What makes bonds different

The securities which trade on the Jamaica Stock Exchange, equities, bonds and preference shares, though providing some form of income for investors and having similar characteristics, have their own unique features.

Ordinary stock, also called equities, form the capital stock of a company, but bonds are debt instruments. Ordinary shareholders are the owners of a company, which gives them the right to vote and a say in the important decisions of the company. Preference shareholders generally do not have that right. There are, however, cases when it may be extended to them, for example, when a stated number of dividend payments is in arrears and when consideration is being given to the creation of funded debt, or to create preference shares senior to, or of equivalent rank to existing preference shares. That is not a right that bondholders have.

Although investors in equities, bonds, and preference shares derive income from their investment, the form is different. Shareholders receive dividends, which come out of the profits of a company. Whether they receive a dividend or not depends on the company making a profit. Even then, the directors, who ultimately make the recommendation, may chose not to recommend one for any of several reasons, for example, the company needing funds for expansion. Dividends are not guaranteed and have to be approved by the shareholders.

Similarly, preference shareholders are not guaranteed a dividend, except they are cumulative preference shareholders. In this case, they are entitled to be paid any dividends in arrears before dividends are paid to ordinary shareholders, or before the preference shares are redeemed, if they are redeemable preference shares.

Bonds pay interest, not dividends, and a company is obligated to pay interest on its debt, such interest being treated as an expense of doing business for tax purposes. A company that does not pay interest on its bonds has defaulted. It also defaults when it does not repay the principal sum borrowed. Although there are generally remedies to address such a situation, it is possible for investors to suffer significant loss.

The interest on a bond is often a stated percentage rate, say 10 per cent of the face value of the bond, payable over its life, but some bonds pay a variable rate of interest, in that the interest is a stated rate above a specified market-determined rate. For example, the rate on a bond could be the equivalent of the weighted average yield of the 180-day treasury bill issued before the interest payment date of the bond, plus 3.0 per cent. In the case of preference shares, dividends are at a fixed percentage rate or a fixed sum, but dividends on ordinary shares, when declared, are not pre-determined. Thus, they change all the time, often growing significantly as profits increase, although sometimes none may be paid.

The price of a bond on the secondary market is strongly influenced by changes in interest rates. It moves in the opposite direction to the interest rate change. For example, bond prices generally fall when interest rates increase to allow investors to derive a yield which is reflective of the yield on new instruments of a similar term to maturity. The opposite happens when interest rates fall. Demand and supply also play in a part in the movement of bond prices.

Although the same is generally true for preference shares, the price of a particular type – convertible preference shares – is influenced by the price of the ordinary shares to which the preference shares are convertible. The price of ordinary shares, on the other hand, is driven by the current and projected future profitability of the company, which influences the demand for and supply of the stock. Nonetheless, the state of the market overall plays an important part in determining how prices move.

The holders of debt instruments have more protection than the holders of preference shares and equities. Secured debt instruments, are described as senior bonds. Such debt is secured by specific assets of the issuer, which may be liquidated to pay investors. So-called ‘unsecured bonds’ are subordinated debt and are not backed by assets. In the event of the liquidation of a company, secured debt holders rank first for repayment, followed by unsecured debt holders, followed by preference shareholders and ordinary shareholders.

Bonds and other debt instruments have a maturity date. Preference shares tend not to, unless they are redeemable preference shares, which seem to be growing in popularity. Ordinary shares, in contrast, are issued in perpetuity.

There is a designated period before the payment of a preference and ordinary dividend when the securities trade ex-dividend, meaning that the buyer does not get the dividend. The seller does. The buyer gets the dividend but the seller does not when the trade occurs before the ex-dividend date, when the security trades ‘cum dividend’, that is, with dividend.

The situation with bonds differs. The buyer of a bond pays the interest which accrued from the last interest payment date to the date of the purchase. The new owner gets the full interest for the next interest payment period when it becomes due, and is effectively refunded the sum paid at the purchase date. That makes everybody happy. Both buyer and seller receive interest for the time that they own the security. Thereafter, the new owner receives interest for each full interest period – quarterly or half-yearly, as the case may be.

The quantity of ordinary shares and preferred shares is expressed as units. Bonds are stated in dollars. The price of shares is a unit price, so, at a price of $90, the value of 1000 units of ordinary shares or preference shares is $90,000. By contrast, the value of a bond having a face value of $1,000 at a price of $90 is $900, not $90,000. The $90 price of the bond is the price for every $100 of the bond. In this case, the bond is priced at a discount as it is worth only 90 per cent of its face value. A bond with a price of $110 – a premium – would be worth $1,100 and one having a price of $100 would be worth $1,000.

Bonds are debt instruments, making them different from ordinary shares and preference shares in the type of income they generate, their obligation to pay income, their claim to assets in the event of bankruptcy, how their value is computed, voting rights, and their lifespan.

Oran A. Hall, 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