Capital gains from bonds can far exceed the coupon interest when interest rates fall, as they have done for years. The size of these gains is impressive

Capital gains from bonds can far exceed the coupon interest when interest rates fall, as they have done for years. The size of these gains is impressive

If you invested in NZ Government bonds in 2019, you could have won outsized returns.

Using the April 20, 2029 bond as an example of a risk-free ten year benchmark, this bond pays a coupon of 3.00% pa.

If you were one of the nineteen successful bidders at the December 14, 2018 public tender for this bond, and assuming you purchased one minimum lot with a face value of $100,000, you would have paid $132,100 for that position given that it was issued at an effective average yield of 2.271%.

(This is because the $100,000 bond pays a nominal coupon rate of 3.00% or $3,000 per year and that $3,000 now represents a 2.271% return. If $3,000 is a 2.271% return, you would have to pay $132,100 to achieve that bid rate.)

One year later, at the December 12, 2019 public tender, this same bond was tendered and the average winning yield was just 1.499%. There were 22 successful bidders at that auction. On the same basis, that means that the $3,000 coupon payment at 1.499% is achieved when the price paid for the $100,000 nominal bond is $200,133. (Yes, $200,133 at 1.499% is $3,000 which is the fixed amount the bond still pays its holder.)

It is only theoretical that you could have sold the bond you bought on December 14, 2018 to an average bidder at the December 12, 2019 tender. But there is an active secondary market for these bonds and it is likely you would have achieved a price close to that on the secondary market (probably less brokerage, of course).

Ignoring the transaction costs, that means your December 2018 purchase at $132,100 would have been realised on December 12 2019 for $200,133. In anyone's language, that is a huge profit for holding a risk-free Government bond for one year. It works out at a 51.5% annual capital gain (on top of the 2.271% effective interest return). You spent $132,100 up front (plus brokerage), and got back $200,133 plus $3,000 at the end (less brokerage). And the underlying bond is NZ Government guaranteed.

This is why bond investors smile - especially when their expectations that interest rates will fall, come true.

And that is the risk they take - the interest rate risk. If, rather than falling to 1.499%, the rate had risen back to 3.00%, then their $132,100 would have been worth about $100,000 again, plus the $3000 coupon interest (and also less brokerage). That would have been a loss of at least -$30,000.

Falling interest rates give outsized returns to bond investors. Rising interest rates can do the opposite (although there are strategies to profit here too, but they are more technical and complex).

But our imaginary investor has probably been doing this for some time, very successfully.

In 2017 there was no 20-Apr-2029 bond available, but there was a 15-Apr-2025 NZGB that paid a coupon of 2.75%. Using the same calculations, from 19-Jan-2017 to 18-Jan-2018, when net tender successful yields moved from 3.133% to 2.688%, they would have gained 16.6% on the capital value plus the $2,750 coupon payment for their $87,775.50 investment. If they repeated it in the 2018 year they would have gained +40.6% plus their $2,750 coupon.

Over all three years, their original $87,775 investment would have grown to $200,133 in value plus they were paid $8,500 by the Treasury for holding the bond. That is an effective compound gain of +33.4% each year (although brokerage and taxes would have reduced it of course).

Neither equities nor real estate were able to match that.

Rising interest rates would have generated losses, however.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

10 Comments

Comment Filter

Highlight new comments in the last hr(s).

Could you model the capital losses for NZGB holders buying bonds right now, if the 10 year yield moves to 2%, 2.5% and 3%?

Bond rally well and truly over now. All negative returns for over a month or more, and wondering whether to bail completely (I thankfully took half out around end of September). Trouble is longer rates are on the rise, but this is not showing at all in term deposits, so it's back to cash where I'm earning the princely sum of 1.68%, or a deposit at 2.7%, but locking away for a year.

This is a rotten environment for prudent, risk averse investors. I'd go so far as to say we're getting slaughtered.

Should have said my only reason for keeping in the bond funds I'm in from now is I still expect the share crash (it has to happen with US markets all in space somewhere) - despite I can't time it - and thus punting on a sharp bond rally as they go down (then I'll bail before the pent up inflation hits, and ... well, end of the world basically).

If you were one of the nineteen successful bidders at the December 14, 2018 public tender for this bond, and assuming you purchased one minimum lot with a face value of $100,000, you would have paid $132,100 for that position given that it was issued at an effective average yield of 2.271%.

Hmmmm....you have used a perpetual bond calculator for your analysis, when in fact the bond above has a maturity of around 10 years;

NZDMO has announced the results of Nominal Government Bond tender number 663 held on 14 December 2018
Tender Date: Fri 14 December 2018
Bids close: 2.00pm
Results: From 2.05pm
Settlement Date: Wed, 19 December 2018

Government Bonds Issued
Series Offered 3.00% 20-Apr-29
Total Amount Offered ($million) 250
Total Amount Allocated ($million) 250
Total Number of Bids Received 43
Total Amount of Bids Received ($million) 447
Total Number of Successful Bids 19
Highest Yield Accepted (%) 2.49
Lowest Yield Accepted (%) 2.475
Highest Yield Rejected (%) 2.6
Lowest Yield Rejected (%) 2.49
Weighted Average Accepted Yield (%) 2.4828
Weighted Average Rejected Yield (%) 2.5084
Amount Allotted at Highest Accepted Yield 61.2
as Percentage of Amount Bid at that Yield*
Coverage Ratio 1.788

Maturity (Years) 10.3425
Secondary Market Yield: N/A
Interpolated Swap Yield: 2.791%

Swap over WA Successful Yield (bps) 30.78
Swap over WA Unsuccessful Bid Yield (bps) 28.22
Swap over Market Yield (bps) N/A

The quoted price (2 decimal places) based on the above and $100.00 principal is:
COUPON BONDS (biann) (source - section 6)

Clean Price: $104.69
Accrued: $0.49
Dirty Price $105.18

Each bid to buy Government Securities from the Treasury (“bid”) or offer to sell Government Securities to the Treasury (“offer”) must be of a minimum amount of $1,000,000 (face value) and in multiples of $1,000,000 thereafter

I'm perplexed by this article, most of it seems seriously flawed. The clean price of the NZGB 3 4/29 has never been above 118.37. This bond has never been to 132, or even 200, as claimed. Very crudely, if the atm yield drops 75bp (from 3% to 2.25%) from purchase then this represents capital appreciation of $100k x .0075 x 10 = $7,500. The capital price would go from 100 to 107.5 (ignoring discounting).

So unless there is leverage, the article is widely inaccurate. Maybe I've missed something?

Also, Government Bonds aren't risk free - the capital price moves as explained. They are the risk free rate however at any point in time.

Do you expect the author to offer an apology and correction to remedy the dissemination of grossly misleading opinion?

I'm ambivalent, though a little surprised it's still up.

...though a little surprised it's still up.
Same here - it's a blatant distortion of reality.

Yes the bond maths seems "a bit" wrong. Pity that whilst the message of the post is still true, it is undermined by the example being incorrect.

A bit wrong? On this very website they list the clean price of the April 29's as 114.30. This bond was first issued around 3 years ago a par so that gives annual capital appreciation of <5% - yet the article claims the annual capital appreciation has been 33% and that these returns are superior to houses and stocks.

The S&P is up >40% over 3 years so this article is flawed in it's logic, the maths and the conclusion. It should be removed.