The scope of any investment made is to increase the net wealth of the investor. Investing in a fixed deposit account with a bank, purchasing a bond or buying a share is only the purchase of a stream of future cash flow that should increase the investor’s wealth.

During meetings held between financial intermediaries and investors various terms are used that are not properly explained to clients. In this article we try to clarify the interaction of cash and yield to maturity.We start by distinguishing between the two broad categories of investments. Fixed deposits and bonds are rather similar, in that the future cash flow is known on the day of purchase, if the bond is held to maturity. This means that throughout the holding period, each year the investor will receive regular interest (or coupon payments) and, upon maturity, the nominal amount invested (the capital) is returned in full.

Equities, commodities and other products have a different and uncertain cash flow. There is no predetermined rate at which the client will receive interest yearly. In the case of equities each company will determine the dividend payments (versus a fixed coupon) and distribute dividends either once or twice yearly.

Most companies have a declared dividend policy whereby the investor knows the portion of profits that the company will distribute to its shareholders. Whereas when investing in bonds and fixed deposits the capital is returned in full upon maturity, equities do not have a maturity date. When the client sells the equity he will receive the market value of that equity, which can be either higher or lower than the capital invested.

Focussing on fixed income securities, the yield to maturity of a bond is then similar to the Internal Rate of Return (IRR) of an investment. This is equivalent to the discounting rate used for a stream of future cash flow.

Compare the following two bonds. Both bonds have a coupon (interest rate) of six per cent, and both bonds mature on February 17, 2015 and pay interest only once yearly. The price of Bond 1 is 103.6 with a yield of five per cent, while the price of Bond 2 is 100 with a yield of six per cent, assuming both bonds are of similar rating and credit quality.

There are many situations where we advise clients to switch from Bond 1 to Bond 2. The client remarks that he will still receive six per cent per annum and the capital upon maturity, and that it would not really benefit him to sell and buy the new bond.

Working out the actual cash flows would be the best way to demonstrate that the switch benefits the client. The cash flow from Bond 1 (assuming a nominal value of € 25,000).

Selling Bond 1 at 103.6 gives the investor €25,900 (€25,000 nominal at 103.6). This amount is then re-invested into Bond 2 at a price of 100. Then the client holds a nominal of €25,900 of Bond 2.

Thus the cash flow from bond 2 yielding six per cent is as follows:

If the investor decides to sell Bond 1 and buy Bond 2, he receives an increase of € 1,116 over a four year period, clearly a substantial increase in return with only a one per cent increase in yield.

In the example above we simplified the calculations by using two identical bonds except for the yield. In calculating the return for the client one should consider the tax on interest and fees charged. Each investor then has to ascertain the amount of fees that will be charged for the transaction as these will decrease the overall gain for the client. Your investment manager should demonstrate that the transaction would benefit you as the client after all fees are deducted.

Finally, consider the change in the credit quality of the investment. Switching from a high credit quality to a low credit quality would increase yield but also risk. The client manager should ensure that the overall credit quality of the portfolio after the switch is within your risk tolerance and acceptable.

This article has been prepared by Sandro Baluci of Curmi and Partners Ltd, and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

www.curmiandpartners.com

Mr Baluci is portfolio manager with Curmi and Partners Ltd.