As most investors may know, bonds are loan instruments issued by corporate entities and governments to raise funds for a variety reasons, including: expansion, working capital requirements, and to pay down debt which may carry higher interest rates.
A "Repo" is an abbreviated term for a repurchase agreement. It is essentially a loan instrument, and operates such that a dealer sells government securities to an investor (who is the lender), and at the same time agrees to repurchase the securities from the investor at a specified price on a future date. That future date is usually short, and in the Jamaican context that could be up to 365 days. Because of the short-term nature of repos as well as the fact that these instruments sometimes have the backing of a sovereign body, the liquidity risk of repos is usually considered very low. And as a corollary, so is the return.
Savvy investors, who are seeking better returns, will prefer to invest in bonds instead of repos. This is because bonds generally provide the investor with regular interest income, mainly semiannually or quarterly, as well as provide prospects of capital appreciation.
An example will help. An investor earning 5.0% p.a. on his US$100,000.00 repo will get US$5,000.00 in interest at the end of one year (ignoring the impact of tax). At the end of one year, therefore, he will have US$105,000.00. Another investor with the same amount of US$100,000.00 earning 5.0% p.a. on a bond will also earn US$5,000.00 in coupon (coupon is the term given to the interest paid on bonds). However, the investor in the bond has the prospect of benefitting from capital appreciation. Let us use the example the Royal Bank of Scotland 9.5% 2022 bond. On May 24, 2012 an investor bought 100,000.00 Face Value of the bond at a price of 103.50, amounting to US$103,500.00. On January 25, 2013 he could sell them at a price of 117, receiving US$117,000.00 for them. This amounts to a capital appreciation of US$13,500.00 (US$117,000.00 minus US$103,500.00). His total return of US$18,500, representing his capital appreciation plus his coupon (ie US$5,000 plus US$13,500) represents a 17.8% return, and at the end of the year the investor has in hand US$122,000.00 (US$117,000 plus US$5,000) compared to the US$105,000.00 from the repo. One can now very easily see how an investor in bonds is considerably better off than an investor in a repo.
There are several other such examples where bond investors have benefited considerably over the past year. One particular Genworth Financial traded up from a price of 99.625 on April 24, 2012 to a price of 120 on January 25, 2013. Another Credit Agricole, (France's second largest bank), bond traded up from a price of 96.50 on March 28, 2012 to a price of 109.50 on January 25, 2013. One Bank of America 2016 plain vanilla bond traded up from a price of 98.50 on January 23, 2012 to a price of 110 on January 25, 2013. I could go on, but the point is well made.
The beauty about the abovementioned bonds, is that all of the issuers are investment grade rated and carry lower levels of credit risk.
And speaking of risk, one such risk is that the price of the bond could fall below that which the investor paid for it, and this would result in a capital loss if the investor sells at the lower price. This brings into focus the question of timing, as well as objective, which are important considerations in trading securities. A savvy investor seeking high returns will try as much as possible to purchase bonds which have prospects for price appreciation. The bonds mentioned above may not offer the investor the same magnitude of returns if he were to purchase those same securities now at the current prices. However if the objective were to get a particular level of interest on a regular basis, the investor may be perfectly justified in buying at current prices.
Finally, choosing suitable bonds may be too much for investors to do on their own, especially if they are not themselves in the market on a daily basis, and may require the help and advice of a trusted financial advisor, especially someone who is in tune with the daily rigours of the market. A good financial advisor can also show an investor that risk is not something to be feared but rather something to be faced, armed with all the necessary information and strategies. Then the investor will be equipped to invest comfortable in bonds instead of making do with the low returns of repos.
Pamela Lewis is VP, 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, e-mail us at: email@example.com or visit our website at www.sterling.com.jm