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.