One of the most confusing components of “bond math” is the pricing. Like most assets — the price is a major determinant of your total return. Today we look at the pricing of fixed income instruments and how your total return is calculated. We present several concepts that are simplified for brevity and all examples use a fixed rate security.

A bond is a loan. When you buy a bond, you are lending a specific amount of money (called the principal or face value) to a company or a government. In return, they agree to pay you interest (the interest rate or coupon). And repay your principal or face value at a specific date in the future. Bonds trade in relation to their “par value”. “Par value” is 100. If you buy a bond at 100, it means that exactly what you pay for the bond, you get back from the issuer at the maturity date. Bonds can trade above their par value, which means they trade at a premium, or bonds can trade below their par value which means they trade at a discount. Incidentally, a discount in the bond market is NOT always a good thing, and a premium is NOT always a bad thing.

Why would you buy a bond at a premium?

A large French bank recently issued a note with a 9.25 per cent coupon and a 2027 call date. The bond quickly traded to a premium due to the attractive coupon. Many investors are comfortable paying a premium for the bond and here is why. If you pay US$103 for US$100 worth of this bond, you will enjoy a 8.4 per cent yield, still quite attractive. Notice the yield is BELOW the interest rate. The lower yield reflects the fact that you paid US$103 but will only receive US$100 from the issuer in 2027. You take a small capital loss. However, this is far outweighed by the generous coupon you are earning.

Many high quality bonds trade at a premium. Investors can buy at a premium and still earn an attractive return. In the bond world, a premium is not a bad thing and does not mean you are overpaying.

How do the discounts work?

The reverse of the above is also true. Bonds can trade BELOW par value. The National Oil Company in Mexico recently issued a 10 per cent 2033 note. Some investors purchased this note at a price of 92; this meant the investor received US$100 worth of the bond but only had to pay US$92. This amounted to a yield of 12 per cent. Note the yield is higher than the coupon because of the capital gain the investor will earn at maturity (ie the difference between 100 and 92). There could be many reasons that a bond is trading at a discount. A discount largely reflects the market’s CURRENT view of the risk of the instrument and the issuer. It implies that the return needs to be higher than the interest rate to entice investors to buy the bond in the current environment.

Prices don’t stay the same but your return does

As market conditions (or the issuer’s financial and strategic position) change, the pricing is also likely to change. If the issuer’s financial or strategic position improves, demand for the bond could increase and so would the price. If interest rates decline and newer bonds at lower interest rates are issued, then the price of the existing bonds could rise. Most importantly, once you have purchased a bond, your return does not change (regardless of what happens to the price) as long as you hold the bond until maturity. That return is locked in because of the nature of the investment — the issuer is repaying you 100, regardless of what price you purchased the bond at.

Marian Ross is vice-president, Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

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