A guide to investing in Swiss bonds

An underestimated asset class

Most investors believe that shares are the most traded investment form in the world. In fact, there is another asset class that trades 1.5 times as much as stocks.

We are talking about bonds, of course. In 2017, the global bond market was worth over $100 trillion, dwarfing the equity market (which is worth $70 trillion). Their ignorance can easily be forgiven, because if you read the news, over 80% of the coverage was focused exclusively on stocks.

In this article we dive deep into the world of bonds and explore the magical connection with Switzerland.

Bonds: a brief overview

Bonds are a form of contractual debt instrument between a borrower (the debtor) and a lender (the creditor). There are usually 5 key characteristics of a bond:

• Capital amount – the total amount that the debtor borrows from the creditor.
• Coupon rate – the interest rate that the debtor pays the creditor on the principal amount.
• Coupon Interval – the frequency with which the coupon is paid. Usually this is quarterly.
• Maturity – the duration of the bond. The principal amount must be repaid at the end of the term.
• Collateral – Assets of the debtor that have been pledged to creditors as collateral for the loan in the event of default.

Bond investors make money in two forms, similar to equity investors: income and capital gains. However, the mechanism by which these two types of gains are generated is very different.

Unlike a dividend (which is a payment from a company’s profits to its shareholders), which can be variable and unpredictable, the coupon (interest) on bonds to bondholders is fixed and must be paid regardless of the circumstances. Failure to comply with this obligation would be treated as default of payment, which has significant disadvantages, not least the possibility for bondholders to initiate insolvency proceedings against the borrower.

The way capital gains in bonds work is also different. Unlike shares, whose price is based on discounting future profit expectations to today, the nominal amount of the bond should, at least in theory, remain the same from issue to maturity. If the face value is $100 at issuance, investors should still receive $100 at maturity (for example, in 20 years). However, there are two factors that affect the price of bonds (if they are publicly traded):

• Risk-free return on alternative assets: Because of the time value of money, where $100 is worth far less in 20 years than $100 today (due to inflation and the cost of delayed satisfaction), there are alternatives for investors when investing in fixed income assets. For example, if the base rate for bank deposits (which are considered risk-free) rises, deposits will be more attractive than bonds. As a result, the demand for bonds (in an order of magnitude that is proportional to the extent of the interest rate increase) shifts towards deposits, leading to a decline in bond prices.

• Borrower’s credit risk: If a borrower is unable to repay the principal amount at the end of the loan period (or to pay the coupon during this period), the borrower would default on the bond. This worsens the borrower’s creditworthiness and significantly increases his risk, making his debt less attractive and the bond price lower.

The charm of bonds

Bonds have very different characteristics to equities. Because the coupon is usually fixed, investors can expect a constant yield over the life of the bond (hence the term fixed income securities). Bonds also enjoy liquidation preference over equities. This means that if the debtor is in financial distress, bondholders are paid first (after the liquidation of a company is completed) and before shareholders (who hold shares). These two main characteristics make bonds less risky than shares.

The charm of investing in Switzerland

Switzerland has long been a popular investment destination, as evidenced by the high inflow of foreign direct investment and a large current account surplus. There are 3 main reasons for this popularity:

• High socio-political stability – Switzerland is a mountainous landlocked country in Western Europe. As a result, it has historically been incredibly difficult to conquer. In combination with its declared political neutrality, it has experienced virtually no wars in recent centuries.

• A diversified and highly developed economy – the high degree of stability has allowed Switzerland to focus its energy on developing its domestic economy and, as a result, it is a highly developed, service-oriented advanced economy, highly integrated with, but not part of, the EU, and therefore enjoys a degree of autonomy.

• A highly developed financial sector – partly because of its stability, the European aristocracy had for centuries brought its wealth to Switzerland and enjoyed the anonymity and security that this brought. As a result, Switzerland has built up a highly developed financial sector in proportion to its size, which can compete with Paris and Frankfurt.

