We all know that the price of bonds has an inverse relationship to the movement of interest rates. When interest rates goes down, the price of bonds goes up, and vice versa. The longer the duration of the bond, the greater this effect will be.
Therefore, we have seen a bit of a rally in some bond prices for the last few months when interest rates were being cut.
Some bond prices, on the other hand, actually went down. Why is this so?
This is because there is another factor that affects the price of bonds – the default risk of the entity issuing the bond. This effect is negligible for sound government bonds but plays a greater role in the case of corporate bonds.
Since the collapse of Lehman Brothers and the downturn of the economy, there is a greater perceived risk of defaults for corporate bonds. With a lack of buyers, this has lead to a fall in the prices of many corporate bonds despite the falling interest rates.
This means that anyone who buys these bonds and successfully holds them to maturity (without the issuing going bankrupt) would be able to gain from capital appreciation on top of the coupon payouts.
Of course, the hard work lies in finding and identifying suitable bonds to invest in. It might not be possible to eliminate 100% of the risks.
However, there is one group of people who can invest in corporate bonds with certainty. They are the bond issuers themselves! They can literally buyback their own bonds at a discount to the face value and cancel off their debt.
Recently, there are more of such bond buybacks taking place (for those companies with spare cash).
In a series of annoucements to SGX, we can see that ICICI BANK UK PLC has been buying back their bonds on half a dozen occassions during the last three months.
We also had Olam International offering to buy back their convertible bonds. With the price of Olam shares having dropped by quite a bit, the convertible option of their bonds has become of not much use. Olam was able to buy back some of their recently issued convertibles at 65% of their face value.
This works out to be a cool gain of about $40 million.