If you are new to buying bonds, we have prepared a short guide to the practicalities of dealing in, and owning these instruments.
First….. select and identify your bond.
Once you have determined which bond or bonds to buy according to appropriate criteria of maturity, credit quality and yield (see Types of Bonds for more on this subject), it is important to correctly identify the security to prevent errors in dealing or other misunderstandings. When dealing in equities this process is usually fairly easy, and most equities will only have one class of share, and one ticker. Not so bonds, and each issuer may have several bonds trading in the market at any given time. Market convention describes bonds in the following notation: Issuer, coupon, maturity. Thus, the Tesco bond illustrated below would be described as the “Tesco five point five percent 13th December 2019”.
|GBP||Tesco Plc||5.5%||13 Dec 2019||9.75yrs||105.5||4.72%|
What will the final cost be?
The price that you see on the screen will typically be around 100, perhaps ranging in the 80 to 120 area. This price is expressed as a percentage of the nominal value (i.e. the redemption value) of the bond. This is known as the “clean” price of the bonds and on this basis an investor buying £10,000 of bonds at a price of 99.30 will pay £9,930. However, we must also consider the factor of any accrued interest (see below).
What is accrued interest? If an investor buys a bond on its first day of issue, or just after the last coupon payment, the price seen on the screen will be the full price. However, when buying a bond half way through its coupon period (for instance 6 months after the last coupon payment for an annual bond), there will be an adjustment for the income that has “accrued” to the bond. This is standard practice in the bond market and strikes a fair balance between buyers and sellers, as well as neatly differentiating between cash flows from income and those from capital gains.
With the majority of non-gilt bonds, the basis of this accrued interest is calculated on a “30/360” basis. This assumes that each month has 30 days, and each year has 360 days. Thus, let us assume that we are buying £10,000 nominal of the Tesco 6% 13 June 2008 as of today’s date (12th December 2007). The market price is 99.80 and the trade is for settlement in three days time
£10,000 nominal of Tesco 5.5% 13 Dec 2019 @ 105.5 = £10,550
The settlement date is the 12th March 2010. Thus, we have to calculate how much accrued interest that we should reimburse the seller for. The bond pays a coupon annually and the last payment was the 13th Dec 2009.
Period 13 Dec through to 12 March = Total 89 days on a 30/360 basis.
So, the accrued interest will equal 29/360 days times the annual coupon, times £10,000 nominal, or:
30/360 x 5.5/100 x £10,000 = £44
Thus, our contract note will show roughly the following:
£10,000 nominal of Tesco 5.5% Dec 2019 bonds @ 99.80 = £10,550
Accrued interest = £44
Commission = £25
Total = £10,619
Note: The price shown on the screen will not include accrued interest and will be known as the “clean price”. The effective price that you pay, including any accrued is known as the “dirty price”.
Accrued interest for gilts
The Debt Management office produces a detailed document on calculating the accrued interest on gilts which can be downloaded in pdf form by clicking here. This covers the subject in some detail, including the more complex calculations performed on index linked gilts.
At the risk of oversimplifying the subject, the main variations from the calculation process shown above are as follows:
1) Most gilts pay coupons twice a year (the majority of non gilts pay annual coupons). The exceptions to this rule are some of the undated bonds such as 2.5% Consuls.
2) The accrued interest is calculated on “actual/actual” basis, where the true number of calendar days is used to determine the apportionment of the dividend.
Selling your bonds
The best strategy for investing in bonds is typically that of “buy and hold”. Remember, unlike equities there is no need to sell in order to realise your investment; capital will be returned to you on maturity.
However, from time to time all investors will need to sell a bond in order to raise capital, or perhaps in order to switch into some more tempting investment opportunities elsewhere. In the event of this, bonds can be sold back into the market. Please note that this market price may be higher or lower than your purchase price and may impact the return that you receive on the investment.
When selling a bond, the accrued interest must also be factored into the calculation. In this case, any unpaid interest will be paid over from the new buyer to the seller, effectively the reverse of the scenario illustrated above.