Most investors believe that stock is the most traded asset in the world. The truth is that there’s another asset class that is 1.5 times the size of stocks.
We are talking, of course, about bonds. In 2017, the global bond market was sized at over $100 trillion, which dwarves the equity market (at $70 trillion). Your surprise would be forgiven because if you read the news, over 80% of the coverage concentrated exclusively on stocks.
In this article, we will dive deep into the bond world and explore the magical combination it has with Switzerland.
Bonds: a quick overview
Bonds are contractual debt instruments between a borrower (the debtor) and a lender (the creditor). There are usually 5 key characteristics of a bond:
• Principal amount – the total amount borrowed by the debtor from the creditor.
• Coupon rate – the interest rate paid on the principal by the debtor to the creditor.
• Coupon interval – the frequency at which the coupon will be paid. Normally it is quarterly.
• Duration – the length of the bond. The principal will need to be repaid at the end of the duration.
• Collateral – debtor’s assets pledged to creditors as security on the loan, in case of default.
Just like stock investors, bond investors make money in 2 forms: income and capital gains. However, the mechanisms of how these 2 types of gains come into play are very different.
Unlike dividend (which is a payout from the profit a company makes to its shareholders), which can be variable and unpredictable, coupon (interest) on bonds that are paid out to bondholders is fixed and must be met no matter the circumstances. Failure to observe such a covenant would be treated as a default, which carries a significant penalty, not least the ability of bondholders to institute insolvency proceedings against the borrower.
The way how capital gains works in a bond is also different. Unlike stocks, where the price is based on discounting future earnings expectations into the present day, the principal bond amount (nominal value) should stay, theoretically at least, the same from issuance to maturity. If the par value is $100 at issuance, then at the end of the duration (e.g. in 20 years), investors should still get paid $100. Yet there are 2 factors which affect the price of bonds (assuming it is being publicly traded):
• Risk-free return offered by alternative assets: due to the time value of money, where $100 in 20 years will be worth far less than $100 today (due to inflation and the cost of delayed gratification), investors are faced with alternatives when investing in fixed income assets. For example, when the base rate for bank deposits (which is considered to be risk-free) goes up, it makes deposits relatively more attractive than before, when compared to bonds. As a result, the demand for bonds will shift away (in magnitude proportional to the extent of the rise in the rate) towards deposit; thus causing a fall in bond prices.
• Credit risk of the borrower: if a borrower could not pay back the principal at the end of the loan period (or it could not pay the coupon during that period), then the borrower would have defaulted on the bond. This degrades the creditworthiness of the borrower and makes it significantly more risky, thereby decreasing the attractiveness of its debt and hence leading to a decline in its bond price.
The charm of bonds
Bonds have quite different characteristics compared to stocks. As the coupon rate is normally fixed, investors can expect to receive a steady return over the duration of the bond (that’s why they are also known as fixed income). Bonds also enjoy liquidation preference over shares. This means in the event of financial distress by the debtor, bondholders will be paid first (once liquidation of a company has been completed) before shareholders (who hold stocks). These 2 key features make bonds less risky than stocks.
Furthermore, like stocks, most bonds can be publicly traded in exchanges, thereby increasing their liquidity and offering capital movement in addition to the income element. This makes bonds enjoy quasi-stock like features and broadens its appeal to investors.
The charm of investing in Switzerland
Switzerland has long been a popular investment destination as evidenced by the large flow of foreign direct investment (FDI) and a high current account surplus. There are 3 key reasons behind such popularity:
- High social-political stability – Switzerland is a landlocked, mountainous Alpine country in Western Europe. As a result, it has been historically incredibly difficult to invade. Combined with its declared political neutrality, it has experienced virtually no wars in the past few centuries.
- A diversified and highly advanced economy – the high level of stability has enabled Switzerland to focus its energy on developing its internal economy and as a result, it is a sophisticated, service-orientated advanced economy that is highly integrated with the EU (but not part of the union, thereby it enjoys a certain degree of autonomy).
