AS most investors may know, bonds are loan instruments issued by corporate entities and governments to raise funds for a variety reasons, including: expansion, working capital requirements, and to pay down debt which may carry higher interest rates.
A “Repo” is an abbreviated term for a repurchase agreement. It is essentially a loan instrument, and operates such that a dealer sells government securities to an investor (who is the lender), and at the same time agrees to repurchase the securities from the investor at a specified price on a future date. That future date is usually short, and in the Jamaican context that could be up to 365 days. Because of the short-term nature of repos as well as the fact that these instruments sometimes have the backing of a sovereign body, the liquidity risk of repos is usually considered very low. And as a corollary, so is the return.Savvy investors, who are seeking better returns, will prefer to invest in bonds instead of repos. This is because bonds generally provide the investor with regular interest income, mainly semi-annually or quarterly, as well as provide prospects of capital appreciation.Here is an example which will help. An investor earning five per cent per annum on a US$100,000 repo will earn US$5,000 in interest at the end of one year (before withholding tax) for a total of US$105,000. Another investor with the same US$100,000 earning five per cent per annum on a bond will also earn US$5,000 in coupon (coupon is the term given to the interest paid on bonds). However, the investor in the bond has the prospect of benefiting from capital appreciation. Let us use the example the Royal Bank of Scotland 9.5 per cent 2022 bond. On May 24, 2012 an investor bought 100,000 face value of the bond at a price of 103.50, amounting to US$103,500. On May 22, 2013 he could sell them at a price of 120.375, receiving US$120,375 for them. This amounts to a capital appreciation of US$16,875. His total return of US$21,875, representing his capital appreciation plus his coupon represents a 21 per cent return as opposed to just five per cent with the repo. One can now very easily see how an investor in bonds is considerably better off than an investor in a repo.The beauty about that bond too, is that the issuer is investment grade rated hence carrying lower levels of credit risk. Speaking of risk, one such risk is that the price of the bond could fall below that which the investor paid for it, and this would result in a capital loss if the investor sells at the lower price. This brings into focus the question of timing, as well as objective, both of which are important considerations in trading securities. A savvy investor seeking high returns will try as much as possible to purchase bonds which have prospects for price appreciation. The bonds mentioned above may not offer the investor the same magnitude of returns if he were to purchase those same securities now at the current prices. However, if the objective were to get a particular level of interest on a regular basis, the investor may be perfectly justified in buying at current prices.Finally, choosing suitable bonds may be too much for investors to do on their own, especially if they are not themselves in the market on a daily basis, and may require the help and advice of a trusted financial advisor, especially someone who is in tune with the daily rigours of the market. A good financial advisor can also show an investor that risk is not something to be feared but rather something to be faced, armed with all the necessary information and strategies. Then the investor will be equipped to invest comfortably in bonds instead of making do with the low returns of repos.Pamela Lewis is VP, Investments and Client Services at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm If an investor bought US$103,000 Royal Bank of Scotland 9.5 per cent 2022 bond on May 24, 2012 he could have sold them on May 22, 2013 at a price of US$120,375. His total return of 21 per cent would far exceed the five per cent he would have earned if he invested in a repo. (PHOTO: AP)View the original article here
Should you invest in bonds rather than repos?
