Debunking The Myths Of Premiums And Discounts: How Bond Prices Work

Debunking the myths of premiums and discounts: How Bond Prices Work

Over my long 15-year career as an Investment Advisor, I’ve realized that many bond investors are still unaware of how to use bond prices to their advantage. Today we are going back to the basics - specifically as it relates to how yields and bond prices work … Investments 101. A widely held misconception is that you are “losing money” if you buy a bond above par (i.e. a price of 100). The yield to maturity, which is quoted at purchase, takes this price premium into account and gives the investor the return he or she would earn if the investment is purchased at the quoted price, held to maturity and redeemed at 100.

We all know the old saying “buy low, sell high”. However, buying low does not necessarily mean buying at a discount. For example, an investor has $108,000. He wants to buy Bond A which has a price of 108, a coupon of 10% per annum and 10 years to maturity. He will be able to buy $100,000 face value of this bond with his $108,000. He will receive $10,000 per year as long as he holds the bond. If the investor holds the bond until maturity, he will receive 10 payments of $10,000 (assuming the coupon is paid annually-most bonds pay interest semi-annually) and one payment of $100,000 representing the return of his principal. In total, he would have earned $192,000 on his investment of $108,000. This roughly works out to 8% per year. The table below summarizes this:

Funds Paid for Bond purchase

(108,000.00)

Coupon Payments Received Years 1 - 10

100,000.00

Repayment of Principal at Maturity

100,000.00

 Total funds received by investor (coupon + principal)

192,000.00

Approx. annual rate of return  (IRR)

8%

If you notice, the approximate per annum return of 8% is less than the coupon of the bond (10%) because the bond was purchased at a premium. At maturity, the investor received $100,000 but over the life of the investment he received another $100,000 in interest payments. This does not mean that the investor lost money. Rather, it means that the investor earned 8% per year, instead of 10% - which he/she would have earned if the investment was purchased at 100 (par). The coupon payments must be included in the calculation of return.

Investors can still profit from buying bonds with seemingly high prices. For instance, the GOJ 2022 bond is currently priced indicatively at 123.5. In the month of February 2010, its price was roughly 109.7. If an investor bought at 109.7 and sold at the current price of 123.50 they would have realized a gain of 12.6% which does not take into account the coupon payments received over the period. Some may have thought that a price of 109.70 was expensive, however, the strong support of the Jamaican global bonds was a factor leading to the price appreciation, in addition to this bond’s tax free status. Of course, the path many times is not smooth, and there were periods of high volatility, however, the brave investors would have been rewarded.

 

The yield to maturity is the critical consideration - it will tell you upfront, what return you will receive on your investment (assuming you hold it until maturity and the issuer does not go bankrupt). The yield takes into account: the coupons, the price (whether a premium or discount), the return of principal and the number of years until maturity. No matter what happens to the price of your bond during the holding period – your yield to maturity remains the same.

If prices are at historic highs, meaning yields are low, there may not be a high potential for capital appreciation. However, if prices appear high with fairly attractive yields, an investor could still make a buy decision since he is locking in a steady return and income.  Any unanticipated price appreciation in excess of that would be “brawta”. Similarly, a price decline would not necessarily be cause for alarm, because this would not change/affect the investor’s return (i.e. the yield to maturity) which is fixed and represents what he/she will earn if the bond is held until maturity.

Investors should be aware that if a bond is trading at a significant discount, it may mean that the market doubts the issuer’s ability to repay the loan.  Many high and low rated bonds are currently trading above par. For this reason, it is important to be guided by the risks and yields of the bonds. The key is to determine what is a reasonable yield for the risk of the bond. Investors should keep in mind that there is an inverse relationship between price and yield, meaning that a higher price corresponds to a lower yield. Additionally, there is a positive relationship between risk and yield. The higher the yield, the higher the risk. 

In conclusion, buying at a premium does not mean you lose money. The key indicator of your return is the yield to maturity which takes into account the price of the bond. Bond investors can still earn capital gains on bonds that are priced above par.

Pamela Lewis is Vice President, Investments and Client Services at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at [email protected] or visit our website at www.sterling.com.jm

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