A primer to bond investing
The Sterling Report
HAVE you ever seen a preview to a movie you know nothing about and just got really excited about seeing it? Just a few clips and highlights, and you are convinced that it is a must-see; then upon going to see the movie you are disappointed. Not only is the storyline weak, but the actors are not convincing, and it's then you realise that the preview was the best part to the movie. Walking away from the theatre you feel cheated and silly for not reading the reviews or even reading about the script or the cast. Whereas in this scenario one may only lose $2,600 on movie tickets (assuming they went with just one friend and ate nothing), if this same attitude is taken with our investment we stand to lose way more money. Here we will investigate what steps are to be taken before investing in bonds.
Most if not all investors are now more aware of the importance of including bonds in their portfolio. Whereas it is indeed important, a few things need to be addressed before buying a bond. The age, risk tolerance and personal circumstances should be outlined. For instance, if you are the type of client who will lose sleep if the bond falls slightly in price or if you have to check on the price daily, then maybe you should reconsider bonds. It has been stressed repeatedly that bonds are medium to long-term investments, that is, a three-year period or longer. Whereas bond prices can increase over very short periods and investors are able to take capital gains, one should not think that this is the norm.
When choosing a bond, try and understand the different types available in order to choose the one that best fits your objectives. The most common bonds are government vs corporate bonds, senior vs subordinated bonds, and convertible bonds.
Government bonds are issued, as the name suggests, by a government authority, with the promise to repay investors both interest and principal.
Corporate bonds, on the other hand, are issued by institutions, again, it is the corporation's promise to pay interest and principal as stipulated in the bond contract. In some instances the company's physical assets may be used as collateral for the bonds. Corporate bonds tend to carry a higher coupon rate to compensate for the additional risk.
Senior bonds have priority over subordinate bonds in the payment of interest and redemption (when it becomes due). This point of clarification is needed in the event the company faces severe financial difficulties.
Convertible bonds are defined as bonds that can be changed to a specific number of shares in the same corporation. This change can be triggered if the bond price trades below a predetermined price. For example, the security will trade as a bond if it goes above a price of $25; however, should it fall below that price the bond will begin to trade in synch with the stock. There is also a convertible contingent bond; this is similar to the traditional convertible bond as it also has a predetermined price at which the bond converts to stock. The difference, however, is there is another higher trigger price which the company's stock price must reach before an investor has to make the conversion.
As simple as it may seem, the distinction between coupon rate and yield tends to confuse investors. It is imperative that investors understand the difference so that they thoroughly understand which bond is being advertised.
Coupon rate is the yield paid by a fixed income security. This rate is simply the annual payment paid by the issuer to the bondholder based on the face value, whereas the yield is the rate of return on the bond if held to maturity. The yield to maturity encompasses the following variables: current market price, coupon rate, face value and the maturity date.
Special care and thought should be given when looking at bonds. Investors should make every effort to understand the terms and conditions of the bonds; ensure that it aligns with their investment needs, and check the reviews on the issuer and terms of the bond before taking the plunge.
Dian Blackwood is Assistant Vice President, financial planning with Sterling Asset Management Ltd. Sterling provides medium to long-term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org