by
Justin McCarthy | Jun 12, 2013
Q.
In your newsletter “The Wire” you had an article titled “Why Invest in Bonds”. At the end of that you claim that Government Bonds received 14.5% capital gain which although very attractive it has posed me to ask the very question.
If Bonds can make capital gains then what’s to say they will not fall foul to a capital loss? And if this is the case then an investment in bonds could lose value if that capital loss is greater than the interest gained?
A.
Bonds can and do increase and decrease in value on the secondary market. Many bonds are purchased for a premium (i.e. over their $100 par value) and will only ever return $100 upon maturity, resulting in a capital loss. However, this is ignoring the running yield or income component and the mechanics of how bonds are priced and valued will almost always prevent a loss on a hold to maturity basis. That is, the income component will be greater than the capital loss. While it is possible to incur an overall loss if a bond is sold prior to maturity, it is extremely rare if a bond is held to maturity.
To explain we will refer back to our Q & A from the 29 May 2013 which discussed various definitions of yield. In that edition we explained how the true measure of return for bonds is yield to maturity. The following is an edited except from that edition:
The yield to maturity refers to how much a security will earn if it is held to its maturity date. It is the annualised return based on all coupon payments plus face value if you hold the security until maturity or the market price if it was purchased in the secondary market. It includes any gain or loss if the purchase price was below or above the face value...if a bond is trading at a premium the yield to maturity will be the running yield LESS the annualised capital loss being the difference between the current market price and $100 face value that will be returned upon maturity and adjusted for discounting.
For example, the Qantas fixed rate bond currently has a nominal yield of 6.5%, a maturity of 27 April 2020 and is currently trading at a premium to face value at around $103.64. If we calculate yield to maturity we find yield to maturity is 5.85% compared to the coupon rate of 6.5%. This means that the effective return over the life of the security if bought today would be 5.85% taking into account the current premium price of the security.
(Prices and yields were as at 28 May 2013 and a guide only, subject to market availability. FIIG does not make a market in these securities)
The important point is that the valuation of bonds takes into account both the running yield (or income) and the capital gain or loss. The market constantly adjusts the value of bonds for changes in interest rates and credit worthiness but that adjustment mechanism is always based around the yield to maturity. As long as the yield to maturity is showing a positive figure, an investor could expect to come out ahead from investing in bonds, unless the issuer was to default. Investors use the yield to maturity to benchmark against other fixed income investment options such as term deposits and other bonds (as well as other asset classes) with an eye to ensure that the return from investing in a bond compensates for the risks involved.
We invite readers to send any questions they have to thewire@fiig.com.au and each week we will endeavour to answer the most common queries.