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Wednesday 30 November 2022 by Jessica Rusit Trade opportunities,Commentary

Discounted bonds and improved returns

Lower coupon fixed rate bonds trading below par, while offering an attractive entry point, also provide an improved yield to maturity and income stream. Here we look at the better returns on offer when a lower coupon fixed rate bond is trading at a discount to its face value.

Discounted bonds

At issuance, a fixed coupon bond generally prices at a capital price of $100 (also referred to as par) to its face value and is set at a fixed coupon rate. This locked in rate is expressed as an annualised percentage, which is also the same as the bond’s yield to maturity (YTM) at par. The YTM is the annualised return an investor can expect to receive based on the current price and the coupon of a bond, assuming the investment is held to maturity.

For illustrative purposes, if a new fixed rate issue prices with a 3.00% coupon, then its YTM is typically 3.00% also.

However, once it begins trading in the secondary market, the price can move higher than $100 (referred to as trading at a premium to its face value), or lower than $100 (referred to as trading at a discount to its face value). This is what we refer to as a discounted bond.

As is well known, there is an inverse relationship between the yield and the price of a bond, as illustrated in the chart below. In a rising interest rate environment, yields on fixed coupon bonds rise, while their capital prices fall.

This inverse relationship applies to fixed coupon bonds only. Floating rate notes (FRNs) do not have this interest rate sensitivity as the coupon on these securities resets on a regular basis (usually quarterly), eliminating much of the interest rate risk.

Bonds with longer tenor or maturity are more sensitive to movement in interest rates than shorter dated bonds. This refers to duration, which is a measure of how sensitive a bond’s price is to interest rate changes.

Generally, a lower coupon bond with a longer tenor is more sensitive to interest rate changes compared to a higher coupon bond with a longer tenor. This is because higher coupon bonds return principal more quickly through a higher income stream, than what lower coupon bonds do.

Lower coupon bonds

Fixed income investors seeking income are more likely to prefer higher coupon bonds over lower coupon bonds. However, with the Reserve Bank of Australia (RBA) significantly hiking rates this year, lower coupon bonds offer improved returns as they’re now trading below par.

Being more sensitive to interest rate moves, lower coupon bonds typically trade at a larger discount to their face value compared to higher coupon bonds (all else being equal). Not only does this make for a more attractive entry point, but it also means there is potential for capital upside if held to maturity, improving the bond’s YTM. This provides a boost to the bond’s income stream in due course.

Lower coupon bonds also generate a higher income stream (also referred to as running yield) when purchased below par. The running yield is a function of dividing the bond’s expected annual income stream by its market price. As such a bond’s running yield will be higher than the coupon rate if it’s trading below its par value.

To illustrate the improved returns that lower coupon bonds generate when they’re trading at a discount, we look at the Transurban 2031 bond as an example. This is a fixed rate bond that pays a 3.25% semi-annual coupon and matures in 2031. With the move in rates, the bond is currently trading at $81.73, and as per the Example 2 in the table below, the returns are significantly higher as a result when compared to Example 1 where it was issued at $100 capital price.

Its running yield has increased from 3.25% to 3.97%, providing a higher income stream, and accounting for the capital return at maturity, the YTM has improved from 3.25% to 5.97%. This is a significant increase to its YTM, also considering it has an investment grade credit rating.

For those subscribing to the view that we are very close to the highs in the interest rate cycle, and we may experience a drop over the coming months, this heightened sensitivity to interest rate which has driven a significant price discount in recent months could offer the reverse outcome and deliver an earlier capital upside compared to the option of waiting until maturity of the instrument.