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Let’s get down to business: You can buy bonds when they’re first made available to purchase - aka ‘issued’ - by a company and hold on to them until maturity. This is the primary market. You can also buy bonds way after they have been issued, from another investor. This is known as buying in the secondary market. You can do this through an online stockbroker.
Primary, secondary…You’ve lost me!
Investors who buy bonds when they’re first released – aka ‘newly issued’ - are the first buyers. These buyers can go on to sell their bonds to other investors creating a pool of buyers and sellers bargaining over the price of bonds. This pool is named the ‘secondary market’, whereas buying at issue is the ‘primary market’. The price of each bond may start at an issue price of £100 but if later buyers are prepared to pay more, the price will go up or, if buyers will only pay less the price will go down.
Come again? How can price change?
There’s a quote for this: ‘Something is only worth what someone is willing to pay for it’. That’s exactly how trading in the financial markets works. Imagine bargaining for a rug in a Moroccan bazaar. If the price tag says £100 but you want to pay £95 and the seller agrees then that’s the price - you buy the rug at a discount. Now imagine a different scenario. When you go to buy the rug an eager tourist comes along willing to pay £104 and you have to offer £105 to secure the deal so you buy it at a premium. Demand, or lack of it, can affect the price of anything.
Talk me through discounted bonds
You can buy a bond at a discount today and when it matures, in 1,2, 5 years, you'll get more for it. That’s because when a bond matures the full issue price is paid back. For example, say you buy a bond for £90 and at its maturity you get £100 back for it, that’s £10 in income. Now imagine you bought 100 of these bonds. You would make £1,000 in income (£10 multiplied by 100).
Why the discount?
We all love a discount but there’s a reason the bond’s price has fallen. It may be because the interest on this bond is not competitive (because interest rates in general have gone up) or it could be that the company or government behind the bond has become less stable, so the price has dropped due to lack of demand. To sum-up, the discount is really a compensation for taking on a less attractive or riskier investment. But, in the end, you’re rewarded.
Is it worth it?
It’s hard to tell from face value. To know if you're getting a good deal or not you need to look at your total return. This is because when you buy a discounted bond you’ll continue to receive regular interest payments plus you’ll get the extra money at maturity.
Luckily, there's a quick way to check this – a magic number called ‘yield to maturity’ (YTM) or simply ‘yield’ is provided with every bond. This shows your average return per year if you hold the bond until maturity. For discounted bonds this number will be higher than the interest paid each year (aka coupon %) because it will add the extra money you receive at maturity.
Buying bonds at a premium…what’s that?
A bond’s price could also be higher than the issue price if there’s demand for it. These are said to be ‘at a premium’. If you buy at a premium, you’ll get less back for the bond at maturity. For example, say you buy a bond for £110 and at maturity you receive £100, you'll have lost £10.
Sounds like a bad deal to me!
It’s not all bad. There’s a reason behind the price increase. It may be because the bond’s interest rate is better than what else is on offer. This can happen when interest rates in the market fall. And, if the company behind the bond is doing well financially that can also drive demand since it’s offering a ‘safer’ investment.
So is it worth paying a premium?
It can be. Paying a premium doesn’t have to lead to a loss overall. The higher interest rate can makevup any money lost at maturity. You need to look at the yield to evaluate your average return each year if you were to hold it until maturity.
Using the yield percentage allows you to compare discounted bonds against bonds at a premium. But which is best to buy?
It sounds like a better deal to buy at a discount but in reality this isn’t always the case. In fact, buying at a premium may get you the better deal because you’re receiving higher interest payments regularly, and, ultimately, putting more money into your pocket sooner. On the other hand, with discounted bonds you have to wait until maturity to receive a slice of your earnings.
BUT, there is a risk to consider with buying bonds at a premium. If the company decides to payback the loan early before the bond’s maturity it means you miss out on the last run of interest payments. This could hugely decrease your overall earnings. Ask your broker about the bonds’ ‘call provisions’, which simply means the payback terms. Ideally you don’t want them to be able to payback at all but it may be a risk you have to take.