- A sophisticated financial sector – also a result of Swiss stability, European aristocracy have for centuries, shielded their wealth in Switzerland, enjoying the anonymity and security it brings. Consequently, Switzerland has developed a more highly sophisticated financial sector (relative to its size) than rivals such as Paris and Frankfurt.
Types of bonds to invest
There are many different types of bonds to invest in, but they can be broadly broken down into 5 categories:
- Government
- Municipal
- Corporate
- RE bonds
- P2P lending (mini-bond)
A deep dive into the different bonds in Switzerland
10-Year Government bonds
QuickFacts
Underlying asset overview: lending capital to the Swiss government in return for a fixed interest payment.
Capital input requirement: CHF 10,000
Yield: -0.5% for the 10-year government bond
Capital value fluctuation: Nil
Income risks: N/A
Capital risk: very low
Payback period: 10 years
Liquidity: high as the bond is publicly traded
Ongoing management cost: very low (less than 0.5% of AUM)
Transaction cost: depending on the broker, around CHF 10 to 15 per trade
The Swiss Government’s 10-year bond is quite a conundrum. On the one hand, it is immensely popular with institutional investors (e.g. central banks, pension funds, mutual funds). On the other hand, it is a negative yield bond.
What does that mean? Instead of the borrower (i.e. the Swiss Government) paying a coupon (interest) to the creditors, a negative yield means the relationship is inverted. So, investors need to pay, regularly, for the privilege of lending money to the Swiss Government. This bond was issued with a -0.055% coupon rate, which meant that for every CHF 10,000 invested, investors were expected to fork out CHF 5.5 every year, until the maturity of the bond.
Why are the returns negative?
Swiss Government bonds are perceived to be an extremely safe asset class by investors (for the reasons outlined in the previous section). Consequently, demand for such bonds vastly exceeded supply and therefore the yield was naturally lowered. Furthermore, this bond was denominated to CHF, an extremely strong safe-haven currency that was expected to appreciate against others. As a result, even if investors had to forego the coupon payment (and even pay a small fee to the borrower), they were happy to do so as the gain in CHF (against their native currencies) would vastly outpace the loss in income.
Other examples of Swiss Government Bonds:
15-Year Geneva canton bond
QuickFacts
Underlying asset overview: lending capital to the canton government to fund its operating and capital expenditures
Capital input requirement: CHF 50,000
Yield: 2.875% nominal coupon yield
Capital value fluctuation: usually within +/-10%
Income risks: very low
Capital risk: very low
Payback period: 15 years
Liquidity: relatively high as the bond is publicly traded
Ongoing management cost: very low (less than 0.5% of AUM)
Transaction cost: depending on the broker, around CHF 10 to 15 per trade
The 15-year Geneva Canton Bond is very similar to the 10-year Swiss Government Bond in many ways:
- They are both issued by the public authority
- They are both used to fund public expenditures and investments
- They are both traded on exchanges thereby ensuring a high degree of liquidity
The key difference lies with the issuer: whereas the former was issued by the Swiss central government, the latter was released by the local authority in Geneva. In reality, as the financial viability of both institutions is fairly stable (as a result of healthy tax revenue and prudent fiscal policies), the creditworthiness of both are fairly high.
One important area to note, however, is that the volume of the canton bond is much less than government bonds (by a factor of 100). This means the volume of canton bond traded will be significantly less than the government one and thus impact on its liquidity.
9-year Roche Holdings corporate bond
QuickFacts
Underlying asset overview: lending capital to companies to fuel their operating and capital expenditure programmes
Capital input requirement: CHF 1,000
Yield: 2.375% nominal coupon yield
Capital value fluctuation: usually within +/-10%
Income risks: low
Capital risk: low
Payback period: 9 years
Liquidity: relatively high as the bond is publicly traded
Ongoing management cost: very low (less than 0.5% of AUM)
Transaction cost: depending on the broker, around CHF 10 to 15 per trade
Companies often need capital to grow (e.g. marketing, acquisition). They can achieve this using 2 primary methods: issue shares (rights issue) or issue debt. Shares are cheaper in the short-run because there are no regular coupon payments required. However, they erode the long-term value of existing shareholders through dilution. Bonds are the reverse. They are more expensive to maintain in the short-run but they do not lead to dilution of existing shareholder values. This is why most companies prefer borrowing to issuing more share capital.
