[ad_1]
Instruments like bonds and preference shares are usually attractive to more conservative investors because of their relative ability to hold their value and for the regular income they generate. I am noticing, though, that some interests are seeing preference shares, in particular, as a source of capital gains.
It would seem that this view is emerging because of the fact that, like bonds, the prices of preference shares do fluctuate. If their prices increase, they provide some scope to gain capital when they mature, or even before, if bought at a discount.
Further, an opportunity is also seen to make capital gains if the price of instruments bought at face value rises above that level.
Investors are generally concerned with the total returns, made up of the income portion and the capital portion. If the investment is bought at a discount, the total return is the capital gain plus the income. If it is bought at a premium, the total return is the income portion less the loss of capital.
The informed investor
The informed investor knows the total return to be derived from a fixed-rate bond and preference share at the time the investment is made, whether it is bought at a premium, at a discount, or at par or face value.
In each case, the price at redemption is generally par or the assigned face value, so the investor knows if there will be any gain or loss of capital, or if the capital returned at redemption is the same as that which was invested.
The return on the investment is generally calculated on an annual basis. At the most basic level, the principal gained or lost on an annual basis is added to or subtracted from the annual income – interest in the case of a bond and dividend in the case of a preference share – and the result expressed as a percentage of the sum invested.
Investors who elect to sell before the instruments are redeemed can know their return at the time of sale, considering that they know the market-determined selling price, the cost price, how long they held the instrument and the income earned each year.
When interest rates fall
In cases in which interest rates increase, the price of the fixed-rate bond or preference share tends to fall, but the price rises when interest rates fall.
In cases in which the preference dividend or interest is not fixed, it is not possible to make an accurate determination of the total return of the investment at the time the investment is made as the income portion may change from time to time.
The investor who buys bonds and preference shares at face value generally expects the return of the principal sum invested if they are held to redemption. In such a case, there is no expectation of any capital in addition to the amount invested.
Capital gains should not be seen in isolation from total returns. They are an important part of it. Investors who buy fixed-rate bonds and preference shares in the secondary market should be aware that their expected return includes both the principal sum and capital gain. Their return is fixed when they make the investment.
Variable rate instruments
With respect to variable rate instruments, the basis on which the dividend or interest is calculated can be such that it makes the instrument very attractive, leading to increased demand for it. There will be a higher price and lower return to the new owner.
In such a case, there is an opportunity for investors willing to sell to make capital gains on the instruments but it is not usual for there to be the potential for any significant capital gains on either instrument.
It should also be remembered that the prices of preference shares and bonds inch closer to their face value the nearer they are to the redemption date. In normal circumstances, it is not reasonable to expect meaningful capital returns from either instrument if they are bought close to redemption.
For investors who have no interest in selling before the redemption date of the instruments, or in buying at a discount or premium, changing market conditions do not really matter. On the other hand, investors interested in capitalising on opportunities to make more money tend to pay attention to price fluctuations.
It is not the norm, though, for preference shares and bonds to be meaningful sources of capital gains, particularly when interest rates are stable. Their capital gains potential should not be confused with that of ordinary shares, on which the potential is limitless.
– Oran A. Hall, the author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. Email finviser.jm@gmail.com
[ad_2]
Source link