Types of bonds in which you can invest

There are many different types of bonds to invest in, but they can be roughly divided into 5 categories:

• Government Bonds
• Municipal bonds
• Corporate Bonds
• RE Bonds
• P2P Lending (Minibond)

A deeper insight into the various Swiss bonds

10-year government bonds

Overview

Overview of the underlying assets: Lending of capital to the Swiss government against a fixed interest payment.

Capital required: CHF 10,000

Yield: -0.5% for a 10-year government bond

Fluctuation in capital value: zero

Income risks: N/A

Capital risk: Very low

Payback period: 10 years

Liquidity: High, as the bond is publicly traded

Current administrative costs: very low (less than 0.5% of AUM)

Transaction costs: depending on broker, approx. CHF 10 to 15 per trade

The 10-year bond issued by the Swiss government is quite a mystery. On the one hand, it is very popular with institutional investors (e.g. central banks, pension funds, investment funds). On the other hand, it is a negative interest 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 that the relationship is reversed. Investors must therefore pay regularly for the privilege of lending money to the Swiss government. This bond was issued with a coupon of -0.055%, which meant that for every CHF 10,000 invested, investors had to pay out CHF 5.5 each year until the bond matured.

Why are the returns negative?

Well, Swiss government bonds are considered by investors (for the reasons explained in the previous section) to be an extremely safe asset class. As a result, demand for such bonds far outstripped supply, which is why yields naturally declined. In addition, this bond was denominated in CHF, an extremely strong safe-haven currency that was expected to appreciate against others. Even if investors had to waive the coupon payment (and even pay a small fee to the borrower), they would be happy to do so because the gain in CHF (against their home currency) would far exceed the loss in yield.

Further examples of Swiss government bonds:

• 5-year bond
• 20-year bond
• 30-year bond

15-year bond issued by the Canton of Geneva

Overview

Overview of the underlying values: Loan to the canton to finance its operating and investment expenditure

Capital investment requirement: CHF 50,000

Yield: 2.875% nominal coupon yield

Fluctuation in capital value: Normally within +/- 10%.

Income risks: Very low

Capital risk: Very low

Payback period: 15 years

Liquidity: Relatively high, as the bond is publicly traded

Current administrative costs: very low (less than 0.5% of AUM)

Transaction costs: depending on broker, approx. CHF 10 to 15 per trade

The 15-year bond issued by the Canton of Geneva is very similar to the 10-year Swiss government bond in many respects:

• They are both issued by a government
• They are both used to finance public expenditure and investment
• They are both traded on stock exchanges and thus ensure a high degree of liquidity

The main difference is the issuer: While the former was issued by the Swiss central government, the latter was issued by the local authority in Geneva. In reality, the creditworthiness of both institutions is relatively high, as the financial profitability of both is relatively stable thanks to healthy tax revenues and prudent fiscal policies.

However, an important point is that the volume of cantonal bonds is much smaller than that of government bonds (by a factor of 100). This means that the traded volume of cantonal bonds is much lower than that of government bonds, which has an impact on the latter’s liquidity.

9-year corporate bond issued by Roche Holdings

Overview

Overview of underlying assets: allocation of capital to companies to support their operating and investment programmes

Capital investment requirement: CHF 1.000

Yield: 2.375% nominal coupon yield

Fluctuation in capital value: Normally within +/- 10%.

Income risks: Low

Capital risk: Low

Payback period: 9 years

Liquidity: Relatively high, as the bond is publicly traded

Current administrative costs: very low (less than 0.5% of AUM)

Transaction costs: depending on broker, approx. CHF 10 to 15 per trade

Companies often need capital to grow (e.g. marketing, acquisition). They can achieve this in two main ways: Issuing shares (subscription rights) or issuing debt instruments. Shares are cheaper in the short term because no regular coupon payments are required, but they weaken the long-term value of existing shareholders through dilution. Bonds are the opposite. Their short-term maintenance is more expensive, but does not dilute the values of existing shareholders. For this reason, most companies prefer to borrow rather than issue more share capital.

