What on earth are you talking about?? How can there be a 'secondary market for Fixed Interest?
For investors used to only investing in Term Deposits, this is quite a logical question. However, Term Deposits are a very small part of the 'Fixed Interest' market of investments. With a Term Deposit, you are lending money to your bank/Financial Institution and they are promising to pay you a fixed rate of interest and repay your capital at a date in the future.
However, there are many more 'fixed interest' securities available for more sophisticated investors to use. These investments provide diversification of risk in your portfolio and often enhanced investment returns. But it is important that you understand how these investments work.
I suggest that you read this article with reference to our two other blog articles on Fixed Interest to fully understand this blog article:
When Fixed Interest securities are issued, they are issued to a 'primary market'. For Government Bond, these are with registered Financial Markets participants. For other Local Authority/Corporate/Bank securities, these are often through specific entities. However, once the issue has been made, these securities are available in small blocks for smaller non wholesale investors to purchase and sell.
It is important to understand that this is a continual market. That is, the securities are valued continuously. As a result the 'Value' of your security is unlikely to stay the same as when you purchased it. This is different to how Term Deposits work.
When a Fixed Interest security is issued, it is issued at its 'Face Value'. This is commonly in a $5,000 or $10,000 amount. If an investor purchases this security when it is issued and 'holds it to maturity', then the investor will get all the 'coupon payments' and the Face Value returned during that time period.
However, if an investor purchases the security on the secondary market (the New Zealand Debt Exchange or NZDX ) you pay the 'purchase price'. This can be higher or lower or the same as the Face Value. The amount that you will pay is determined by market demand and will be affected by 1. The time to maturity on the security, 2. The coupon rate versus current interest rates, 3. They Type of Security, 3. The Credit Rating of the offering.
An example to try and illustrate
If you were to purchase a $5,000 Face Value security in Fonterra Co-operative Group at present, the code is FCG020. This has an A+ rating and is Senior Ranked Debt.
The 'coupon rate' is 6.83% for this security which matures on 4th March 2016. Therefore, if you purchased one security, the interest that you would get paid (in 2 instalments during the year) would be 6.83% of the face value of $5,000. Thus, your interest payments before tax would be $341.50 pa, or each instalment would be $170.75.
But, as interest rates in general are much lower than 6.83%, to purchase this income stream, you have to pay a price that adjusts the income so that it reflects the current market interest rates for a security with this credit rating and time to maturity.
The market has determined that the 'yield' on this security is 4.20%. That is higher than current cash rates and term deposit rates. To get this 'yield' - or 'income to maturity' you pay a purchase price that is higher than the 'face value of $5,000.'.
Therefore, the price that you pay will be $5,398.00. If you 'hold this security to maturity', this means that you will get the $5,000 at maturity, and a 'yield' or return of 4.20% between now and then. Clearly, the extra $398 that you have paid over and above the face value of $5,000 is used to 'purchase the extra income stream.'
You will also have to pay stockbrokers commission on the purchase - which ranges from 0.40% to 1.5% or 2.0% depending on the arrangements that you have in place. This commission needs to be taken into account in the calculation of the value to you of having this investment in your portfolio.
When you are building up a portfolio of direct bonds, it is important to have diversification of issuer, maturity, yield and credit risk. This is why in general, at Moneyworks, we use Fund Managers who have well diversified portfolios for our clients.
The investment recommendations for our clients are continually being reviewed based on their goals and objectives, and the economic and investment environment. If you would like more information on Moneyworks Financial Planning and Investment Advice services, please contact us on email@example.com.
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For more blog entries that you might be interested in:
By Carey Church