S$-denominated bonds and bond funds have gained popularity over the years due to the low interest rate environment. While most Singapore corporate bonds are prohibitive to retail investors due to the minimum investible amount of S$250,000, you can invest in most S$ bond funds for as low as $1,000. However, with interest rates at historic lows, can you still make money by investing in a S$-denominated bond fund?
I looked at two bond funds available to retail investors – United Singapore Bond Fund managed by UOBAM and Shenton Income Fund by Nikko AM (formerly DBSAM).
Why S$ funds invest in US$ bonds
According to the fact-sheets of the two funds, both funds can invest in foreign currency bonds even though both are S$ denominated.
The main reason is that the size of S$-denominated bond market is much smaller than the US$-denominated bond market even though it had been a record issuance last year with more than USD $23.8 billion new S$-denominated bond issues. In comparison, SIFMA puts the US bond market at just under $37 trillion (including municipal bonds) as of the end of 2011.
Another reason is also because the yields of US$-denominated bond could be higher than the S$-denominated bond by the same issuer – a function of the demand-supply dynamics in the S$ bond market, where S$ bonds have been under-supplied on insatiable demand by investors (mostly retail).
That fund managers choose to pass on some S$ issues in preference for their foreign currency denominated ones suggests “richness” (i.e., overpricing) in the valuation of S$ issues. Fund managers rather employ currency management (taking FX risks) to hedge or protect the portfolio against currency movements vis-a-vis the S$.
Portfolio Yields and Duration
Compared to an individual bond, a bond fund is better-diversified with many bond holdings and therefore there is no fixed interest or maturity. However, the fact-sheet will usually indicate the portfolio yield and duration of the bond fund.
When interest rate rises, the price of the bond will fall and it is the same for bond funds. Duration measures the sensitivity to a change in interest rates. For example, the value of the Shenton Income Fund will decrease by approximately 4.33% for every 1% percentage increase in interest rate. Whereas for the United Singapore Bond Fund, a 1% change in interest rate will decrease the value of the fund by approximately 7.1%.
What could eat into returns?
Take note also of the initial sales charge. As stated on the fact-sheets, distributers of Nikko AM is charging up to 3% initial sales charge while UOB AM’s is slightly better at 2%. High initial sales charge can wipe out your returns.
Another unavoidable cost that will affect fund performance is the management fee. UOB AM charges 0.5% p.a. for management fees, while Nikko AM charges 1% p.a.
Comparison and Analysis of Returns
Here comes the most important factor – Returns. I compare the returns of the two funds over the years against inflation.
Source: Bloomberg and Department of Statistic Singapore
*Year to date return (Annualised basis) on Nikko AM Shenton Income Fund includes 1% management fees and 1% initial sale charge.
**Year to date return (Annualised basis) on United Singapore Bond Fund includes 0.5% management fees and 1% initial sale charge.
***Year to date inflation rate is the average inflation from Jan to April 2013
From the chart above, Nikko AM Shenton Income Fund had delivered higher returns compared to the United Singapore Bond Fund over the 1 Year and 3 Year period. Here are the possible reasons that I gather for the out-performance of Shenton Income Fund.
First reason: The fund invests in high yield bonds. By going down the credit curve, the fund will garner a higher return, but also at the same time potentially taking on higher risks as lower grade issuers have a higher probability of default due to their higher levels of indebtedness.
Second reason: This fund invests in local currency denominated bonds to gain from the appreciation of the local currencies. For example, Shenton Income fund invests in the local currency version of Philippines and Indonesia government bonds to gain from currency appreciation. The fund managers are taking on a directional view on currency appreciation. If they are right, it adds to the returns of the fund but if they are wrong and the local currencies depreciate instead against S$, then the losses from the foreign exchange can similarly drag down the performance of the fund.
Third reason: The fund also invests in convertible bonds which are bonds embedded with equity options. While convertible bonds may pay an attractive coupon, in addition to price gains, investors are subject to equity risks in addition to the credit risks of the issuer. There is ultimately no free lunch, the higher returns are due to the higher risks undertaken. In fact, fund managers invest in convertible bonds to articulate their positive views on the equity to benefit from the price gains on the bond if their view is right. Comparatively, the United Singapore Bond Fund’s top 5 holdings consist of much safer Singapore government bonds and Singapore government-linked companies and this explains the lower return.
If you further scrutinize the returns of the two funds, you can see that despite its riskier nature, the Nikko AM Shenton Income Fund’s five year returns cannot even beat the inflation rate over the same period and the fund’s three year return only beats inflation by a whisker over the same period. Risk averse investors will definitely feel safer buying the United Singapore Bond Fund which is less risky in terms of bond holdings. However, this fund has very low returns year to date (annualised basis) and the returns over the past few years also hardly beat inflation.
In summary, while the Shenton Income Fund registered double digit returns over the last 2 years, the returns over a tenor of three or five years do not seem to adequately compensate investors due to the additional risks of investing in high yield, local currency and convertible bonds. While United Singapore Bond Fund is much safer, the returns over the years is not compelling enough. In addition, the duration of both funds are relatively long and therefore will be sensitive to any increase in interest rates.
The returns generated from the two S$-denominated bond funds are not fantastic. (Comparatively, the returns to banks are – sales charge and management fee are risk-free and can be juicy!)
At current low interest rates, I will not invest in bond funds as I don’t want to be caught by a rising rate. Where to put my money then? Do you have the answer?