Bonds
§ When you buy a bond you are lending money to the issuer.
§ The bond market is far bigger than the stock market.
§ This is because they are popular with institutional investors.
§ Bonds offer safety and predictable returns.
The 3 components
Ø Maturity Date – The date when the issuer must return the original amount borrowed.
Ø Principal – the original amount the company borrowed when it issued the bond. This amount is printed on the front of the bond certificate so it is known as the bond’s face value.
Ø Coupon – The bond’s interest rate which is fixed. The interest is paid twice a year. A $1000 bond with a 10% coupon will pay $100 a year in interest ($50 every 6 months)
Coupon Rates
Coupon rates are higher on long term loans (longer than 10 years) because there is more risk involved
Yield
The total return you get when you invest in a bond is called the yield. The yield is made up of
§ Fixed coupon payments
§ Capital gain or loss incurred when you sell the bond or it matures
Capital Gains or Losses
§ You seldom pay face value when you purchase a bond.
§ If you pay less than the face value you will make a gain when the bond matures
§ If you pay more than the face value you will have a loss when the bond matures
Why would you pay more of less than the face value?
§ Interest rates move up and down over time
§ When interest rates go down, bond prices rise
§ When interest rates go up, bond prices fall
§ If you had a bond with a face value of $1000 and a 10% rate and the next year you wanted to sell the bond which this year was being offered at 8%.
§ You would be able to sell it for more than the $1000 because the buyer would be getting a higher rate of interest on the 10% than the 8%
Calculating a Bond’s Yield
Bond has $1000 face value but you paid $950 for it with an interest rate of 10%, with 2 years to maturity
§ Annual Interest
o 1000*10% = 100/year
§ Capital Gain per year
o 1000-950=50/2=$25/year
§ Your return per year
o $100+$25=$125
§ Average price of the bond
o (950+1000)2 = $975
§ Yield
o (125/975)*100% = 12.82%
When is the best time to buy bonds?
· When interest rates start to fall because when rates fall the bond price rises.
· If you sell your bonds later on people will be willing to pay more for them. (Capital gain)
· Inflation – The prices of goods and service rise because of higher demand. If inflation is high the government will raise interest rates to discourage consumers from spending and borrowing so much
How to choose a bond
· Look at the company – make sure they are stable
· Term to maturity – What time period is the bond for. Remember that long term bonds more risky
· Coupon size
3 Reasons to Buy Bonds
· Safety – Government bonds are very safe and company bonds safety depends on the company
· Income – Bonds pay regular interest
· Return of principal – You get the face value back
Aggressive Investors Buy Bonds
· They bet on interest rates – they buy the bonds right before they expect interest rates to fall and sell them before the interest rates rise.
· Quality Speculation – buying corporate bonds of struggling companies who will have to offer a high coupon and a low price because of the risk
Fixed Income Products
· Bonds
· Preferred Shares – pay a fixed dividend
· Strip Bonds – Bonds don’t pay interest but a sold at a price less than face value so gain is made at maturity
· Canada Savings Bonds
· GIC’s – Offered by banks, cannot be sold to others and most have a set rate of interest
· Debentures – unsecured bond, it is backed by only the general credit of the issuer, only well known strong stable companies can offer these
Questions on Bond Yield
1) What is the coupon value of each of the following bonds every six months? Formula = Face Value x Coupon Rate /2
a) $4700 at 6.75%
b) $1300 at 7.45%
c) $25000 at 4.45%
2) Find the following for each of the following bonds
Coupon Rate / Market Value / Yrs. To Maturity / Face ValueA / 6.5% / 89% / 6 / $500
B / 8.75% / 93.50% / 9 / $750
C / 9.25% / 99.50% / 19 / $5000
D / 12.10% / 102.25% / 14 / $1000
E / 11.30% / 100.75% / 8 / $100
F / 6.75% / 101.15% / 12 / $3000
a) Annual Interest
b) Market Price Capital
c) Gain/Loss Pr Yr
d) Return per Year
e) Average Price of Bond
f) Yield
Formulas:
· Annual Interest = Face Value X Coupon Rate
· Market Price = Face Value X Market Value (as a %)
· Capital Gain/Loss Per Yr = (Face Value - Market Price)/ Number of Yrs to Maturity
· Return Per Year = Annual Interest + Capital Gains or Annual Interest - Capital Loss
· Average Price Of Bond = (Face Value + Market Price) / 2
· Yield = Return Per Year / Average Price of Bond X 100 -- Answer expressed as a %