Doug Drabik discusses fixed-income market conditions and offers insight for bond investors.
For many investors, fixed income is the core of their investment portfolio with the primary purpose to protect the principal. The secondary benefits and objectives are to maximize income and cash flow. Several, features of individual bonds come up in discussions where comprehension and confusion can influence an investor’s assessment.
Unrealized loss: Interest rates change in a dynamic manner. Since most fixed-income coupons are static, market prices change congruently with fluctuating interest rates. As interest rates rise, market prices fall and conversely as interest rates fall, market prices rise. These varying market prices can create unrealized losses or unrealized gains. This simply means that if an investor chooses to sell at that moment, the loss or gain becomes realized at that point in time. Since many investors buy and hold to maturity, these unrealized losses or gains over the holding period, in essence, do not impact an investor. As an individual bond closes in on its maturity, the price gravitates to par ($100). It is noteworthy that when individual bonds held to maturity (barring default) will consistently produce the known cash flow and the known income the entire holding period regardless of what interest rates (and market price) do over the holding period.
Premium bonds: If you are pricing a car of identical make, model, and features through several dealerships, price is the sole determining factor to consider. But what if the same make and model comes with different engines, tires, or sound systems? Now price and features become considerations and prices may vary. An individual bond’s worth is not determined by price alone. Individual bond features altogether will determine worth. A discount bond (a bond priced below par) is not necessarily a better purchase than a premium bond (a bond priced above par). A 1.0% coupon discount bond with a yield of 1.5% is not as valuable as a premium bond with a 5.0% coupon and a yield of 4.0%. Whether an individual bond is priced at a premium, par or discount depends partly on its coupon, creditworthiness, and maturity. Premiums are not lost even though individual bonds gravitate to par as they approach maturity. The premium is returned back to an investor through above-market cash flow payments (higher coupons) throughout the bond’s holding period. All the dollars invested are working for the investor throughout the entire holding period.
An exact same dollar investment in a discount bond and a premium bond with identical yields, all other factors equal with flat interest rates, will produce the same results from purchase through maturity. The discount bond will produce lower levels of cash flow with a bigger lump sum at maturity whereas a premium bond will produce higher cash flow with less of a lump sum at maturity. However, the identical amount invested would net the same result to maturity.
Cash flow and income: These terms do not mean the same thing. Cash flow is the outcome of a bond’s coupon. Higher coupons create higher cash flows and conversely, lower coupons create less cash flow. Cash flow can be comprised of the return of part of the initial investment as well as income or any combination of the two. Income (yield) is what an investor’s bond produces above the principal invested over a range of time.