A few years ago, when interest rates were quite high, investors could find bonds with excellent credit ratings paying high single interest rates. Today it is difficult to imagine buying an investment grade bond with a 9.0 per cent coupon. But that was the market then.

If you are a lucky investor who is holding such a bond, you may have noticed that when interest rates began to fall, the value of your bond probably began to rise. In a scenario like this you may find yourself with a bond that is valued more than you paid for it and, on top of that, you are still receiving the 9.0 per cent per year interest payments. This is because there is an inverse relationship between interest rates and bond values. You are now holding a precious asset that everyone covets, because gone (at least for now) are those lovely bonds paying those high interest rates, and as a result people are willing to pay a premium for your bond.

This is where capital gains come in. A capital gain is a profit that results from the sale of a capital asset, such as a bond, stock, or real estate; where the sale price exceeds the purchase price. Conversely, a capital loss arises if the proceeds from the sale of a capital asset are less than the purchase price.

You only realise the gain or loss if you sell the asset. For example, suppose you bought a house valued at $10 million and rent that house for $100 thousand per month, and the value of the house goes up to $15 million dollars. You can realise a gain of $5 million, but only if you sell the house. Otherwise you are just sitting on a potential 5 million-dollar gain.

Similarly, if the value of the house went down to $8 million dollars, you would only realise that $2 million-dollar loss if you sell the house. If you do nothing, you still have the house and you are still earning a predictable stream of rental income (all things being well).

That is how it is with bonds as well. The holder of a bond which has increased in value has the option of selling the bond before maturity and realising a capital gain. Many investors will jump at the opportunity to do this, but is it a trick or treat? Some of the questions an investor should ask themselves when this opportunity comes knocking are:

“If I decide to sell, what will I do with the proceeds of the sale?”

“What am I foregoing by selling this bond?”

Using the house example again, if the value went up to $15 million and you sold the house to realise the $5 million dollar gain, you have given up the $100 thousand per month in rental income but you now have $15 million dollars to invest in another house. In the best case scenario, you are able to pocket that $5 million dollars profit and buy another $10 million-dollar house that gives you the same or even higher rental income — you still have a house, you are still getting the same rental income, and you have $5 million dollars that you did not have before.

But what if housing prices have gone up and you are not able to get as nice a house in as nice an area as the previous house, and as a result you are not able to rent the property for as much as you were renting it before?

Correlating this to the bond market, if the bond holder opts to sell, he should ideally seek to find another investment which offers at least the same 9.0 per cent return. In this current market, to get that kind of return would require taking more risk. “Am I willing to take that additional risk?”

The alternative options are often slim as you may have to invest in a junk bond to get the same kind of return, or accept a lower yield if you choose to stay in the investment grade spectrum when selecting a replacement bond. As a result, investors may choose instead to hold the bond until maturity because of the secure predictable 9.0 per cent return.

The key is to weigh the pros and cons and do the math to figure out if it is a trick or treat. The gains you make now by selling may be high enough to compensate for any foregone future interest income or having to replace the bond with one paying a lower coupon.

Toni-Ann Neita is Assistant Vice President – Personal Financial Planning at Sterling Asset Management. Sterling provides medium to long-term financial advice and investments 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: info@sterlingasset.net.jm. You may visit us on Facebook or follow us on Twitter and for more information please visit our website www.sterling.com.jm