Do Income-Producing Securities Generate Capital Gains? | Business

Instruments such as bonds and preferred stocks are generally attractive to more conservative investors because of their relative ability to hold their value and for the regular income they generate. I note, however, that certain interests see preferred shares, in particular, as a source of capital gains.

It would seem that this view emerges from the fact that, like bonds, the prices of preferred shares fluctuate. If their prices go up, they offer some opportunity to earn capital when they mature, or even earlier if bought at a discount.

In addition, an opportunity is also seen to realize capital gains if the price of instruments purchased at face value exceeds this level.

Investors are generally concerned with total returns, made up of the income part and the capital part. If the investment is bought at a discount, the total return is the capital gain plus the income. If purchased at a premium, the total return is the income portion minus the loss of capital.

The informed investor

The sophisticated investor knows the total return to be earned from a fixed rate bond and preferred stock at the time the investment is made, whether purchased at a premium, discount, or at par or at nominal value.

In each case, the redemption price is usually par or the assigned nominal value, so the investor knows if there will be a capital gain or loss, or if the capital returned on redemption is the same as that. that was invested.

Return on investment is usually calculated on an annual basis. At the most basic level, the principal gained or lost on an annual basis is added or subtracted from the annual income – interest in the case of a bond and dividend in the case of a preferred stock – and the result expressed as a percentage of the income. amount invested.

Investors who choose to sell before the instruments are redeemed can know their yield at the time of sale, given that they know the market determined selling price, cost price, how long the instrument has been held and income earned each year.

When interest rates drop

In cases where interest rates rise, the price of the fixed rate bond or preferred stock tends to fall, but the price rises when interest rates fall.

In cases where the preferential dividend or interest is not fixed, it is not possible to accurately determine the total return on the investment at the time the investment is made, as the portion of the income may change from time to time. to other.

The investor who buys bonds and preferred stocks at face value generally expects the return of the invested capital if they are held until redemption. In such a case, there is no expectation of capital in addition to the amount invested.

Capital gains should not be viewed in isolation from total returns. They are an important part of it. Investors who buy fixed rate bonds and preferred stocks in the secondary market should be aware that their expected return includes both capital and appreciation. Their return is fixed at the time of investment.

Variable rate instruments

With regard to variable rate instruments, the basis on which the dividend or interest is calculated may be such as to make the instrument very attractive, resulting in increased demand for it. There will be a higher price and a lower return for the new owner.

In such a case, there is an opportunity for investors wishing to sell to realize capital gains on the instruments, but it is not usual for there to be a potential for significant capital gains on either one or the other. other instrument.

It’s also worth remembering that the prices of preferred stocks and bonds get closer to their face value as they get closer to the redemption date. Under normal circumstances, it is not reasonable to expect significant capital returns from either instrument if they are purchased close to redemption.

For investors who have no interest in selling before the redemption date of the instruments, or in buying at a discount or a premium, changes in market conditions don’t really matter. On the other hand, investors interested in taking advantage of opportunities to make more money tend to pay attention to price fluctuations.

It is not the norm, however, for preferred stocks and bonds to be significant sources of capital appreciation, especially when interest rates are stable. Their potential for capital gains should not be confused with that of ordinary shares, on which the potential is unlimited.

– Oran A. Hall, author of Understanding Investments and lead author of the Handbook of Personal Financial Planning, offers advice and guidance on personal financial planning. Send an email to [email protected]