Calculating Bonds’ and Shares’ Coupons
A bond’s coupon is the dollar amount that its issuer pledges to pay at agreed intervals to the bond-holder. (In Australia these payments usually occur quarterly and sometimes semi-annually; but for the sake of simplicity let us assume annualised payments). As an example, consider a 10-year corporate bond with a face value of $1,000 whose issuer undertakes to pay the bond-holder $65 per year for 10 years. At the end of the 10 years, the issuer pledges to return the $1,000 to the bond-holder. This bond’s coupon is $65 and its initial yield is 6.5% (i.e., the coupon of $65 ÷ its face value of $1,000). During these ten years, no matter how many times or at what price the bond changes hands, the $65 annual coupon remains fixed. The price investors will be willing to pay for the bond, and therefore its subsequent yield, depends upon three things: a change of the purchasing power of the $A and perceptions about further changes during the bond’s remaining life; the yield on “risk free,” i.e., Commonwealth Government, bonds maturing at the same time as this bond; and the bond’s “risk premium” (i.e., bond-holders’ perceptions of the borrower’s ability to pay the coupons and repay the principal as promised, and hence their demand for a higher yield than that available from government bonds).
Three risks thereby inhere in the ownership of a corporate bond. Analogously, a company’s annual “coupon” is its earnings per share – that is, the excess of its revenues over expenses and obligations to creditors during a given year, divided by the number of shares on issue; and its yield is its coupon divided by its shares’ market price. As an example, consider a company whose net income during the previous year was ten cents per share and whose shares presently trade at $2.00. Its coupon is therefore $0.10 and its yield is 5% (i.e., $0.10 ÷ $2.00). A bond’s coupon is typically fixed and thus does not depend upon the company’s operations or profitability. A company’s coupon, in sharp contrast, depends entirely upon the company’s profitability. The typical company’s earnings vary – often widely – from year to year; accordingly, so too does its coupon.
Consider as an example a company whose shares sell at $2 and whose coupon can reasonably be expected to grow without interruption and at a rate of 25% per year during each of the next five years. (It is interesting to note that analysts often talk about such companies – and vital to emphasise that in the real world they are exceedingly rare and for all practical purposes do not exist). At the end of the first year, the investor receives a coupon of ten cents (either up-front, in the form of a dividend, or as earnings retained and re-invested in the company, or some combination of the two). This represents an earnings yield of 5% on the initial investment of $2. At the end of the second year, the coupon grows to 13 cents (a 25% increase over the previous year), which represents a yield of 6.5% on the $2. Given the growing coupon, the yield increases year by year such that, at the end of the fifth year, it reaches 15% (i.e., a coupon of $0.31 ÷ $2.00). Clearly, then, if a company is able to increase its annual coupon from one year to the next and one retains ownership of its shares, then the yield on one’s initial investment also increases.
Equally clearly, the greater the coupon’s rate of growth the greater the yield on one’s investment. This is a fundamental attribute which distinguishes ownership of a company’s equity (shares) from ownership of its debt (bonds). It is this compounding which makes the ownership of “growth companies” – if their coupons actually increase steadily, they do not squander the coupons they retain rather than pay as dividends to shareholders and if their shares can be bought at a sensible price – so rewarding, since the market price of these shares will tend over time to rise roughly in tandem with the growth of their coupon (see also Buy and Hold: A Response to Today’s Critics). Alas, and as Benjamin Graham put it (Security Analysis: The Classic 1934 Edition, McGraw-Hill, 1996, ISBN: 0070244960), “with encouragement from the past and a rosy prospect for the future, the buyers of ‘growth stocks’ [are] certain to lose their sense of proportion and pay excessive prices” (see also “Irrational Exuberance” in Australia and Reasoned Scepticism Versus Irrational Exuberance).
Comparing Fixed and Variable Coupons
Bearing Graham’s injunction clearly in mind, by comparing their coupons we can ascertain whether the ownership of a given and relatively “risky” investment, such as a particular company’s shares, is preferable to that of a “risk free” Commonwealth bond. (Australian Government bonds are often dubbed “risk-free” because the probability of default is regarded as miniscule. Clearly, however, a government-induced shrinkage of the purchasing power of the $A is very likely. In this sense these bonds – particularly those with redemption dates in the more distant future – are hardly “risk free.” Ask anyone who purchased them during the 1950s, 1960s and 1970s). We find, generally speaking, that the share is the more sensible investment when its yield is and remains significantly greater than that of a comparable bond; conversely, a bond is more attractive when its yield is equal to or greater than that of a comparable stock.
Consider Telstra and government debt. Assume (as was possible late in 1999) that you can buy either one share at $8.20 (its average closing price in October of that year) or a five-year Commonwealth Government bond at a price of $8.20 and a yield of 6.35% (the average yield prevailing in October 1999 for Commonwealth bonds maturing in September 2004). Further, assume that whichever you chose you are a “long term” investor; that is to say, you will hold your investment for five years. If you purchased the bond then by late 2004 it is virtually certain that you will earn $2.57 (i.e., 51.4 cents per year for five years) in coupons and upon redemption will collect total proceeds of $10.77 (i.e., $8.20 of principal plus $2.57 of coupons).
Alas, because they are not fixed and are subject to wide variation from one year to the next a share’s coupons are very difficult to predict with any reasonable degree of accuracy. Because we must make assumptions about its coupons, the analysis of the share is (relative to that of the bond) not as straightforward and much more prone to error. Clearly, however, whatever our assumptions if the Telstra share purchased late in 1999 at $8.20 is going to be a better investment than the bond then it must return to you at least $10.77 by late 2004.
Given the general euphoria prevailing late in 1999 – and the virtually-unanimously enthusiastic statements about Telstra by government ministers, brokers, analysts and market commentators – this seemed to be an easy hurdle for Telstra to jump. But if one had applied reason rather than emotion to one’s decision, then one would have quickly realised that this hurdle was considerably higher than the vast majority of market participants recognised (see in particular Telstra: A Contrarian Case for Caution). Table 1 shows Telstra’s actual coupon in 1999 (27 cents). It also shows its projected coupons for the next five years under the then-uncontroversial (considering analysts’ statements and “consensus”) assumption that they would grow without interruption and at a compound rate of 17% per year. At the end of five years, cumulative coupons of $2.50 – slightly less than the bond’s cumulative coupons – would accrue to the Telstra shareholder as dividends, retained earnings or some combination of the two. Further, note that only in the fifth year of ownership (i.e., in 2004) does Telstra’s yield exceed that of a “risk free” Commonwealth bond (7.2% versus the bond’s 6.35%). Under these assumptions, then, Telstra generates a somewhat smaller cumulative coupon than the bond. Further, unlike the bond there is no guarantee that one can redeem one’s initial investment of at exactly $8.20 after five years.
Table 1: A Simple (1999 Vintage) Evaluation of Telstra