This is why Roche Holdings, a Swiss pharmaceutical giant, issued an $850 million 9-year bond in 2016 to make industry acquisitions as well as funding its R&D programmes. With a 2.375% nominal coupon rate and biannual payment frequency, Roche is able to raise capital cheaper and deploy it to more productive areas, thus garnering a higher ROI.
Le Bijou 5-year development bond
QuickFacts
Underlying asset overview: lending capital to Le Bijou for the leasing and refurbishment of apartments in prime locations in Switzerland and convert them into short-term luxury accommodations
Capital input requirement: CHF 50,000*
Yield: 5% per year*
Capital value fluctuation: none
Income risks: low
Capital risk: low
Payback period: 5 years
Liquidity: illiquid as the bond is not publicly traded
Ongoing management cost: none
Transaction cost: none
Not only can big corporations issue bonds, but smaller and more agile ones can also do so too; especially in this Age of Technology. In fact, profitable smaller companies can often move a lot faster than large multinationals, thereby reducing the cost of raising capital.
Le Bijou’s development bond* is a prime example where a company pitched a proven business model to investors and achieved successful scale-up. The underlying business operation is remarkably simple: the company either buys or takes out long leases on apartments in prime locations across Switzerland, before converting them into luxury short-stay accommodation. This is an extremely profitable business model fuelled by the popularity of Switzerland as a tourist and business destination. Furthermore, the above-average yield and the collateralization of the property as a security of the loan has proved to be an alluring combination for investors.
* Update: currently this bond issue is sold out. New issues may become available – press “Get Started” to receive updates.
Lend.ch P2P lending
QuickFacts
Underlying asset overview: pooling capital from individuals in order to lend to private individuals or businesses
Capital input requirement: CHF 10,000
Yield: 5-7% per year
Capital value fluctuation: none
Income risks: medium
Capital risk: medium to high
Payback period: 1-5 years
Liquidity: illiquid as the bond is not publicly traded
Ongoing management cost: none
Transaction cost: none
Traditionally individuals and businesses that require access to capital often had to resort to bank loans, which exerted monopoly on the interest rates and terms. But recent technological advancements, as well as deregulation, now make it possible for private investors to pool funds together in order to lend to eligible businesses and individuals. Platforms like Lend.ch assess the creditworthiness of borrowers and match them with investors with the appropriate risk appetite. The amount of risk undertaken is directly proportional to the rate of interest. Borrowers deemed to be of greater risk are charged a higher interest level.
While this has been an excellent alternative to other fixed-income products, it is not without risks. The two principal risk areas are lack of capital security and liquidity. These loans tend not to be secured (collateralised) against any particular assets. Therefore, in the event of a default, investors need to take bankruptcy proceedings against the individual or businesses, rather than simply claiming ownership of the collateral asset. Furthermore, these bonds are not publicly traded and a viable secondary market is yet to exist, so investors are expected to hold them to maturity.
FAQ
1. How do I invest in Swiss bonds?
For bonds that are publicly traded, simply go to your stockbroker and outline either your requirement or the exact identity of the bond that you wish to purchase and they should be able to execute the deal for you. For non-public bonds (i.e. real estate bonds, P2P lending), get in touch with the issuer directly and they should be able to advise.
2. How much of my portfolio to allocate to bonds?
It depends entirely on your risk appetite and investment objective. Normally it is recommended to maintain a 60-40 spread between equity and bond in a classic balanced risk pension portfolio. Obviously, investors who seek regular income or greater capital security might increase the allocation for bond; whereas these seeking capital growth might favour equity.
3. What happens when the borrower defaults on the bond?
This depends on whether the bond is secured against any asset or not. If it is, then it’s relatively simple to apply to a court for seizure (repossession) of the asset for liquidation. If it isn’t, then a generic insolvency proceeding against the borrower may commence; in which the court will attempt to isolate and liquidate the assets of the borrower in order to repay the loan.
