Quarterly Market Outlook
The Portfolio Protector
We explain the basics of investing in bonds/sukuk, how they work, and why they should be part of your diversified portfolio.
As an investor, you’ve probably heard the mantra “diversify, diversify, diversify” over and over. It is essential to build a portfolio of many different moving parts to help withstand market volatility and preserve capital over time.
In a diversified portfolio, you have investments across different types of securities such as stocks, bonds/sukuk, real estate, and commodities. Then, you diversify within each of these classes of securities. The idea is to mitigate the potential negative effects of a single investment performing poorly. By placing your eggs in different baskets, you prevent the risk of losing all your asset at once. When one basket breaks, you’ve still got the others.
One asset class that plays an important role in a diversified portfolio is fixed-income securities. They deliver exactly what’s on the label – a fixed income. Also known as bonds/sukuk, they are often regarded as the most boring asset class but get this: boring is GOOD. You want boring but predictable. In a world where it seems like anything could go wrong at any time, it’s nice to have something stable and relatively safe to depend on, like a regular passive income stream. If there’s a capital gain, that’s a bonus!
While bonds/sukuk may not be the best hedge against inflation, the steady income from bonds/sukuk can shield you from the volatility of the equity market. So, whether you are planning for retirement or living in retirement, bonds/sukuk have a place in your portfolio.
What are bonds/sukuk?
Bonds/sukuk are investment products that represent loans/financing made by investors to governments, municipalities, corporations, or other entities. When you invest in a bond/sukuk, you are essentially financed money to the issuer in exchange for regular profit payments, known as coupon payments, and the return of the principal amount at the bond/sukuk's maturity date. It’s basically an official IOU (“I Owe You”).
Bonds/sukuk come in various forms, including government bonds/sukuk, corporate bonds/sukuk, municipal bonds/sukuk, and mortgage-backed securities, each with its own risk and return profile. Government bonds/sukuk are considered the safest, as they are backed by the full faith and credit of the issuing government. Corporate bonds/sukuk, on the other hand, carry slightly higher risk but also offer higher potential returns.
Bonds/sukuk can come with short term (1-3 years), medium term (4-10 years), or long term (more than 10 years) maturity periods. There is also the perpetual bond/sukuk, nicknamed “perp”, which has no maturity date. This means that you’ll get coupon payments forever, with no requirement for the issuer to pay the principal amount. Although perps have no maturity date, they typically come with a “call” date, usually five years, upon which the issuer can buy back the bond/sukuk and return the principal amount to the investor. If the issuer does not call the bond/sukuk, the yield rate can be revised higher to compensate for the longer holding period.
In Malaysia, corporate bond/sukuk yields can vary depending on factors such as credit rating, issuer reputation, economic conditions, and market demand. Generally, corporate bonds/sukuk are classified into different categories based on their credit ratings, including investment-grade and high yield (also known as non-investment grade or speculative-grade) bonds/sukuk.
This table explains the differences between investment-grade and high yield corporate bonds/sukuk.
As you can readily invest in bonds/sukuk or bond/sukuk funds denominated in another currency, like the USD, SGD, or AUD, this can also be seen as a form of diversification as it can help mitigate the risk of adverse currency fluctuations. Doing this can also provide exposure to other markets.
Purchasing a bond/sukuk directly depends on the availability at the point of time (for primary issuance) or the availability of the inventory from the secondary market. These bonds/sukuk are traded over the counter (OTC), so you will need to get in touch with your Relationship Manager to know what’s up for sale. A direct purchase can also be pricey. For example, a typical direct bond/sukuk investment could be RM250,000. Same goes for bonds/sukuk in a different currency.
A more efficient and much cheaper way to include bonds/sukuk in your portfolio is to invest in a fixed income fund. We will address that further down this article.
What affects their performance?
One key factor that can affect bond/sukuk performance is interest/profit rates. When interest/profit rates rise, bond/sukuk prices tend to fall, and vice versa. This is because a lower bond/sukuk price is needed to compensate for the higher return expected from a higher interest/profit rate environment. Conversely, when interest/profit rates fall, existing bonds/sukuk with higher yields become more valuable, leading to an increase in bond/sukuk prices. So, there is an inverse relationship. Herein lies the main risk, but at the right time, it is an opportunity. There’s also the risk of the issuer defaulting, but as the previous table explains, the higher the risk, the higher the yield.
Credit ratings, issuer financial health, and market sentiment also play significant roles in determining bond/sukuk prices and yields.
Locking in yields
Now that you know what bonds/sukuk are and how they work, let’s get into making them work for you. We should ask ourselves: what’s the interest/profit rate outlook?
Our in-house expert expects Bank Negara to keep the overnight policy rate (OPR) at 3% in 2024, given that the monetary policy remains supportive of the economy and is consistent with the current assessment of inflation and growth prospects. View the full report here.
With that information, NOW is the time to add a sturdy bond/sukuk fund to your portfolio so you can lock in at the higher yields. Future You will thank Present You for the wise move.
These are some of the bond/sukuk fund options you can discuss with your Relationship Manager:
Source: Lipper IM, fund historical performance as of 31 January 2024.
Investing into direct bond/sukuk (instead of bond/sukuk fund) depends on the availability of the issuance at the point of time (for primary issuance) or the availability of the inventory from the secondary market. These bonds/sukuk are traded over-the-counter (OTC) hence you need to get in touch of our Relationship Managers to know what’s available at the moment.
Overall, bonds/sukuk play an essential role in building a strong foundation for a diversified portfolio, whether directly or through a bond/sukuk fund managed by experts. Understanding how they work will help you maximise their benefits in any economic environment. Give your Relationship Manager a call today to see how bonds/sukuk can fit into your overall strategy.
Get in touch with RHB Premier today.
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