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Introduction to fixed interest instruments

Introduction to fixed interest instruments

Executive Summary

After completing this "nice-to-know" chapter, the investor will understand what fixed interest instruments are; what primary issues are; how transferability and secondary markets work and what bonds offer to the investor.

Government and semi-government bonds

Bonds are long-term fixed-interest securities issued by the central government or a lower-ranking public body. Bonds are also referred to as government bonds, government securities, government stock, or BOND-edged bonds and semi-BOND-edged bonds or semi-BONDS when related to the stock of lower ranking public bodies (e.g. Eskom, Transnet, Telkom, Development Bank etc.).

These marketable certificates of loans are issued by the government or a lower public body for the purposes of:

  • Repaying maturing debt,
  • Regulating monetary conditions; and
  • Financing expenditure.

Thus, the outstanding marketable stock debt of the central government represents to a large degree the borrowing requirements of the central government. This amount has grown from R1,3billion in 1954 to R2,6 billion in 1965, doubled again in the following 7 years to 1972, and trebled from that year to a figure of R16,3 billion at the end of 1981. A major increase took place during the eighties to an excess of R70- billion at the end of 1989, and at the end of 1993 the amount in issue was recorded at R160-billion.

Primary issues

Bonds are issued by the Treasury in terms of the Exchequer and Audit Act 66 of 1975. There are various ways in which the Treasury may issue Bonds.

  • Issues at predetermined prices by public notice in the Government Gazette and the details published in a prospectus.
  • Issues by the Treasury, via the Reserve Bank, through the invitation of tenders for given amounts of stock.
  • Issues by the Reserve Bank on behalf of the Treasury on a "tap" basis - the Reserve Bank invites bids from market participants who are informed of the Reserve Bank's intention to issue stocks.

Demand for primary issues is generally from the dealing banks, insurance companies, pension funds, mining houses, stockbrokers and the Public Investment Commissioners. The rates at which bonds are issued are thus determined by market participants. The Reserve Bank, however, reserves the right to accept or reject bids made for stock on 'tap'. As mentioned bonds are fixed interest securities - when they are issued the borrower promises to pay the holder a specific interest rate on the bonds he holds. This is termed the "coupon rate": the bonds pays. Such interest is paid biannually, usually on the anniversary of the date of issue of the bond and 6 months thereafter. Bonds are fixed-period loans and thus not redeemable early. In short, they are only redeemable when they reach their "maturity date", such date being set at the time of issue. Bonds are issued for various terms ranging from 1 year to 25 years.

Bonds are categorised into two types:

  • Short-term" or "Liquid-Asset Stocks" with an outstanding maturity not exceeding three years.
  • "Long term stocks" with a maturity exceeding three years.

Of the total nominal value of stocks outstanding, 20% were short-term and 80% long-term at the end of 1993. In the short-term area the largest holders were the insurers (33%), banks (27%) and Public Investment Commissioners (7%). Of long term stocks the largest holders were the Public Investment Commissioners (50%), and the insurers and pension funds (20%), with banks only holding 3%. Short-term bonds may be held by banks to satisfy their liquidity requirements. The "face value" of the bond is termed its "nominal value" and represents the amount accruing to the holder of the security on the maturity date. Bonds are available in any denomination. The smallest denomination of a bond is one rand unit. This unit may not cost the investor R1 but on maturity of the bond, the borrower will repay R1 per unit. Because of the nature of investors and issuers in the bond market, bonds are generally issued in multiples of one million units. Thus when a price is quoted on the market it is for a minimum of one million rand units. Any deal in quantities of less than one million units are referred to as "odd lots" and such deals generally involve greater dealing costs.

Bonds are issued in the names of the investors or lenders and a register is kept by the Treasury for this purpose. Issues and transfers of government stock are exempted from stamp duty. A standard two week settlement period is used in the bond market. In other words, there is generally a two week lapse between the contract date and the settlement date. Thus it is not really a spot market but rather a forward market.

