By Charles Ross, Contributor
Ross
IN OUR last Financial Gleaner article, we tried to explain how the main measures of the yield on bonds are used when selecting the bonds in which you may choose to invest. Although bonds are fixed income investments, they have different characteristics from the money market type of investment that most people are familiar with. In today's article, we will compare the two types of investments in an effort to highlight both the similarities and the differences between them.
MONEY MARKET YIELD
Money market type investments usually quote a fixed interest rate for a fixed period for a given sum of money invested. It is therefore very easy for the investor to calculate exactly how much interest he or she will earn while the funds are invested and how much money they will receive at maturity. Very often, the investor is taking the risk of the institution issuing the money market investment. In the case of repurchase type agreements, the investor may be taking the risk of the issuer of the underlying security. Note, however, that if the underlying security is issued by the Government of Jamaica, that investment is likely to be less risky than say a certificate of deposit in a bank.
BOND YIELD
On the other hand, at least two yields are usually quoted for bonds: the current yield and the yield to maturity. The current yield comes closest to the interest rate quoted on a money market instrument, as it is the return that will be earned if the bond is bought and sold at the same price. However, as there is no guarantee that the bond's price will remain unchanged, the current yield is not a certain return but it can be used to determine the cash flow that the investor will receive while he or she holds the bond. The yield to maturity is the most commonly quoted bond yield and this is very important to medium to long-term investors. The yield to maturity is used to compare the returns on bonds of different maturities with each other and with the overall yield curve. The yield curve shows how bond yields increase as the maturity of the bonds increases. These comparisons help investors to make judgements about which bonds are likely to offer the best returns. It is sometimes difficult to compare the yield to maturity directly with the interest rates offered on money market investments, as the latter tend to be much shorter in duration than the average bond. However, the yield curve will give a guide as to how attractive the bond is, versus the money market investment.
It is important to remember that the yield to maturity is a notional return that will only be earned if the bond is held to maturity. This yield takes into account the price paid for the bond whether it is at a premium or a discount and the fact that, at maturity, only the face value is redeemed by the issuer of the bond. Since many bond investors do not hold the instruments until maturity, a more useful measure of the return on a bond investment is the holding period return.
THE "HOLDING PERIOD"
RETURN ON BONDS
This concept takes into account both the interest earned on the bond, and any capital gains or losses that are realised between the time when the bond is bought and when it is sold. It can be expressed as an annualised percentage, which can be easily compared with rates being offered in the money market. The only drawback with the comparison is that, at the outset of the investment, the holding period return can only be estimated as there is no way to be certain what the future bond price will be when the bond is sold. The alternative is to compare the historical returns in the bond market with the returns available in the money market. Note again, however, that there are no guarantees that past returns will also hold in the future.
REINVESTMENT OF INTEREST EARNED
Another area in which bonds differ from money market investments is in the area of the reinvestment of interest earned. In the money market, interest can be easily added to the principal and reinvested at maturity, allowing for the compounding of interest earned on the investment. This is not quite as easy with a bond investment, as sometimes it may not be possible to get additional bonds to purchase, especially if the coupon payment is very small or if there are restrictions on the minimum increment in which a bond can be traded. If this difficulty arises, the investor can accumulate a number of coupon payments and then buy additional bonds. Alternately, additional funds can be used to bring the coupon payment up to the minimum amount required to make the additional bond purchase.
For Jamaican investors, there is an additional benefit from investment in Government of Jamaica eurobonds: Most of those bonds give tax-free returns a benefit that is not available on the average money market investment.
Charles Ross is Managing Director of Sterling Asset Management Ltd.
