New investors are often surprised to learn the sheer size of the bond market. The Canadian secondary debt market is approximately 30 times greater than the total Canadian equity trading market.
If a bond is purchased at its new issue price the value is normally $100 per $100 par value (also known as face value). However, most new issue bonds are not floated to the general public, but are bought by the large investment dealers such as the Canadian banks. The general public has access to buy bonds in the secondary market from these dealers where bond prices will be trading at their perceived value based on many different factors such as world or county specific economic news, interest rates, credit rating, etc.
Due to the numerous variables, bonds are rarely trading at exactly $100 in the secondary market. Bonds that trade at a higher price than their par value ($100), say $102, are said to be trading at a “premium.” Bonds that trade at a lower price, say $97, are trading at a “discount.”
We will use XYZ bond to illustrate bonds trading at a premium or discount.
The original XYZ bond was issued at 100 with a four per cent coupon and a five-year term to maturity. Most bonds in Canada pay their coupon on a semi annual basis (twice per year). Therefore in this case, the client would receive a fixed amount of two per cent per six months on the total face value of the bonds purchased. After the initial issue date, the price is not fixed and will fluctuate prior to maturity based on several factors as mentioned above.
Bond prices move inversely to interest rates. Therefore, if interest rates have increased after a year from when XYZ bonds were initially issued, the price of the bond will decrease.
Many clients find this relationship difficult to understand so let’s use an example to illustrate why this occurs. Let’s say that interest rates rise to the extent that a new five-year ABC bond, which is similar in term and credit quality as XYZ bond, when initially issued at par is paying a coupon of five per cent. All else being equal, investors would find the ABC bonds more attractive than the four per cent coupon XYZ bonds issued a year earlier. Therefore the market in general would sell the XYZ bond, causing the price to drop, in order to buy the more attractive ABC bond.
The opposite may happen to bond pricing if interest rates decline. If new bond issues are currently paying three per cent coupon, the market would be more inclined to buy higher coupon paying bonds such as the XYZ bond paying four per cent. The market would buy the XYZ bond, pushing its price above those that are issued at three per cent causing the XYZ bond to trade at a premium. If XYZ is trading at $102, the premium above $100 can be seen as payment for a higher coupon.
Here are some key tips in acquiring bonds;
- Never buy a bond solely on the coupon alone. Yield to maturity for bonds is often the more important number to review as it allows bonds of different coupons and maturities to be compared to each other. Yield to maturity is the total return, made up of interest and repayment of principal that you will receive if you hold the bond to maturity.
- For taxable accounts, you should ensure that you are reporting all capital gains from bonds purchased at a discount and all capital losses from bonds purchased at a premium.
- The coupon component on bonds is considered interest income. We encourage investors to hold investments that generate interest income within a registered account, such as an RRSP or RRIF, if they have the option.
- If you are an investor in a high tax bracket and have bonds in a non-registered account, consider those trading at a discount. Bonds trading at a discount will result in both interest income and capital gains. The taxable capital gains is more tax efficient than the interest income component. Naturally, the higher your tax bracket, the greater the benefit of investing in bonds trading at a discount.
- If you have capital loss carry forwards and are avoiding equity markets then you should ask your advisor to look for bonds trading at a deep discount. This will convert part of your total return to capitals gains. The capital gain component generated on a bond held to maturity may be offset by your capital loss carry-forward room.
- We recommend sticking to “vanilla” type bonds versus those that have features that you may not understand or that do not appear to benefit you. Before purchasing, you should obtain a complete understanding of all features (i.e. extendable, callable, changes in coupon rates) on bonds and determine how this may impact you as the holder.