Deferred coupon bonds, watch out for the effective yield

With interest rates at their peak and the European Central Bank having started its cuts, bonds offering coupons much higher than the cost of money are a powerful lure for savers.

At this time, there are several companies offering issues with maturities of more than ten years and which give very attractive coupons. One of the most recent is that of Barclays placed in April, which matures in 2044 and has a face rate of 9.5%. The coupon payment, however, is not periodic (neither semi-annually nor annually), but is made in a lump sum upon redemption of the bond, which can be at 20-year maturity or even earlier, given that the bond in question (like many very long-term debt securities) is callable, i.e. callable by the issuer before maturity.

In the table below, besides the Barclays bond, there are two others with similar characteristics: one from Société Generale and one from Unicredit. The former matures in August 2038 and has a coupon of 6.5%; the Unicredit bond matures in November 2036 and has a coupon of 6.3%. In the illustration, the three bonds are compared with bonds with the same maturity, but which pay interest as they mature (among them a Btp and other corporate issues) and which have a much lower coupon, more than halved. However, the comparison shows that the actual net return at the end of the investment differs little.

The explanation lies in the fact that a facial return paid only at the end of the investment is inclusive of the automatic reinvestment of coupons: in absolute terms, that return calculated on the nominal value of the investment is, in reality, the result of more capital employed. For example, a return of 9.5 per cent per annum on 1,000 euros invested for 10 years should generate a periodic flow of 95 euros per year for a total of 950 euros received. However, if the coupon payment only takes place in 10 years, the yield drops to 4.5%, taking into account that the interest has been automatically reinvested and that, therefore, the gain relates to a larger capital: in the first year the investor invests EUR 1,000, but in the second year EUR 1,095, in the third year EUR 1,190, and so on.

Thus, the investor who thinks of renouncing annual coupons in exchange for a much higher rate than the market rate must bear in mind that his renunciation has a value that decreases as the duration of the bond lengthens. The hypothesis of early redemption, on the other hand, cannot be quantified. In addition, it is not certain that a sale of the bond on the market before maturity would be at par, because the absence of flows would have an important weight on the price.