Bonds have always been preferred by investors who are looking for predictable income, potential capital appreciation and relative safety. Nowadays, many investors are wary of the current conditions and have been afraid to take on any risk (relative to equities). This is the reason that bonds have become so popular. But in the words of LL Cool J “Don’t call it a comeback, I’ve been here for years!” In the same way, bonds have been around for a very long time, they are not new to the market. But how comfortable are you with all the bond terminology? Let us look at the words that you probably hear frequently but may not fully understand.
The first term is the principal or the face value of the bond. This is how much you are lending to the borrower (but not necessarily how much you have paid for it!) This is also the amount that you as the investor will get back when the bond matures.
The interest that you earn is calculated at a particular rate called the coupon. This is quoted as a percentage- for example 5%. So, if the face value on the bond is $10,000 and the coupon is 5%, what would you earn? Well, if the bond pays interest semi-annually, you would get $500 in interest for the year, but you would get the first half of that ($250) for the first payment and the rest ($250) in the second payment for the year.
The thing about bonds is that you can buy them at a premium or a discount. What does that mean? If you paid $11,000 for a 10,000 (face value) bond, it means that you bought it at a premium. On the other hand, if you paid $9,000 for the same 10,000 (face value) bond, then you bought it at a discount.
Almost every investor prefers to buy bonds at a discount. But it depends on the coupon that the bond is paying. If the bond has a coupon of 12% and rates have since fallen to 7%, new comparable bonds would be issued at 7% which would mean that the 12% bond would be selling at a premium.
Turn that around- if interest rates went up to 7% and a bond was issued before at 5%, they would have to sell it at a discount for an investor to be interested. The discount would compensate the investor for the difference in the market interest rate. The effective rate that an investor is getting when the coupon and either the premium or discount is factored in is called the yield. This is why you need to be armed with information on the coupon and the yield when you are assessing bonds!
The last word for now is the callable bond. A callable bond allows the borrower to buy back the bond before the maturity, normally at a specific price. When the bond is called, investors get back their principal. This can be bad for the investors if rates have gone down since they have to reinvest at a lower interest rate. Most borrowers would want to refinance when rates fall, if they have borrowed at high rates. There is a lot more to learn about bonds, but that is for another day.
Lisa Minto is the Assistant Vice-President, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: [email protected]