Bonds 4: “Does it make any sense to buy a bond at a premium?”

Susan
By Susan June 20, 2012 08:55

Bonds 4: “Does it make any sense to buy a bond at a premium?”

 

A loan of money that takes the form of bonds is a bit like the suitcase full of bank notes that is exchanged in gangster movies: the total sum of the bank notes in the suitcase would be the total amount of the loan, and each individual bank note in the suitcase would be a bond.

 

Bonds are issued in small denominations, making them more easily tradeable on an exchange than a lump sum in the order of billions. And just like bank notes, bonds have a face value. The similarity ends there, though, because contrary to a bank note, the price of a bond can be different from its face value.

 

 

Bonds trading at face value, at a discount, or at a premium

 

When you buy a bond, it is a rare occurrence that you will buy it exactly at its par, or face, value. More often than not, you will buy it for either less than its face value: at a discount; or for more than its face value: at a premium.

 

Bonds might trade at a discount, resulting in an increased yield, so as to compensate investors for a riskier investment.

 

Some bonds, called zero-coupon bonds, trade at a discount because they don’t have a coupon. But they still earn you interest: instead of this interest being distributed in the form of an annual or semiannual coupon, it is paid out all at once when the bond is redeemed at maturity. So you would buy those bonds for less than their face value, and the difference between the price you paid and the face value represents the amount of interest, or return on investment, that will accrue until the face value of the bond is redeemed at maturity.

 

Other bonds might trade at a premium, that is, for more than their face value. As the price of a bond is reflected in its yield, a premium price would eat into the yield. Now buying a bond for more than it’s worth does not mean you’re getting a bad deal! Indeed, there are many sound investing reasons to buy a bond at a premium.

 

 

Because you are interested in income, more than capital gain

 

Buying a bond at a premium means that, at the moment of buying, if you are intending to hold the security to maturity, you are signing up to make a capital loss: you are shelling out more money than you will get back when the bond is redeemed, since a bond is redeemed at face value.

 

But this does not mean you are losing money: if this bond has a high coupon, you might make up that capital loss in income, since you will receive the amount of the coupon every year.

 

Let’s take the example of a German government bond reaching maturity in 2020. Its coupon is 3.25, its “offer” price (the price you pay when you buy it) is 116.948 – let’s round that to 117. This price is expressed as a percentage of its face value: 117 means 117%, or 117 for a face value of 100.

 

If you buy this bond, you are making a capital loss of 17: you pay 117 for something that will bring in 100 when redeemed. You are aware of this capital loss when buying: this is not the same as default. You know you are signing up to that.

 

But in the meantime, until it reaches maturity in 2020, this bond will also bring you 3.25 annually in income, over 8 years. That’s a total of 3.25×8 = 26.

 

You lost 17 in capital, but you made 26 in income: the difference is a positive 9. So you didn’t lose money at all – and if we were being technically correct, we would have to account for the interest that you could earn on those coupons also: most calculations assume you will reinvest the interest you earn as well.

 

So the first reason to buy a bond at a premium would be because you are interested in income, and you are prepared to take a capital loss, as long as it’s compensated by income.

 

 

Because you prefer safety

 

But let’s take a look at that bond’s yield: it’s tiny at 0.918 – not even 1%! This happens a lot at the moment: we see a lot of tiny yields of less than 1%. That’s less than inflation across the Eurozone, including German inflation.

 

If you buy this bond, your purchasing power is not going to go up, on the contrary – you will be losing purchasing power because the return that you’re making on the bond cannot keep up with inflation, assuming that inflation is above your yield. And inflation hardly ever stays as low as 0.918%…

 

Now isn’t that in total contradiction with what I was saying earlier , namely, that buying bonds is a good way to preserve capital, to protect your money from the erosion that inflation is responsible for?

 

So obviously somebody buying that bond wouldn’t do it because they want to “grow” their money, that wouldn’t be their strategy. Their strategy would be dictated by market conditions at this moment in time: they have a choice between, say, German or Greek debt. Which one is most likely to be paid back? Obviously German debt – and the low yield of that German bond reflects that.

 

This is called “flight to quality“: investors are afraid some issuers might default, so they are buying safer debt. The more money investors pile into German debt, the higher the demand, the higher the price – this pushes down the yield.

 

So what is happening here? If people are not buying bonds to preserve their money from inflation, and if more people buying German debt pushes prices up (resulting in a capital loss for bond buyers), why on earth are investors still chosing what might seem like a bad bargain?

 

What is happening is that, due to current circumstances, people are buying just to preserve their capital (not completely, since they’re taking a slight capital loss when buying). They’re even willing to let go of purchasing power at this stage in an attempt to protect their money however they can. So they’re sacrificing purchasing power over the security that German debt represents, and the promise of at least getting their money back.

 

 

And what if the Euro broke up?

 

And the third reason… Well, this wouldn’t have even crossed the minds of investors ten years ago, but this question weighs heavily on their decisions now. In the eventuality of the Euro breaking up, what would happen?

 

In the scenario that the Euro breaks up, the German Euro would become redenominated and would become the German (or Deutsche) Mark. Now we would all be expecting the mark to absolutely appreciate in that context: the German economy is much stronger than that of most European countries at the moment, they have weathered the crisis with their treble A credit rating intact, they have very strong exports and are even experiencing economic growth.

 

So the German Mark would appreciate and rocket in value, in comparison to the Irish Punt, formerly known as the Irish Euro.

 

Now if you are an Irish citizen owning German debt redenominated in marks, the value of this portion of your money would be protected, and in fact would show significant growth when you repatriate it against the punt. If this was to play out, you would be delighted – relieved – to have bought German debt, even at a premium.

 

However, you must consider if the possibility of this threat is high enough to risk losing purchasing power, in an environment of record low interest rates and quantitative easing? For each trade, there is risk and return

 

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Susan
By Susan June 20, 2012 08:55