PERSONAL FINANCE 101
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Dear Investor Juan,
I'm thinking of investing in one of the listed bonds in the table above, say $50,000 in ROP 13. How much annual interest would I get? Can you please help me understand what the COUPON %, INDICATIVE OFFER PRICE, and INDICATIVE OFFER YIELD % mean?
I would really appreciate it if you can help me out on this.
Thanks,
Harris
Dear Harris,
While in the table you provided we only see US-dollar denominated bonds issued by the Philippine government (ROP = Republic of the Philippines) and a Philippine government-owned and -controlled corporation (GOCC) like PSALM, all of the terms we'll discuss in this post are also applicable to peso-denominated bonds and corporate bonds.
Here are the important terms and features that you need to know about if you're thinking of investing in bonds.
1. Par or face value
- The amount paid by the bond issuer (borrower) to the bond holder (lender or investor) on the bond's maturity date, when the bond expires or is redeemed
- You can think of it as the principal of the debt issue
- The percentage of the par value that is annually paid by the issuer to the bond holder as interest
- A COUPON FREQUENCY of SA (semi-annual) means coupon payments are made every six months.
Coupon payments and the par value constitute the cash flows received by the bond holder in return for buying (or investing in) a bond and holding on to it until maturity. If you buy ROP 13 bonds with a total par value of $50,000, you'll receive coupon payments worth $50,000 x 0.09 x 0.5 = $2,250 every six months until the bond matures in February 15, 2013 (that's four payments) and one payment of $50,000 on that date. In the Philippines, coupon interest is taxed at 20%, so you'll actually just get to take home $2,250 x 0.80 = $1,800 in interest every six months.
3. Price (INDICATIVE OFFER PRICE)
- How much a bond sells for
- Different from the par value
Just like other assets or investments, the price or market value of bonds fluctuate depending on market and macroeconomic forces. Of course, the higher the demand for a particular bond, the more expensive it becomes. Also, changes in interest rates directly affect the price of bonds: increases in interest rates (not to be confused with the coupon rate discussed above, which is fixed) result in lower bond prices, and vice versa.
The bond price is quoted as a percentage of the par value. This means that an ROP 13 bond with a par value of $1,000 and a price of 116.125 is currently selling at $1,000 x 1.16125 = $1,161.25; or, if you plan to buy bonds with a total par value of $50,000, you would have to pay $58,062.50. Because ROP 13 is selling for more than its par value, it is said to be selling at a premium; bonds selling at below par are selling at a discount.
4. Yield to maturity (INDICATIVE OFFER YIELD %)
- The percentage return an investor would earn every year if he or she holds on to the bond up to maturity
Because you would have to pay a higher price than par to invest in the ROP 13 bond, you would only earn around 1.3% per year on your investment (excluding taxes) up to maturity, way lower than the coupon rate of 9% per year. Of course if you're lucky and the bond further increases in price before maturity, you can always sell it at that higher price and earn a higher return, possibly even higher than the coupon.
To illustrate how yield to maturity or YTM is computed, let's take a look at a better example, one whose remaining years to maturity is more whole: say, ROP 17, which has a coupon rate of 9.375% and remaining years to maturity of 6.06 ~ 6 years. An ROP 17 bond with a $1,000 par value would cost $1,345 today (since it has a price of 134.50), and you will get 12 payments of $1,000 x 0.09375 x 0.5 = $46.875 each every six months and the par of $1,000 on the maturity date six years from now.
The negative cash flow in Period 0 (now) indicates a cash outflow from the perspective of the bond holder (you). All future cash flows are inflows.
To get the YTM of the bond, you can use the IRR function of Excel (we multiply by 2 to annualize the YTM).
We see that if you invest in ROP 17 today and you plan to hold on to it until maturity, you will just earn around 3.041% per year (excluding taxes), which is very close to 3.085% quoted in the table (the difference is due to the fact that the bond still has 6.06 years to maturity and not exactly 6 years).
So, that's it. I hope now you have a better idea of how to evaluate bonds. If there's one thing we learned from this, it's that ROP 13 bonds are quite unattractive with a yield of only 1.3% per year, and that, in general, bonds with more years to maturity offer better yields (although historically, that is not always the case).
By the way, before I forget, at issue, bonds are sold at par (price = 100) and the coupon rate equals the YTM. It means the ROP 13 bonds were actually quite attractive when they were issued in 2002, but the price has since increased because of decreasing interest rates.
In a future post, I'll talk about the different risks associated with bonds. I'll keep you posted.
