Oran Hall | Why investors find bonds attractive

Investors who see themselves as conservative consider bonds to be the ideal securities, but investors who have a greater appetite for risk also find them useful in building balanced portfolios.

Although not risk-free, bonds appeal to investors who see them as offering security of principal and certainty of income.

A bond is a debt instrument. The borrower undertakes to pay the principal sum at the maturity date and interest at set intervals – generally semi-annually or quarterly. A bond is secured by specific assets of the borrower – though it is not unusual to see ‘unsecured bonds’ being offered to investors in our market. An oxymoron? An unsecured debt instrument is a debenture.

Bonds are seen as safer than instruments like ordinary shares. The principal sum is generally repaid at the maturity date, as opposed to equities, which have no maturity date. Investors must sell to willing buyers to get back their money.

The issuers of bonds have an obligation to pay interest; a company has no obligation to pay dividends on its shares. Beyond that, the level of interest to be paid is prescribed, but how much dividend is paid, if any, is effectively determined by the directors who base their decision on matters such as the level of profit and the plans the company has for expansion.

The fact that a bond is secured by the assets of the issuer does not guarantee that investors will receive interest when due, and the principal at maturity. There are investors who recount tales of woe due to the failure of the issuers of bonds to re-pay the principal although they paid the interest regularly. Even when the maturity date was extended, they were not able to recover their investment.

In addition to the assets backing bonds, there are usually protections in place to secure the funds of the investors. As can be seen by examining the prospectus of any of the issues on the Jamaican market, there is a trustee whose primary role is to protect the interest of bondholders. It is worth noting, though, that the so-called unsecured bonds, though not giving the bondholders physical assets to protect them, their comfort being the good name and financial strength of the issuer, may still be good investment grade.

In the vast majority of cases, though, investors do receive their principal at maturity. The major issue is that the matured funds are never able to buy the same basket of goods and services as the original sum was able to because of inflation.

Bonds are useful in diversifying an investment portfolio and moderating fluctuations in its performance. High-yielding bonds boost its performance and provide an alternative when stock markets are in the doldrums.

Investors must protect themselves when they participate in any financial market. They should not make any investment blindly and should seek good professional counsel and guidance before committing to any investment, including bonds.

It is best to seek guidance from more than one source and, where possible, get the opinion of parties which are not connected – directly or indirectly – to an issue of securities. Figures do not lie, but how well they are analysed and interpreted depends on the competence of the analyst.

It is necessary to keep sentiment out of investment decisions. Basing a decision to buy a bond or any other investment on the name of the issuer without seriously considering the merits of the instrument is unwise.

Priority consideration should be given to the financial strength of the issuer, including profitability, cash flow, debt in relation to equity and the strength of its asset base, and the proposed use of the funds, because they are able to indicate how able the issuer will likely be to meet its financial commitments to investors.

There are other steps investors can take to protect themselves when investing in bonds. Avoid concentrating funds in one instrument. Diversification is not limited to investing in more than one type of instrument.

A bond portfolio, for instance, can be diversified by maturity, issuer, sectors of the economy, currency, and market – but investors must be very cautious when investing in bonds issued in foreign markets.

The following can help to make investing in bonds more profitable. Investors approaching retirement may find it helpful to invest in bonds spread over several maturity dates to hedge against having to sell in unfavourable market conditions to realise funds for important commitments.

Some issues are designated for accredited or sophisticated investors, so investors who do not meet that classification should take a pass. Investors should also avoid the hype associated with new issues, see what independent rating agencies say about them, where possible, make sober decisions based on fact, and look more favourably on instruments that are marketable, for instance, by being listed on the stock market.

The financial intermediaries that offer bonds to the investing public should do more serious research to be better able to guide their clients and be careful to ensure the instruments are suitable for them. In the case of new issues, they should do simple and brief analyses of the often long, detailed and complicated offer documents for the benefit of the investor.

It is reasonable to invest in bonds for the purposes of security of principal and certainty of income, but how well these objectives can be met depends on the quality of the instrument as determined by the financial strength of the issuer.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com