Transferability and secondary markets

There is an active secondary market for bonds. The main parties involved are the banks, insurance companies, pension funds and stockbrokers. The Reserve Bank plays a particularly active role, as both buyer and seller. Turnover figures on government stock are produced by the Bond Market Association. Secondary market activities were some R60 billion a month during 1993 having grown from R5 billion a month four years previously.

Bonds are transferable by means of a duly completed deed of transfer (form CM42). The transfer deed, together with the certificate must be lodged with the Treasury where the register of holders is kept. In addition, bonds may be split into any denominations, provided a surrender of the certificate to be split accompanies the duly completed transfer form.

The price of bonds in the secondary market is based on the bond current yield" or "yield to maturity". The yield to maturity is the current trading value or market interest rate of the bond based. This value is useful for two reasons:

  • The values of the yield to maturity of similar bonds can be compared.
  • The yield to maturity forms the basis of the calculation of the market value of the bond. It is used to discount future cash flows of bonds plus capital redemption value to obtain the present value at which the bond is trading.

The present value of a bond is established first by calculating its "all-in price", which consists of two component parts:

  • The "clean price" of the bond. The clean price represents the present value of the future interest receipts and redemption proceeds discounted by the yield to maturity. The clean price is quoted in a rand price per cent i.e. represents the amount which the buyer has to pay for each nominal unit of stock.
  • Between the time of the previous interest payment and the settlement date, the seller has earned interest on the bond. In other words, the seller is owed this interest by the buyer who will actually receive this interest as party of the full interest payment, which he will receive at the next coupon date. This interest is referred to as "accrued interest" and included in the settlement price.

Accrued interest is calculated according to the following formula: c x d/365 Where c = coupon rate percent per annum d = no. of days from last interest date to settlement date.

The all in price is equal to the clean price plus the accrued interest: All-in-price = clean price + accrued interest.

However, it is important to note that the register is closed one month prior to the dates on which six-monthly interest is payable. In other words, it is stock transacted during this period (termed "ex interest"), the coupon interest is paid to the registered holder of the stock (i.e. the seller), and not to the buyer on the coupon date. Clearly this must come into consideration when calculating the settlement value. In this instance, the accrued interest is calculated in terms of the following formula: C x d/365 Where: C =coupon rate percent per annum D = no. of days from settlement date to next interest.

In such instances, the "all-in price" is calculated by subtracting the accrued interest from the clean price. All-in-price = clean price - accrued interest.

The actual "consideration" would then be calculated according to the following formula: Consideration = nominal amount x (clean price + accrued interest) /100 (Consideration = nominal amount x all-in price/100) Or if the transaction takes place within one month of the next coupon date and register has already been closed: Consideration = nominal amount x (clean price - accrued interest)/100 (Consideration = nominal amount x all-in price/100)

Investors also like to be able to establish what the return per annum is that they will get on their investment in bonds.

The "cash yield" represents the per annum rate of return on money invested in the bond, if the bond is retained to maturity, taking into account the fact that interest rates will continually change throughout the life of the bond. The cash yield is calculated using the following formula: Cash Yield = (coupon rate/clean price) x 100

Let us now examine how we actually calculate these values by looking at a practical example.

Example:

Stock: 9.5% 2005

Interest dates: 15 May and 15 November

Maturity date: 15 May 2005

Nominal amount: R1 000 000

Yield to maturity: 17%

Contract date: 8 June 1994

Settlement date: 16 June 1994

The clean price would be R61.21 Accrued interest = 9.5% x 32/365 = R0.83 (There were thirty two days between 15 May 1994 and 16 June 1994)

The all-in-price would be 61.21 + 0.83 = 62.04

The consideration would be determined as follows:

Consideration = nominal account x (clean price + accrued interest)/100 = R1 000 000 x (61.21 + 0.83)/100 = R620 400.00 The cash yield = (9.5/61.21) x 100 = 18.52

Now let us alter the settlement date. Suppose the bonds were transacted for settlement on 27 October. This is within one month of the next coupon date, namely 15 November, and thus the register would be closed.

