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Right now I'm studying how bonds work and from what I have studied, the crucial thing about bonds is the maturity date, where you are assured you'll get the principal if you sell at that time, and the interest coupons.

Take a look at this specific bond :

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Let's say I invest in it right now, would I get my initial investment back PLUS the 6.25% coupon interest rate by 15 April 2015?

17

There are a few things you need to keep in mind:

  • the coupon is based on the par value of 100 but the bond is currently trading at 102. At 102 the yield to maturity is 2.5%, not 6.25%
  • the coupon and yield to maturity are annual rates, so over a holding period of ca. 6 months you are only going to make half that, i.e. 1.2%
  • and, most importantly, you will only make that return if the company does not default by April 2015 and pays the last coupon and repays the notional as expected. That is not a 100% probability (otherwise the bond would trade at a higher price/lower yield to reflect the lower risk).

By buying a short term bond, you significantly reduce your exposure to interest rate moves, but your credit risk (the risk that the issuer may default on its payments) is still there.

So to answer your question no, it is not a zero risk investment, although it is very low in this case (the probability of the Australian government to default is low).


Regarding the first bullet point, I took the figures from Bloomberg but I can give you a simplified example that outlines the principle (in practice you need to take the ex-coupon date and settlement date on your trade into account to run an exact calculation).

The bond pays a coupon of $3.125 every 6 months. The half yearly coupon has just been paid (on October 15th) and there is approximately 6 months left in the bond. If the issuer does not default you will receive 100 + 6.25/2 at maturity or 103.125.

If you buy the bond at par ($100), you would make a return of 3.125% over 6 months, or ~6.25% per annum, as you expect. But if you buy the bond at $102 (current price), you will only make a little more than 1% over the 6-month period.

  • 3
    Can you explain your first bullet more? I'm not sure I understand fully. Thanks! – Mark Gabriel Oct 23 '14 at 13:45
  • @MarkGabriel Here you are. – assylias Oct 23 '14 at 18:07
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As the bond nears its maturity date, you will be unable to buy it for much less than its maturity value (including the interest), for exactly this reason. You simply can't execute the transaction you describe.

Remember, everyone else in the market has all the same data you do. Everything obvious, and many things not obvious, will already have been factored into the trading prices of stocks and bonds.

4

As @assylias said, if the company goes under you get nothing. So bond investing is not risk-free.

Further, you won't get a 6.25% return. That's the coupon rate, based on the face value of the bond. Interest rates today are much lower than that, and the price you pay for a bond reflects current interest rates. For example, if a long-term bond paid 10% of its face value and interest rates went down to 5%, you'd have to pay $2000 for a bond with a face value of $1000 (oversimplified, see below). That's how the bond market works: prices adjust to keep the interest payments in line with current interest rates.

Here's the catch: regardless of how much you pay for a bond, when it matures you get its face value. If you paid more than face value for the bond, which is the case for just about any bond purchase today, you eat the difference. That's the oversimplification in the previous paragraph: the price also depends on the time to maturity. The longer the remaining time, the closer the price will be to the value dictated by interest rates; the shorter the remaining time, the closer it will be to the face value.

One further, but minor, complication: when you buy a bond, in addition to the purchase price you also pay pro rata interest to the seller. Bond interest is typically paid every six months, which is why the coupon payment for your example is $312.50; that's 6.25% annual interest, divided by two because there are two interest payments each year. If you bought the bond on July 15, you'd be half way through the six month interest period, so you'd pay the seller $156.25 in interest. You'll get it back in January, when you get the $312.50 interest from the bond issuer.

So what you get back on a bond investment if you hold it to maturity is interest based on the face amount of the bond and, at maturity, repayment of the face amount. Look at what the bond will cost you, and decide whether it's an appropriate investment.

4

You can't "invest right now" in that bond. The bond was sold to investors by the issuer on its issue date which was many years before the maturity date. All you can do now is to buy the bond off another investor who wants to sell it early (that's the bond market). If you do that, he will want to recover the interest that has accrued while he held the bond so you have to pay more than the par value.

The market works something like this:

  • The issuer offers a bond that matures in 5 years time and pays 10% coupon. If you buy this bond for $1000 and hold it for 5 years you will get $1100 back. Lets say you do this...

  • After 3 years, you decide you need the cash. So you offer the bond for sale. You've held the risk for 3 years so you want some payback for that. On the other hand, anyone who buys it is going to want some interest for the remaining 2 years until it pays out.

  • So you offer the bond for sale at 106%.
  • A buyer called Fred comes into the market and gives you $1060 (106% of $1000). So you've made $60 profit. He gets the bond and now has to sweat it out for 2 years.
  • After 2 years, the bond matures and Fred gets the $1100 so he's made $40 profit.

So you and Fred share the risk and share the profit.

  • If the bond has face value $1100 five years from now and is sold by the issuer for $1000 today, then it is not a coupon bond in the usual sense of the word (and it does not have a 10% coupon) but rather it is a zero-coupon or original issue discount bond. In the US, such bonds are deemed to pay interest every year and that deemed interest must be declared each year on income tax returns and the like. (There are exceptions for US Savings Bonds and the like). Zero-coupon bonds are great to hold in tax-deferred accounts, but trickier investments outside of them. – Dilip Sarwate Oct 23 '14 at 16:44
  • To expand on @DilipSarwate's comment regarding your first bullet point, if the original face value for the bond is $1000, it has a maturity of five years and a coupon rate of 10%, then each of those five years you will receive $100 (10% of $1000) and at the end of the five years you will receive $1000 back, for a total outlay of $1000 and a total income of $1500, netting you $500. Here, I am ignoring tax effects and assuming holding to maturity, in order to focus on the statement in the first bullet point. – a CVn Oct 24 '14 at 9:25
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On the maturity date the issuer will pay the principal plus any due interest to whoever owns the bond on that day. The coupon rate is quoted as 6.25% but that's annualised. In this case the bond clearly pays interest twice a year because the next interest payment is shown as 312.5 cents per 100 dollars (i.e. 3.125%).

There's no question of "if they sell" - the bond matures and the owner gets the payment. And they won't get paid "by" the maturity date, it will be on the maturity date plus some standard settlement period (e.g. two business days).

In this case the Australian Treasury is extremely unlikely to default on an AUD bond but in general an issuer could of course fail to make the payment. They would have then defaulted. For a public company this would usually result in bankruptcy proceedings. The bondholders might get some return from liquidating the assets of the company. There is a strict order of precedence in terms of which classes of debt holders get paid first.

If you buy treasury bonds issued by sovereign states in their own currency then the default risk is extremely low. It was usually assessed as being zero in recent times until Russia managed to default on rouble bonds during a period of chaos (1998).

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