelled coupon payments may or may not accumulate, meaning that investors may or may not receive the cancelled coupon payments at a later date.Looking at the same HSBC 6.25% PerpNC5 bond, we can see that it does in fact have a discretionary coupon clause, which are non-cumulative in nature.Discretionary Coupon<img src="/uploads/hsbc3_56b01ada87.png" alt="">Thus, it is important for investors to review the bond prospectus (available on the BondbloX platform), especially when investing in perpetual bonds. Fully understanding key points such as coupon resets, call schedule, seniority/payment rank, conversion triggers and discretionary coupons will help investors compare perpetual bonds effectively and make an informed investment decision.&nbsp;

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Perpetual Bonds – Key Risks to Know Before Investing

Today everyone around us seems to be a bond market expert! They seem to be always quite certain about the direction of interest rates. What if, one believed that in the long run it is hard to predict rates. The world is full of uncertainty, and we can’t know for sure what will happen to interest rates in medium to long term. What should one do then?GFC, Taper tantrum, COVID, the spike in inflation in 2023 were events that were not predicted. We have seen overnight interest rate go from six percent to zero and back to five and a quarter percent. This creates a reinvestment risk if you have a lot of maturities at the time rates are low. Similarly, we have seen massive movements in the US 10 year yield over the last 10 years. From a low of 0.53% to a high 4.91%. It can be embarrassing to the experts if one were to ask them about the historical performance of their views.If an individual investor had a USD 5 million bond portfolio at 5%, she would make a quarter million dollars per annum. But if yields were to fall to 2 percent, her income would fall to just one hundred thousand dollars. A large drop in income can be hard to digest. How does one insulate oneself from this extreme volatility? One way is to be a great forecaster! The other way is to build a bond ladder. If you know a good forecaster listen to her, else read on.&nbsp;<h3>What is a Bond Ladder?</h3>A bond ladder is essentially a portfolio invested in bonds with equally spaced maturities. For instance, let’s say you have USD 1 million. With corporate bonds typically having a USD 200,000 denomination, you can construct a 5-year laddered portfolio consisting of 5 bonds. Each bond has a different maturity ranging from 1 year, 2 years… to 5 years.&nbsp; Each of the bonds’ maturity dates represent a rung on your bond ladder, giving you a portfolio with bonds maturing every year within the 5-year time horizon. If you have access to the BondbloX online bond platform, you could do USD 100,000 each of fractional bonds, with a bond maturing every year for the next ten years too!As you receive the principal redemption proceeds of the maturing bond every year, this is rolled over into new bonds at the end of your bond ladder. This keeps the laddered portfolio intact.In the illustration, at the end of the first year, you will receive USD 200,000 which will be invested into a new 5-year bond so that the overall portfolio continues to have a 5-year horizon. The same process gets carried forward in every subsequent year.<figure class="image"><img src="https://2749033.fs1.hubspotusercontent-na1.net/hubfs/2749033/Bond%20Ladder%20Illustration-png-1.png"></figure>Bond Ladders are generally defined in terms of the starting year and ending year, for example, the above strategy is called a ‘1-5 years ladder’. Pimco, one of the giants in the investing world offers the following ladders: 1–5, 1–11, 3–8 and 3–11 years[1].&nbsp;&nbsp;<h3>Why Bond Ladders?</h3>Bond Ladders are a method for people to have predictable cash follow, without having to buy ultra long-term bonds. Some of the features of Bond Ladders include:<h4>1. Consistent and Predictable Stream of Income</h4>Bond Ladders allow us to create a stream of steady and consistent income from our bond portfolio’s coupon payments and principal redemptions. From the earlier illustration, your laddered portfolio can return you 10 coupon payments annually (assuming coupons are paid out semi-annually). This is in addition to one principal redemption every year.Laddered portfolios also provide cashflow predictability. Since all future coupon and redemption payments follow a predetermined schedule, we can know with certainty how much money we expect to receive since the formation of the portfolio (or the time of reinvestment). Thus, we can accurately time our spending/consumption based on our incoming cash flows.<h4>2. Weathering Interest Rate Risk</h4>Ladders are a neutral investment strategy, appropriate for any economic situation. If rates rise, you will anyway have some bonds maturing which, you can reinvest at higher rates. Fidelity[2], one of the worlds largest asset managers notes that ladders can also offer some protection from bond prices falling due to higher rates, as bondholders are paid the full principal of the bond when it matures. Hence they note that investors “should have the temperament” to hold the bonds in the ladder “until they mature to maximize the benefits of regular income and risk management”. Conversely, if rates fall, you will only have some bonds reinvested at lower rates. You will not be affected much because you will already have existing bonds that do not mature in the near-term, with previous higher yields locked in. Since cyclicality of economic cycles and interest rates is the underlying assumption in this strategy, the duration of your ladder should be longer than the economic cycle.