In essence, bonds are structured to deliver profits to investors. Investors receive a coupon when they hold onto a bond which corresponds to a level of yield (or interest) on the bond principal (or face value). These coupons form the main contribution to a bond investor’s return, which means investors should pay close attention to the yield of a bond when making an investment decision. In the absence of big changes in interest rates or a significant deterioration or improvement in a company’s fundamentals, the yield at which a bond is purchased is a fairly good approximation of the return an investor will receive. The fixed nature of coupons from bonds means that an investor who holds a bond to maturity will even be able to calculate in advance his total profit upon maturity of the bond!
Potential capital appreciation
Instead of holding a bond to maturity, investors may also choose to sell their bonds to other investors in the secondary market. This is similar to the stock market, where stocks change hands at prices agreed upon by both the buyer and the seller. An investor who does so can benefit from potential capital appreciation if the yield on the bond declines, resulting in a corresponding increase in the bond price. As such, the bond investor may not have to wait for a bond to mature to profit from the investment.
Conversely, if bond yields rise, there could be mark-to-market losses – an investor who wishes to sell the bond in the secondary market prior to maturity could face losses on the bond. However, as opposed to the stock investor, the bond investor has the option of waiting for the bond to mature to avoid realising mark-to-market losses.
The Research Team is part of iFAST Financial Pte Ltd.