Sticker Shock?
When buying high can still be smart
With
interest rates coming down, the prices of most high-quality bonds have gone up. That means many of the bonds we offer are now trading at a premium, that is, above their original face (par) value. Understandably, some investors balk at the comparatively higher prices (compared to previous years or even just a few months ago) worrying that paying “extra” means they’re losing out. But that’s not the case.
What Does It Mean to Buy at a Premium?
A bond’s face value is, for example, usually US$1,000. If market demand is high and interest rates are lower than the bond’s coupon rate, investors are willing to pay more than US$1,000 to receive its fixed interest payments. That “more” is the premium.
For example, a bond with a 6 per cent coupon pays US$60 per year. If comparable new bonds on the market are offering only 4 per cent, investors are often willing to pay more than the bond’s US$1,000 face value to lock in the higher 6 per cent income stream.
Yield: The Great Equaliser
When you buy a bond at a premium, you are essentially pre-paying part of the bond’s future cash flows. But you still receive the same fixed coupon payments every year. What matters most isn’t the price tag by itself, it’s the yield.
Yield tells you the true return you can expect from a bond after taking into account the price you paid, whether it’s at a discount, at par, or at a premium. If the yield is attractive compared to other investment options, the bond can still be a worthwhile choice. This makes yield the best way to compare bonds “apples to apples” because it levels the playing field regardless of the bond’s price.
Other Reasons Prices Can Be High
While higher coupons are the most common reason bonds trade above par, sometimes prices rise because of other factors such as a credit rating upgrade, a scarce supply of that bond, or the bond being seen as a safe investment. These factors also reflect quality and investor demand, not overpricing.
The Big Picture
Buying at a premium does not mean you’re overpaying or losing money. It reflects the reality of a strong bond market in which higher coupon payments, and in some cases a bond’s scarcity or quality, are especially valuable. Focus on the yield — your actual return — rather than the sticker price. That’s the key to making intelligent, confident investment decisions.
Toni-Ann Neita-Elliott, CFP is the vice-president, sales & marketing at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investors. Visit our website at www.sterling.com.jm. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm
BY Toni-Ann Neita-Elliott .