&nbsp;<h4>3. Less Effort, Satisfying Reward</h4>Bond laddering resembles the ‘buy-and-hold’ passive strategy that provides the elusive “smooth income” and “peace of mind”. While it is not entirely passive in its approach, investors only need to take action as a bond is maturing, since they have to reinvest the redemption proceeds into another bond at the end of the ladder. However, investors can also choose to sell and replace a bond if the forward-looking credit profile of the issuer is no longer positive. Ladders don’t help if the bonds default, so try to avoid defaults or notable credit events. Continue to monitor your portfolio daily via online bond platforms that give you the daily portfolio value.<h4>4. Lower Bond Trading Fees</h4>Bond trading via a conventional method can have fees from 25bps to 150bps per trade. An active trading strategy can really rack up fees. A ladder in contrast has a fraction of the fees – one percent saved in trading translates to a one percent additional return on the portfolio.&nbsp; Even if one trades via efficient online bond trading platforms, the passivity of the Bond Ladder does improve the net return.<h4>5. Benefit from Higher Average Yields</h4>Since laddering involves consistently reinvesting in the longer end of the curve, investors can enjoy higher average yields from longer-term bonds’ term premium, during a normal upward sloping curve. This benefit gets eroded during the not so normal periods of inverted yield curves. The corporate credit curve is upward sloping benefiting the net returns achieved.&nbsp;<h3>Limitations of Bond Ladders</h3>Active strategies by skilled investors can yield much higher returns wherein investors extend duration when yields are likely to fall and shorten duration or move into higher cash positions when they think yields will rise. The ladder’s primary goal is not to maximize returns unlike active strategies. It is a relatively conservative strategy with an emphasis on smooth income and almost passively managed.Secondly, to build a diversified laddered portfolio, the initial investment required may be high. For instance, Asian corporate dollar bonds have a minimum investment size of USD 200,000. Therefore, from our earlier illustration, building a 5-bond laddered portfolio requires a sizeable USD 1 million. To achieve a more diversified 20-bond laddered portfolio, an investor would then need about USD 4 million.While the barriers tend to be high, for bonds with smaller minimum denominations, this is not a constraint. With the rise of fractionalisation of bonds, investors do not require a large initial outlay to construct bond ladders. with the ability to compose their very own customized portfolio.BondbloX fractionalizes bonds so that they can be traded at minimum denominations of USD 1,000. Therefore, it is possible to achieve a diversified 20-bond laddered portfolio with as little as USD 20,000. Most bonds in the United States are traded with a minimum trading size of USD 1,000 and these can be used to <a href="https://bondblox.com/announcements/bondblox-to-offer-access-to-u-s-corporate-municipal-and-treasury-bond-liquidity-with-integration-to-ice-bonds">construct bond ladders</a>.&nbsp;<h3>Bond Laddering – Considerations</h3>Here are some considerations to think about while constructing bond ladders. There is no standard universal method since everyone has a different risk appetite and funding needs.<h4>Considerations for your Ladder:</h4><ul><li>How many rungs should your bond ladder have?</li><li>What is the time horizon?</li><li>How should the rungs of your bond ladder be spaced? The spacing between the rungs should be roughly equal. For instance, this could be a 1 year or 2 year spacing depending on the individual.</li></ul><h4>Considerations for your Portfolio:</h4><ul><li>Be comfortable with the risk level that you are taking. For lesser credit risk, high grade bonds would be preferable. For non-experts they should seek the advice of the bond advisors</li><li>Diversify your portfolio and avoid being overweight or underweight in one particular sector, credit or sovereign. This will lower the average risk of your portfolio.</li><li>Callable bonds can be a risk factor – some of these include AT1 bonds issued by banks or high-yield bonds like the popular 5NC3 (5 year bond callable after 3 years) It is preferable to limit exposure to such bonds as they cause unpredictability of the ladder</li></ul>&nbsp;<h3>BulletShares vs. Bond Ladders</h3>BulletShares, are&nbsp; exchange-traded funds (ETFs) with fixed maturities.. BulletShares have ETFs within them with termination dates like individual bonds. These ETFs typically pay monthly distributions and as each fund terminates, the net asset value (NAV) of the fund’s assets is distributed to investors. Since they are ETFs, they offer investors access to real-time pricing and intraday trading.In comparison, bond ladders use individual bonds instead of ETFs. Investors in traditional ladders can specifically choose bonds in the portfolio that they are comfortable with. &nbsp;BulletShares, buy ETFs, which buy bonds – thus, fees and commissions may apply at each layer and for each buy/sell transaction. For many investors bullet shares are a great way to create their first ladder. The taxation of the BulletShares may differ with that for bonds.&nbsp;<h3>Conclusion – Fractional Bonds Help!</h3>Bond laddering is a smart and simple strategy for investors seeking stable income and reduced risk exposure. Spreading investments across bonds with different maturity dates, can help manage interest rate risk, maintain diversification without compromising on returns. It can also be tailored to your individual financial objectives. With the advent of fractional bonds, bond ladders can be constructed with much a much smaller investment corpus.Want to create your first bond ladder? Write to us at <a href="mailto:bbxsales@bondblox.com">bbxsales@bondblox.com</a>&nbsp;References[1] https://www.pimco.com/us/en/investments/managed-accounts/corporate-bond-ladder-managed-account[2] https://www.fidelity.com/viewpoints/investing-ideas/bond-ladder-strategy

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