I don't get this one bond question.....

[snakesnake]

I ran into this question in the CFAI materials and the answer doesn’t make sense to me:
Q: A buy and hold investor purchases a fixed rate bond at a discount and holds it until it matures. Which of the following is least likely to contribute to the investor’s total return over the investment horizon?
1. Reinvestment of coupon payments
2. Capital gain
3. Principal payment
The answer in the back is ‘Capital gain’ but why is there no capital gain total return? If you buy the bond at say 95 and then its redeemed for 100, that is a capital gain, is it not?

 

[cpk123]

capital gain occurs when the position is SOLD - but this is a buy and hold - so selling never arises.

 

[snakesnake]

cpk123 wrote:
capital gain occurs when the position is SOLD - but this is a buy and hold - so selling never arises.

So buying a bond at a discount and then holding it till it is redeemed does NOT count as a capital gain?
I thought that under IFRS as you would be booking an increase in value on a held to maturity investment then a gain does arise in the accounts. Not true?

 

[breadmaker]

If the bond is HTM, you have to use the effective interest method. In essence, the coupon interest and amortization of discount are counted as interest income.

 

[S2000magician]

You should have a capital gain for the difference between the par value and the purchase price.
What I don’t understand is what the distinction is that they’re making between the capital gain and the principal payment. And how they can be sure that the capital gain is less than the reinvestment of coupon payments.
It seems quite weird.
Have you written to CFA Institute to ask them about it?

 

[snakesnake]

breadmaker wrote:
If the bond is HTM, you have to use the effective interest method. In essence, the coupon interest and amortization of discount are counted as interest income.

D’oh! Of course. I can’t believe that just a week ago I sat a chartered accountacy exam where this very thing was on the syllabus…..
Though that’s just the accounting treatment. From a cashflow perspective you do have both cashflows from the coupon as well as the increase in the value of the asset you purchased.

S2000magician wrote:
You should have a capital gain for the difference between the par value and the purchase price.
What I don’t understand is what the distinction is that they’re making between the capital gain and the principal payment. And how they can be sure that the capital gain is less than the reinvestment of coupon payments.
It seems quite weird.
Have you written to CFA Institute to ask them about it?

Well it’s just one question, I’m not going to delve that deeply into it. Just not worth the time/effort.

 

[cpk123]

two things they state

Quote:
buys bond at a discount and holds it until it matures

discount bond ensures that the price paid for bond is less than par.
he is therefore not going to have a capital gain when he buys the bond. and if he holds it till maturity - which means he is not selling the bond - there is no capital gains then.
reivestment of coupon payments - would happen. (irrespective of type of bond par, discount or premium).
principal repayment too will happen. so the other two choices are eliminated.
Am I missing something here?

 

[S2000magician]

cpk123 wrote:two things they state

Quote:buys bond at a discount and holds it until it matures

discount bond ensures that the price paid for bond is less than par.
he is therefore not going to have a capital gain when he buys the bond. and if he holds it till maturity - which means he is not selling the bond - there is no capital gains then.

Technically, he has a capital gain, but on his financial statements he’s amortizing that gain over the life of the bond, lumping it in with interest income.
I don’t know if the tax authorities allow you to amortize it like that, or if you declare the full capital gain when the bond is repaid. I suspect that it’s the latter.

 

[MrSmart]

S2000magician wrote:

cpk123 wrote:two things they state

Quote:buys bond at a discount and holds it until it matures

discount bond ensures that the price paid for bond is less than par.
he is therefore not going to have a capital gain when he buys the bond. and if he holds it till maturity - which means he is not selling the bond - there is no capital gains then.

Technically, he has a capital gain, but on his financial statements he’s amortizing that gain over the life of the bond, lumping it in with interest income.
I don’t know if the tax authorities allow you to amortize it like that, or if you declare the full capital gain when the bond is repaid. I suspect that it’s the latter.

I guess for a fixed HTM bond the difference between issue and par is part of the YTM, and is not considered a capital gain because no revaluation and excess profit occurs in this case.

 

[lawnm0wer]

I remember this question in the book. While yield to maturity and total return are not exactly the same, the calculations are similar. In calculating YTM, you need the cash flows which include the coupon and the principal repayment, which is the final cash flow in addition to the final coupon. This calculation does not take into account the amoritization of the discount, or what might be used to identify capital gains.