Bonds and preference shares for income, safety of principal
Question: I read your column published in The Gleaner yesterday, and I must say that it was quite enlightening as it answered some of the questions that I had regarding investing in stocks. I currently have savings that I would like to invest but would like to protect my capital. I am considering a long-term type of investment. Could you explain fixed-rate bonds and preference shares in terms of how much I could yield from these types of investments?
Also, I would like advice regarding which financial institution to conduct business with as there are so many and I would prefer to conduct business with one that is reliable and affordable - Samantha
OH: It is reasonable to use bonds and preference shares to meet the safety of principal investment objective because the investor's principal is generally returned at the redemption date.
Bonds are debt instruments. They are certificates that are evidence that the issuer has borrowed a stated sum from the lender, that the borrower will pay interest at a stated rate and on set dates and will repay the principal on a stated date, described as the maturity date.
Bondholders are entitled to the payment of interest before preference shareholders and ordinary shareholders receive dividends and to return principal before those shareholders in the event of the liquidation of the issuing company.
The interest on a fixed-rate bond holds for the full term of the instrument and is calculated on the face value of the instrument. For example, a bond bearing an interest rate of 10 per cent per annum pays $10 per $100 - the face value, or par value, of the instrument - from the time it is issued to the time it matures. This applies even if the price of the bond is above or below the face value.
Bond prices rise above or fall below par value because they trade at a price that allows investors who buy them from other bondholders, rather than from the issuer when they are first issued, to derive a return that is in line with market rates at the time the new owner is buying the bonds.
Preference shares are similar to bonds in some ways and similar to ordinary stocks in others. Although they rank above ordinary shares in the payment of dividends and above them in return of principal in the event of liquidation, they rank below bonds.
Dividends are paid at a fixed rate at pre-determined dates, and principal is returned to the shareholders if the shares are redeemable. There are some preference shares that are issued in perpetuity as are ordinary shares.
The directors of the company determine if dividends are paid, similar to the case of ordinary shares. There are some preference shares that have a cumulative feature whereby dividends not paid in one year accumulate and are paid in subsequent years.
Like bonds, the prices of preference shares are influenced by changes in interest rates in the financial market. Their price generally increases when interest rates decrease and decreases when interest rates increase.
The situation is different with convertible preference shares - preference shares that are convertible to ordinary shares at a set ratio. In this case, the price of the ordinary shares has a strong bearing on the price of the preference shares.
The Benchmark Investment Note is the primary government-issued bond, but there are far fewer issues than the Local Registered Stock, which it replaced after the National Debt Exchange (NDX). The amount of corporate bonds on the local market is negligible, and the market for preference shares is also small.
The dividend rates on the listed preference shares range from about 7 per cent to about 9 per cent, but the last trade prices on the Jamaica Stock Exchange are generally above the issue price of the shares primarily because of the decline of interest rates in the market. Thus, yields are generally below 7 per cent at the lower end and 9 per cent at the upper end.
Unlike the preference shares now on the market, most of which are to be redeemed five years after being issued, some government bond issues have long maturities. I identified one maturing in 2048.
The Benchmark Investment Notes I have identified bear coupons ranging from 5.50 per cent to 7.25 per cent, but recent sales by the Ministry of Finance, by tender, of Notes it had previously issued, have been at prices giving investors returns of 3.52 per cent for an instrument maturing in 2021 and 7.09 per cent for an instrument maturing in 2048.
I am sorry, but I am not able to recommend financial service providers through this column or privately. I suggest that you seek guidance from experienced investors with whom you may be acquainted.
- Oran A. Hall, the principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. Email email@example.com