Sunday 16 September 2012

Government Bonds – A Primer

Equities are not the only investment class. Most retail investors usually neglect bonds, as they are not listed on the stock exchange and are not as volatile or exciting as shares. Moreover, trading in government bonds (known as Singapore Government Securities or SGS) requires one to visit the local banks that serve as traders in the secondary SGS bond market. The bank officers are usually clueless about the trading process and often need to consult their Treasury colleagues at the headquarters. Nevertheless, SGS bonds can be a useful asset class in any investment portfolio.

Before beginning, there are several important basic knowledge to be learnt for bond trading. Firstly, bond prices are quoted in values of $100. So, a bond that is priced at $108 means that you buy $100 worth of bonds at $108.

Secondly, the bond prices quoted are clean prices, meaning it does not include the interest accrued. The price that you actually pay is the dirty price, which is the clean price ($108 for the example above) plus any accrued interest at the date of settlement. Let's work through this with one of the SGS bonds, NZ10100F, which has a coupon (i.e. interest) rate of 2.875% and matures on 1 Sep 2030. Its current quoted price is $109.48. Its accrued interest since the last coupon payment (on 1 Sep 2012) is $0.10, representing the coupon of 2.875% for 13 days since 1 Sep 2012. So, if you wish to buy this bond, you'll need to pay the clean price of $109.48 + accrued interest of $0.10 or $109.58. The further away from the last coupon payment date, the higher is the accrued interest. Nevertheless, you will actually get back the accrued interest from the next coupon payment, which will be for the period from 1 Sep 2012 till 31 Mar 2013. Of course, when you sell the bond, the buyer will also have to pay you the accrued interest for the days that you have held on to the bond since the last coupon payment.

So, after paying $109.58 for the bond, what do you get back in return? You'll get a semi-annual coupon of 2.875% (or $1.4375 per $100 bond) until it matures on 1 Sep 2030, upon which you will also get back the principal of $100. Overall, what is the net return? This is known as the Yield-to-Maturity (YTM), which can be computed either with Excel or more simply, a bond tool, one of which can be found on the SGS website. See below for a screenshot.

Also on the SGS website are the daily closing prices of all SGS bonds (, which is the primary means of checking the price of SGS bonds.

Thirdly, bond prices move in opposite directions from interest rates. When interest rates drop, bond prices rise and conversely, when interest rates rise, bond prices drop. This is because as the prevailing interest rates rise, the fixed coupon from the bond is no longer as attractive and the bond must drop in price to compensate for the relatively less attractive coupon. The amount bond prices move relative to interest rates is dependent on the duration of the bond. The longer the bond is from maturity, the higher the duration and the more the price will move in response to interest rate changes. For small changes in interest rates, the relationship can be approximated by the following formula: Change in Bond Price = Change in Interest Rate x Duration of Bond. Thus, for a 20-year bond with a duration of approximately 16 years, a 0.1% rise in interest rates will result in a 1.6% drop in price. The exact duration of a bond needs to be computed using Excel, but can be approximated by 0.8 x its remaining maturity if it still has more than 10 years remaining and by 0.9 x its remaining maturity if it still has more than 5 years remaining. For bonds that are maturing in less than 5 years, the duration is approximately equal to its remaining maturity.

With the above basic information, you should be ready to start trading in bonds.

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