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Just why do changes in bond values and returns act like a teeter-totter?

March 11, 2011 - 0 comments

Let’s first look at the components of a bond:

1. Face Amount – the principal value of the bond – for example $100,000.  For demonstration purposes, let’s assume I bought this bond for $100,000.

2. Issuer – the entity borrowing funds by issuing the bond – usually a government or a corporation.

3. Coupon Rate – the fixed rate of interest that will be paid by the bond issuer on the face amount of the bond.  For example 3%.

4. Maturity Date – the date on which the issuer must repay the principal/face amount of the bond to the owners – for example December 31st, 2016.

If we were looking at this bond on an investment account statement, it might look like this:

The issuer of the bond will pay the owner(s) of the bond the coupon rate on each due date (usually semi-annually) until maturity.  In our example, the annual interest would be $3,000, of which $1,500 would be paid on June 30th and December 31st each year.  On December 31st, 2016, the owner of the bond will receive $101,500, comprising of the final coupon payment and the principal repayment.

Bonds trade on the secondary market, thus providing liquidity not available in your non-cashable GICs.  But there must be a way to value the bond on the basis of current interest rates.  Suppose I decide to sell my $100,000 bond when interest rates, for 2016 maturities, have increased to 4%.  No one will want to buy my bond (which pays only 3% interest) for $100,000 when they can spend the same amount for an equivalent bond paying 4%.   However, we know that the bond will continue to pay $3,000 of interest each year until 2016 when the $100,000 will be returned.  So we need to calculate how much capital would be required today to provide a 4% return, given the $1,500 semi-annual interest payments and $100,00 at maturity.  This “discounted cash flow” calculation results in a price of approximately $95,500.  If I agree to sell at this price, I will realize a capital loss of $4,500 (my purchase price was $100,000).  The purchaser of my 3% bond for $95,500 will receive a capital gain of $4,500 (in addition to the coupon payments), resulting in a total return identical to buying a 4% bond at $100,000.  Rates have gone up and the value of my bond has gone down. 

Conversely, if rates go down to 2%, I would demand a price of approximately $104,700 and realize a capital gain of $4,700.

 

It’s important to note that if I hold my bond to maturity, I will receive $100,000 (as long as the issuer can pay me back – a topic for another day) and have no capital gain or loss – similar to holding a non-cashable GIC.

These comments provide a very basic look at the bond market and are meant as a primer in this area.  There are many components and complexities that must be taken into account when selecting and trading in bonds for your portfolio.  PWL takes the time to consider the most appropriate and tax efficient holdings for client accounts, either through the use of individual holdings or pools of bonds via exchange traded funds or mutual funds.

By: Kathleen Clough with 0 comments.
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