For this reason, the Swiss pharmaceutical company Roche Holdings is issuing a nine-year bond in 2016 in the amount of 850 million US dollars with the aim of making acquisitions in the industry and financing its research and development programmes. With a nominal coupon rate of 2.375% and a six-monthly payment frequency, Roche will be able to raise capital more cheaply and deploy it in more productive areas, resulting in a higher ROI.

Le Bijou 5-year development bond

Overview

Overview of underlying assets: Le Bijou receives capital for the leasing and renovation of apartments in prime locations in Switzerland, which are converted into short-term luxury accommodation

Capital investment requirement: CHF 50,000

Yield: 5% per year*

Fluctuation in capital value: zero

Income risks: Low

Capital risk: Low

Payback period: 5 years

Liquidity: Illiquid, as the bond is not publicly traded

Current administrative costs: None

Transaction costs: None

Not only large companies can issue bonds, but also smaller and more agile companies, especially in the age of technology. In fact, profitable smaller companies are often much more agile than large multinationals, thereby reducing the cost of raising capital.

The Le Bijou Development Bond is* a prime example of a company that has made a proven business model accessible to investors and successfully scaled up. The underlying business is remarkably simple: the company buys or rents apartments in prime locations throughout Switzerland before converting them into luxury short-stay accommodation. This is a highly profitable business model driven by Switzerland’s popularity as a tourist and business destination. In addition, the above-average returns and the credit protection provided by the property are proving to be an enticing combination for investors.

* Update: This bond is currently sold out. New issues may become available. Click on “Getting Started” to receive updates.

Lend.ch P2P Bond

Overview

Overview of underlying assets: pooling of the capital of individuals in order to grant loans to individuals or companies

Capital investment requirement: CHF 10,000

Yield: 5-7% per year

Fluctuation in capital value: zero

Income risks: Resources

Capital risk: medium to high

Payback period: 1-5 years

Liquidity: Illiquid, as the bond is not publicly traded

Current administrative costs: None

Transaction costs: None

Traditionally, individuals and companies requiring access to capital have often had to resort to loans from banks that had a monopoly on interest rates and conditions. Due to recent technological advances and deregulation, it is now possible for private investors to pool funds to provide loans to suitable companies and individuals. Platforms such as Lend.ch assess the creditworthiness of borrowers and find associated investors who have a corresponding appetite for risk. The level of risk taken is directly proportional to the interest rate. For borrowers with a higher risk, a higher interest rate is charged.

Although this is an excellent alternative to other fixed-interest products, it is not without risk. The 2 main risk areas are: lack of capital security and liquidity. These loans are usually not secured against certain assets, which is why investors must initiate insolvency proceedings against the individual or the company in case of default, instead of simply claiming ownership of the secured asset. Furthermore, these bonds are not publicly traded and there is not yet a functioning secondary market. Investors are therefore expected to hold them to maturity.

Frequently asked questions (FAQ)

• How do I invest in bonds?
  
  For bonds that are traded on the stock exchange, simply contact your stockbroker and specify either your requirements or the exact identity of the bond you wish to purchase.They should be able to execute the transaction for you.For non-public bonds (i.e. property bonds, P2P loans), contact the issuer directly and they should be able to advise you.

• How much of my portfolio should I invest in bonds?This depends entirely on your risk appetite and investment objective. Normally, in a traditional pension portfolio with balanced risk, it is recommended to maintain a 60/40 split between equities and bonds. Of course, investors seeking a regular income or greater capital security may increase the allocation to bonds, while investors seeking capital growth may prefer equities.

• What happens if the borrower defaults on the bond?This depends on whether or not the bond is secured against an asset. If this is the case, it is relatively easy to apply to the court to seize (repossess) the asset for liquidation. If this is not the case, general insolvency proceedings can be initiated against the borrower, in which the court attempts to isolate and liquidate the borrower’s assets in order to repay the loan.