Retail Bonds: Frequently Asked Questions

Retail bonds generally refer to bonds targeted at members of the public. A bond is a debt instrument. When investors purchase a bond, they are lending money to the issuer. In return for the loan, the issuer promises to pay the bondholder a specified rate of interest during the life of the bond and to repay the face value of the bond at maturity. In general, bonds are sold and traded among institutional investors. Retail bonds, however, are offered to the public and are thus subject to regulatory measures relating to the public offering procedures (see Q10).

The Hong Kong Mortgage Corporation (HKMC) issued four bonds with retail tranches during 1999 to 2001. The first retail bond, with the entire issue allocated to retail investors, was issued by the HKMC in November 2001. HKMC retail bonds adopt a new issuance mechanism, enabling retail investors to subscribe to the bonds through appointed placing banks. Other features include offering a bond with different maturity tranches to suit the needs of individual investors. Following the success of the two HKMC retail bonds, the Airport Authority Hong Kong (AA) and MTR Corporation (MTR Corp.) also launched retail bonds in 2002. Some private corporations are also planning to issue retail bonds.

The benefits of investing in retail bonds include stable returns, capital preservation and lower risk. The HKMC, AA and MTR Corp. retail bonds offer assured liquidity, small minimum denomination, and convenient subscription. Under the prevailing low interest rate environment, retail bond yields are relatively attractive compared with the low bank deposit rates.

The subscription price of a retail bond, expressed as a percentage of the principal amount of the retail bond, is determined on the specified price-fixing date with reference to the benchmark yield of a risk-free debt instrument. For the past retail bond issues in Hong Kong, the price of an individual issue is based on the offer yield of an identified issue of Exchange Fund Notes of comparable remaining tenor at the price-fixing date, plus a certain margin.

The total return on bonds is measured by the yield to maturity (see bond yield below), which is calculated with reference to the sum of interest payments, principal amount receivable upon maturity, with respect to the purchase price.

From the time when a bond is issued until the maturity date, its price will vary depending on many factors including, but not limited to, the prevailing interest rates. In general, bond prices will fall when interest rates rise, and vice versa. Investors should therefore be aware that the value of a bond could be higher or lower than the original face value when selling the bond before maturity. Investors can find out the current retail bond price and yield from the designated placing banks.

In addition to interest rate movements, other factors affecting the return on bonds include the credit quality of issuer, term to maturity, liquidity of the market, and overall market conditions.

• Credit rating - Bonds with a higher credit rating in general offer a lower yield. Changes in the credit quality of the issuer during the life of the bond will affect its price.
• Term to maturity - As the risk increases with the life of a bond, the longer the period to maturity, the higher the yield. In addition, the bond price volatility increases for bonds with longer maturity.
• Liquidity of bonds - The liquidity of the secondary bond market will determine how easily an investor can sell or buy a bond. A less liquid market is usually reflected in a wider spread between bid and offer prices.
• Overall market conditions - As with other investments, returns on bonds can be affected by interest rate movements, inflation, exchange rates, political changes, etc.

Coupon rate refers to the annual interest rate as a percentage of the par value of a bond. This can be a fixed rate (i.e. the rate is fixed throughout the life of a bond), floating rate (i.e. the rate is reset periodically based on some reference rate, such as HIBOR or LIBOR, plus a spread) or zero rate. The frequency of the interest payment can be on a quarterly, semi-annual, and annual basis. Zero-coupon bonds pay no interest during the life of the bonds, although they are usually issued at discount to the par value (see par value below) and the bonds are redeemed at par. The return on a zero-coupon bond is the difference between its purchase price and the par value.

Bond yield is the rate of return on a bond, taking into account the sum of interest payment, the redemption value at maturity, and the purchase price. In general, the longer the life of a bond and the lower the credit rating of the issuer, the higher the bond yield. Bond yields move in the opposite direction to changes in price: when the price goes up, the yield will fall, and vice versa.

Par value refers to the amount that the issuer agrees to repay the bondholder at maturity, and is used interchangeably with the principal or face value of a bond.

Accrued interest refers to the interest earned by the seller from holding the bond from the last coupon payment date until the disposal date, when bonds are traded between coupon dates. The buyer, who receives the next coupon, must pay the seller the accrued interest, which depends on the number of days from the last coupon payment to the settlement date of the trade. By convention, bonds are quoted at clean price, which is exclusive of accrued interest, but the invoice price to be paid requires the inclusion of accrued interest.

Term to Maturity refers to the life of a bond in terms of years, until the issuer redeems the bond by repaying the principal.

Investors who are interested in purchasing retail bonds must have a bank account and an investment account with one of the placing banks. Investors can apply for the retail bonds in person, or by Internet or telephone if they already have a bank account and an investment account with one of the placing banks.

Information about retail bonds is available from the issuers and their websites as well as the designated placing banks.

The minimum principal amount of investment in the HKMC, AA and MTR Corp. retail bonds is currently HK$50,000.

The designated placing banks of the HKMC, AA and MTR Corp. retail bonds are committed to make a market by quoting firm bid prices so that investors can sell their holdings if needed. In addition, the placing banks have agreed to quote firm offer price for as long as they may request the issuers to issue additional retail bonds, and thereafter the offer price is quoted on a best effort basis.

When trading retail bonds, investors should pay attention to the credit quality of the issuer, terms of the issue, and market conditions. Prices quoted by the designated banks reflect the trading price of the retail bonds from time to time in the secondary market. The trading prices of retail bonds may be equal to, or higher or lower than, the initial subscription price or purchase price and will vary depending on many factors, including the prevailing interest rates, and the creditworthiness of issuer.

In general, retail bond investors are exempt from profits tax, unless they are carrying on a trade, profession or business in Hong Kong, and the interest and trading profits earned are derived from such trade, profession, or business. In addition, retail bonds are not subject to stamp duty. Investors should consult their own tax advisers regarding the tax consequences of investment in retail bonds.

In the case of the retail bond issues offered by HKMC, MTR Corp and the AA, investors have to pay a handling fee of 0.15% of the subscription price of the retail bonds at initial offering. In addition, the placing banks charge service fees for the opening and operation of an investment account. Investors should check service fee levels with the placing banks.

The Securities and Futures Commission (SFC) is mandated to regulate the securities, futures and related financial markets, and is empowered to administer the relevant Ordinances relating to the offering of retail bonds. Individuals should visit the SFC Electronic Investor Resources Centre for more information relating to this subject, or contact the SFC direct through their investor enquiries hotline 2840-9333.