We will start our review of fixed income securities today.
As there are some good things to know, we shall break it down into a few posts.
First, I want to quickly review a few key terms that relate to fixed income. If you can understand a little of the terminology, it will make the whole area easier to follow.
We will refer to the following example as we go through the terms.
On January 1, 2017, you purchase a new issue of $10,000 par value 5 year Canada Government bonds for $10,250. The bond has a coupon of 8% and a current yield of 7.8%.
Fixed Income Securities
In general, assets in this class provide a known stream of fixed income over the life of the investment. Hence the term.
At the end of the asset’s life, the original capital is repaid in full to the investor by the issuer borrowing the funds.
If you hold the security until maturity, there is relative certainty as to your income stream, both the amount and the timing, and in the repayment of your invested capital.
We will consider the “relative” aspect in due course.
In our example, the fixed stream of income is $400 of semi-annual interest payments for the 5 year life of the bond. At the end of 5 years, you also receive the face value of $10,000. Unless the government defaults on its debt, there is a high certainty as to the timing of the payments and the amounts you will receive.
I would include all debt instruments and most preferred shares in the fixed income asset class.
That said, for every rule there are exceptions.
Some debt issues and many preferred shares may not have expiration dates. Other issues may have variable rate coupons, or interest rates that change based on specific events.
Some debt may have the interest coupons stripped from the instrument. You may purchase the debt paying no periodic interest (zero coupon bonds) or you may invest in the coupon stream with no principal repayment (interest only strips).
Also, one can engage in swaps or asset re-engineering to completely alter the characteristics of certain investments. For example, investors may use futures contracts to increase or decrease the maturities of Treasury bills. Or one can utilize an equity swap to take an underlying fixed income portfolio and create a synthetic equity portfolio without selling the bonds or purchasing shares. But these areas are outside the scope of our discussion.
So while the above definition works in most instances, be aware that there are exceptions.
Principal
The “face value” of the security that must be repaid to the investor at maturity. Principal may also be referred to as the “stated value” or “par value”.
All four terms are interchangeable.
In pricing analysis, the principal is typically viewed in multiples of $100.
In our example, the $10,000 is the principal amount. The par is $100 for pricing.
This differs from what you actually paid for the security. The amount you paid, $10,250, is your “purchase price” or “adjusted cost base”. In pricing terms, you paid $102.50 for the bonds.
In this case, you paid $250 more than the face value of the bond. If you pay more than the par value, the extra amount is known as the “premium”. Had you paid less than the face value for the bonds, the difference would be the “discount”.
Note that with debt instruments, you often purchase accrued interest. For the moment we shall ignore this consideration.
Term to Maturity
This is simply the time remaining before the debt instrument matures and it is retired.
At maturity, interest payments end and the face value of the debt is repaid to the investor. There is no longer any obligation by the issuer to the debt holder.
Investors are not concerned with the original maturity date, only the term that remains.
For example, on January 1, 2017, you plan to invest in a 30 year US government bond that matures on December 31, 2018. The fact that the bond had an original maturity of 30 years is irrelevant. You should only be concerned with the cash flow over the remaining 2 years.
Also, the 30 year bond will exhibit the investment characteristics of a 2 year bond. That is very important.
Coupon Rate
A security’s periodic fixed income payment is called its “coupon” or “interest” component.
It is what is actually paid out in interest income each year and is compared relative to the face value of the debt. Not to what you actually paid for the asset.
In our example, the coupon rate is 8%. For every $100 of face value debt, a semi-annual interest payment of $4 will be made by the government. As you purchased a face value of $10,000, your annual interest income is $800.
As a formula, simply divide the interest payment received by the face value of the debt. If you own debt with a par value of $300,000 and receive an annual interest receipt of $18,000, your coupon rate is 6%.
For most debt instruments, interest payments are made semi-annually on the anniversary date of the issue. In some cases though, interest payments may be made more or less frequently. And in some instances, such as with zero coupon bonds or most money market instruments, actual interest is never paid.
Yield
Yield on a fixed income asset is a different creature from the coupon rate. It may be the same, but often it is different.
The yield represents the annual return to the investor based on his investment cost.
Current Yield (CY)
Whereas the coupon rate compares the interest paid out to the face value of the debt, the CY compares the interest payments to your actual purchase price (adjusted cost base).
In our example, you paid $10,250 for the bonds. But regardless of what you paid for the bonds, you will still receive interest at the coupon rate of 8% based on the face value. So each year you receive $800 in interest.
To calculate the CY, you only need to know the current price of the security and the coupon rate.
Simply divide your annual interest income into the purchase price and you have the CY. And if you know the CY, you can easily calculate either the proper purchase price or coupon rate, assuming you have one or the other.
If you buy a fixed income security at par value, the coupon rate and the CY will be the same.
However, because you paid a premium for your bonds in our example, your CY will be less than your coupon rate. In this case, your CY is only 7.8%.
Note that had you received a discount on your bond purchase, your CY would be higher than the coupon rate. Knowing this rule on the impact of premiums or discounts on your yield versus coupon is very useful for personal calculations.
Also, as interest rates change, that will impact the current price of the fixed income asset. If market interest rates fall, then the current price of your bond should increase, ceteris paribus. Over time, your CY may fluctuate, so you always need to update your calculations based on current prices.
A major weakness in the CY is that it does not factor in potential capital gains or losses into the annual return.
Yield to Maturity
The yield to maturity (YTM) does account for capital gains or losses in its calculation.
To determine the YTM, you need to know the security price, the coupon rate, and the term to maturity. And, if you have any three numbers, you can easily calculate the missing fourth.
While you can calculate YTM by formula, I suggest you use a financial calculator. In our example above, the YTM is 7.7%.
This should make some intuitive sense if you think about it.
In our example the CY is 7.8% and the YTM is slightly less at 7.7%.
The CY only considers the interest stream against the purchase price. The YTM needs to also factor in any capital gains or losses between the purchase price and the face value at maturity.
You paid $10,250 but will only receive back $10,000. Because you paid a premium, you have a capital loss that must be reflected in the YTM. This loss will lower the yield (your overall return) as compared to the CY.
Had you received a discount on the purchase, you would receive a capital gain at maturity. Factoring this gain into your calculations will result in a higher YTM than the CY.
For example, instead of paying $10,250 for the bonds, you only pay $9750. Your CY will increase to 8.2%. However your YTM will rise even higher to 9.0%, reflecting the capital gain at maturity.
Okay, I think that gives you some understanding of the key fixed income terms.
Next we will review the common investments within the fixed income asset class.
