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The paranoia of buying bonds below par

We had family come over to our place over the weekend for Sunday lunch. The children were enthusiastic, playing with some new toys they got whilst the adults gathered around the dining room table for some tea and biscuits, an ideal setup to unwind and try and catch up on each other's lives.My cousin sat next to me at

My cousin sat next to me at table and, weary about how financial markets work and the challenges bond investors face in light of the current interest rate scenario, a discussion ensued.Being quite an active investor, I knew my cousin could keep up with the discussion as we delved deeper into the nitty

Being quite an active investor, I knew my cousin could keep up with the discussion as we delved deeper into the nitty grittiness of the impact central banks have had on keeping bond prices supported, how central banks are slowly withdrawing their accommodative stances, as well as, the positive run emerging markets have had over the past 6 months or so.

The conversation swiftly shifted to whether there are any market opportunities in Europe following the persistent tightening in bond yields, to which I replied that the key going forward in European high yield for the remainder of the year is focusing on bond picking and not to expect much upside capital appreciation, but merely coupon-like returns.

There are some solid European names, bearing sizable coupons I added could provide some form stability in current times, to which my cousin asked "And where are these bonds trading, below or above par?"

This question came as no surprise to me to be honest, it's not the first time I've had conversations with colleagues at work who have struggled to explain the intricate mechanics of fixed income securities to their clients. So I grasped this opportunity to explain the concept to my cousin, and walked away into a quieter room.

All bonds, regardless of whether they are of high quality (Investment Grade) or riskier bonds (High Yield), trade at a yield and not at a price. True, the price of bonds fluctuate, but what is most important is to understand that as bond prices go up (or down), bond yields go down (or up).

The price at which a bond trades is a function of a number of factors, namely interest rates, time to maturity, credit risk, liquidity and redemption value. When an investor purchases a bond, s/he will be locking in a yield (better known as Yield to Maturity) for the duration of the lifetime of the bond.

If a bond trades below par and matures at 100, the YTM will be greater than the coupon rate as the YTM will encapsulate the expected capital gains from the time of purchase till maturity. Likewise, if a bond trades above par and matures at 100, the YTM will be lower than the coupon rate as the YTM will encapsulate the expected capital losses from the time of purchase till maturity.

It's a simple concept. Take a bond trading below par with a low coupon and a bond trading above par with a high coupon (assume that their maturity profiles are identical).

It could very well be the case that these bonds, despite trading at different price levels, are trading at similar yields or YTM due to the all important element of the value of the underlying coupon rate in determining bond returns (one can also conclude here that the two bonds have a similar risk profile).

On a price return basis only, it is true that the bond trading below par will appreciate in capital value till maturity and the bond trading above par will depreciate in capital value till maturity, but bond returns should be viewed holistically, taking account for the all import interest return element, which ultimately determines the yield at which bonds trade.

Investors should base their investment decisions on whether the return they expect to get from their prospective investment (the YTM) is commensurate with the risk of being exposed to the underlying risk of the bond issuer, irrespective of whether the bond is trading below or above par.

Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt.The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website. 

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