With Singapore government bond yields moving steadily lower, corporate bond funds offer an alternative source of income. How risky are such funds?

If you are a Singapore-based income seeker, recent trends pose significant challenges. Singapore’s core inflation rose unexpectedly to 2.7 percent in August. This was the first increase in six months and a reminder that there is little room for complacency when it comes to battling inflation. At the same time, Singapore cannot hold off monetary easing for much longer. In the wake of the Fed’s recent 50 bps rate cut, the SGD is now at a 10-year high against the USD. This could be damaging to Singapore’s exports over the longer term and most analysts expect Singapore to start easing by early next year.

As a result, Singapore government bond yields are on a downward trajectory. The 10-year average return for Singapore Savings Bonds (SSBs) fell to 2.56 percent in October, compared to a high of 3.47 percent in December 2022. Similarly, the Singapore six-month T-bill cutoff yield currently stands at 2.97 percent, compared to its 2022 high of 4.4 percent.

Are corporate bond funds right for you?

The combination of sticky inflation and falling yields is highly problematic for savers and income seekers. Not only are you not able to generate the same income as last year or two years ago, the value of your savings continues to be eroded by higher prices.

There is therefore an urgent need to consider other income-paying options. Singapore has no shortage of corporate bond funds offering income payouts of 4 - 10 percent pa. However, investors remain wary of the risks, especially following high profile defaults by Chinese property developers. So what is the truth about corporate bond funds? Here we respond to some common concerns and misconceptions

Concern #1: Corporate bonds are inherently risky because they are not backed by governments

Indeed, most corporate-issued bonds have more credit risk - and therefore higher yields - than government bonds of similar maturities. This is called the credit spread.
But just like government bonds, corporate bonds are rated either investment grade (IG) or high yield (HY) by global rating agencies. Historically, the maximum one-year default rate for IG-rated bonds is only about 1.0 percent, and between 4 – 50 percent for HY-rated bonds. Additionally, bond fund managers will conduct their own corporate research.
Note to investors: IG corporate bond funds can hold varying proportions of IG and HY bonds. You should determine a corporate bond fund’s IG and HY allocation before investing.

Concern #2: Corporate bond fund returns are set to decline as interest rates fall

Corporate bond fund returns are comprised of two elements – the yield generated by bond holdings and their prices. Given that bold yields and bond prices tend to move in opposite directions, the current rate cut cycle is actually positive for bond prices.
In addition, corporate bond prices can increase due to spread tightening. This is when a corporation’s credit risk is potentially less than previously thought, or when investors are optimistic about the wider economy.

In general, IG bond spreads are currently tight compared to historical levels. But there is still room for tightening among HY bonds, and those offered by undervalued companies.
Note to investors: It is important to track a corporate bond fund’s total return and not just its dividend payout. Bond fund returns can be low or negative despite offering good dividends.

Concern #3: Corporate bond funds are taking more duration risks to achieve higher returns

Bonds with longer maturities have stronger price movements because it is harder to predict what will happen over long term. In a falling rate environment, it is tempting to buy longer term bonds because there is potential for more upside.

Bond fund managers have more flexibility to do this than a direct bond investor. They typically hold a portfolio of bonds across varying maturities. When rates fall, they can lengthen the average duration of their portfolio. But they have the option to hold bonds to maturity when rates climb, thereby limiting the investment risks.

Note to investors: The are typically three types of corporate bond funds: short maturity (average duration up to five years), medium maturity (average duration between five to 10 year), long maturity (average duration > 10 years). You should choose the maturity type that matches your risk tolerance.

Concern #4: Corporate bonds have the same risk as stocks, but offer less return

Unlike stocks, corporate bonds and especially high yield bonds are subject to default risks. However, even if this happens, the impact within a well-diversified bond portfolio is relatively limited.

On the plus side, high yield bond funds tend to pay high dividends than equity funds and experience less price volatility. They are therefore a good option for income seekers who have a longer time horizon. Additionally, there is some overlap between what drives HY bond and equity performances, for example, good economic growth. But there are also important differences - high yield bond prices respond more to lower interest rates, and can therefore benefit more in a rate cut cycle.

Note to investors: There is a wide range of higher-rate and lower-rated HY bonds for managers to choose from, especially as HY issuances in US and Asia rose 40 – 50 percent in 1H24. You should be comfortable with the average credit rating of a HY bond fund before investing.

If you are interested in investment opportunities related to the theme covered in this article, here are some UOB Asset Management funds to consider: United SGD Fund About the Fund Fund Commentary   United Asian High Yield Bond Fund About the Fund Fund Commentary     United Asian Bond Fund Fund Commentary Fund Factsheet You may wish to seek advice from a financial adviser before making a commitment to invest in the above funds, and in the event that you choose not to do so, you should consider carefully whether the funds are suitable for you.