The clean price would be R61.60 Accrued interest = 9.5% x 19/365 = R0.49 (Note there are 19 days from 27 October to 15 November)

The all-in-price would be 61.21 + 0.49 = 61.70

The consideration would be determined as follows:

Consideration = nominal account x (clean price + accrued interest)/100 = R1 000 000 x (61.70)/100 = R617 000.00

What do they offer the investor?

Government bonds are termed "GILTS" because of the high degree of security they offer, interest and capital redemption being guaranteed by the government. Another safety aspect, common to all fixed-interest securities is advanced determination of the amount of interest which you will earn if kept until redemption, the yield is the same as the coupon rate. Government bonds are, however, not entirely risk free. As interest rates rise, so the capital value of a bond decreases. This is because an investor is able to get a higher income for the same capital investment than he could be buying that bond, which will yield a lower rate of return than that available on the open market.

For example if you invested R100 000 in a stock yielding 14% and the benchmark rate for that class of security rises to 15% it is clear that nobody will be prepared to pay R100 000 for an investment giving an interest of R14 000 per annum, when they could get R15000.

Of course the converse is also true in that if interest rates were to fall, you would be sitting with a healthy capital gain as investors would be prepared to pay more than the coupon rate for a higher-yielding investment. In general, the lower the coupon rate the more price sensitive the bond will be. There are two categories of factors influencing interest rate movements, namely macro-economic factors and other factors.

Macro-economic factors, such as inflation, monetary reserves, government borrowing, world interest rates, etc., will all have an impact on interest rates, as will other factors such as business confidence, political stability, etc. Another important consideration is the fact that all interest earned from bond is fully taxable.

For example if inflation is running at 10% and the net after-tax return on your bond is 8%, the buying power of your investment is shrinking at a rate of 2% per annum.

Corporate bonds

Although most companies have no alternative than to use a bank for lending money, larger companies are able to issue their own bonds directly to lenders. The advantage for a company is normally a lower interest rate and the lender normally receives a higher rate than would have been possible from a bank deposit.

By default the bonds usually carry more risk than government bonds. It is, however possible that very large and financially sound companies are given a top credit rating in which case their bonds might actually be less risky than those of some economically weak governments. When a company pledges certain specific assets against the bond it means it is a secured bond. This type of bond will be less risky than an unsecured bond.

Most bonds are fixed-rate bonds, where the interest rate remains constant throughout the life of the bond.

Other types of bonds include:

  • Perpetual bonds - no fixed date of repayment, with a higher flat yield.
  • Floating rate notes (FRN's) - interest rate is not fixed, but changed regularly to reflect the current market interest rates.
  • Zero Coupon Bonds - no interest is received, but will be redeemed at a profit.
  • Inflation Indexed bonds, in which the principle is indexed to inflation.
  • Convertible bonds are those that can be converted into some other kind of securities, usually common stock in the corporation that issued the bonds.
  • Subordinated bonds are those that have a lower priority than other debts of the issuing corporation, so if there is not enough money to pay all the company's debts, the senior (higher-priority) bonds are paid first, and the subordinate bonds are paid out of what money, if any, is left.
  • High-yield bonds (with a correspondingly high risk) are sometimes known as junk bonds.
  • A mortgage is a bond secured by real estate.

Another term for corporate bonds is debentures.

Conclusion

While most people feel that they know what money is, most would admit that they are not too sure about fixed interest instruments or the market. The bond market is just another financial institution and financial instrument, and therefore it is important to understand where they fit into the financial world.

On the whole, the bond market is the province of the large financial institutions, requiring extremely large investments. It is therefore closed to the private investor. It is nevertheless important to understand the workings of the financial markets in general, as they have a dramatic influence on the share market.

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