How can the Bulgarian bonds (which I plan on using for the Bulgarian CIP) guarantee my capital if they sell with large premiums at the moment?
We have received today a very logical and spot-on question from a client in Hong Kong, asking about the particularities of the Bulgarian bonds (and the bond market in general). We have decided to respond publicly, so our other other clients can also get an insight about how their investment in Bulgarian bonds works.
Please find below our client’s question and our answer. The answers is obviously based on the rightful understanding of the client that the investment is 100% safe and guaranteed.
QUESTION: By the way, can you share more info on the mentioned investment which bears zero risk? I found 6 government bonds for Bulgaria which are traded In Luxembourg Stock exchange. For instance the one matured at year 2035 is now traded at the price of 131, with final redemption price at 100.
You are absolutely right about the bonds. They may be selling now at a large premium (31% in your example) and at the same time your capital is still fully guaranteed. So how can that be? The bond, at its issuance has nominal value and fixed interest rate (coupon). Lets assume (purely as example, as we are not aware of the particular ISIN of the bond you are referencing) that the bond that you are referring to has been originally issued with a fixed coupon (annual interest return) of 5%. This means that each year, the owner of the bond will be receiving 5% return (coupon payment), no matter what. Now that the interest rates are much lower, say 1% p.a., this bond has increased in value dramatically, as it will be delivering 5% (instead of the market interest of 1%) until it matures in 2035.
Let’s illustrate this with a simple calculation:
You are now investing 131 EUR and are buying 1 bond unit with nominal (the amount that will be repaid at the maturity) of 100 EUR (we are using 100 EUR base, purely for simplicity, as otherwise bonds are usually issued in larger denominations). So far it looks like you have lost already 31 EUR? Luckily you haven’t. Because, until the bond matures, there are 16 years remaining (2035-2019), during which years, you will receive an interest coupons of 5% on the nominal of 100 EUR, multiplied by 16 years. This means, that at the maturity, you will receive in coupons (100% guaranteed, same as the repayment of the nominal capital), an amount equal to:
5% coupon x 100 EUR nominal x 16 years = 80 EUR
On top of that, you will of course receive the guaranteed 100 EUR nominal capital. So in total, you will get back:
80 EUR from coupons + 100 EUR nominal capital = 180 EUR
Having invested 16 years earlier (today) 131 EUR, you are scoring an annual return (non capitalized) of:
(180 EUR received at maturity - 131 EUR paid at the start) / 16 years = 3,0625% per year.
This is still way more than if you have invested 100 EUR now at 1% per year, in which case, after 16 years, you will receive 116 EUR in total.
As we are not aware for which particular Bulgarian bond you are talking about, the above numbers are only figurative, in order to give you an idea of how the bond market works. Likewise, should the interest rates have declined in the recent years, you would be buying the bonds now with discount (ie for 80 EUR), as they would be paying you out less interest (coupon) than you would be able to receive otherwise.
And of course, should you decide to sell your bond prior to its maturity you will receive its market price, as the current one of 131, rather than the nominal value. Plus you will pocket the high interest the bond will be paying you until you re-sell it. As the remaining time to the maturity shortens, the value of the bond will become closer and closer to its nominal value, as it will reflect the the already paid out coupons.
If you have any other questions, please don’t hesitate to contact us or leave comment below.
Thank you for the good question!