Interest is what borrowers pay lenders for using their money. Interest is paid by governments, corporations, and diverse other organisations. It is paid on several types of instruments, at various frequencies, at various interest rates. Its payment is more certain in some cases than others, and it is paid in a wide range of currencies to many different types of lenders.
From a personal finance point of view, it is the interest that securities – tradeable financial instruments – pay that matters. Interest has a bearing on investment performance and is useful in helping to achieve stated goals, for example, providing stable retirement income, funding the purchase of assets, and funding education.
Interest is often considered certain income. I wish it was so in every case. The certainty of interest depends on the borrower’s ability to pay – a reflection of the quality of the debt instrument. Even so, good debt may change due to the borrower finding it difficult to pay because of unforeseen difficulties with the business. Even governments have challenges.
On the point of the quality of debt instruments, it is often the case that the instruments that carry the most risk tend to pay the highest rate of interest – as compensation for the higher risk. Also, a higher rate of interest is generally paid on long-term instruments than on short-term instruments due to the perceived higher risk but also as a nod to the negative effects of inflation over the longer term of the instrument.
Which instrument an investor uses to earn interest income depends on when and how often the interest is required, the rate of interest, the issuer of the instrument, and the term of the instrument for it also matters when the principal is to be repaid.
Fixed-rate debt instruments have the advantage of paying interest that is known and predictable. The downside is that their prices generally fluctuate with interest rate movements. This is not a problem when they are held to maturity, but selling prematurely if interest rates are above the coupon rate will almost certainly result in a capital loss due to the decline of the price.
Variable-rate instruments tend to hold their value even when interest rates fluctuate. As for the interest, it increases when general interest rates rise but falls when they do because it is computed by adding a stated rate, say 2.0 per cent, to a stated market-determined rate, for example, the weighted average yield of the 182-day treasury bill issued at the beginning of the interest period.
Governments issue a broad suite of debt instruments – long-term, short-term, fixed rate, variable rate, local currency-denominated, and foreign currency-denominated. Governments raise money to fund budgetary needs and service their debt through taxes. One long-term GOJ debt instrument is the Benchmark Investment Note – a fixed-rate instrument that pays interest semi-annually.
The treasury bill is a short-term Jamaican Government debt instrument issued by BOJ at a discount and matures at face value. It is not an interest-bearing security. The income the investor earns is the difference between the sum at maturity and the sum invested. Common maturities are 30, 91, 182, 273, and 365 days.
Jamaican investors also buy the sovereign debt of other countries as well as the debt of their corporations, generally through regulated intermediaries like licensed securities dealers, unit trusts, and mutual funds. Investors earn more interest in Jamaican dollars and see their capital values increase when the Jamaican dollar loses value, but the opposite happens when it appreciates.
Corporate-debt issues have several features similar to government issues. They do not, however, issue treasury bills but issue corporate paper, promissory notes, and repurchase agreements through their securities dealers. They tend to pay interest at maturity.
A few corporate bond issues are listed on the Jamaica Stock Exchange, making them more liquid, and generally pay interest quarterly, but the others trade on the over-the-counter market. Corporate borrowers generally issue secured instruments, which gives lenders some protection. But not all are secured – nothing to back them but the name of the borrower. Let the buyer beware.
For lovers of collective investment schemes, there are a few funds that distribute some income to investors, and there are a few income funds that make it relatively easy for investors to add to and withdraw interest and principal from their accounts.
Whatever the instrument, investors should buy instruments that make payments which are in line with their needs and plans, but there is the risk that interest payments may not be made when due. In such cases, they are required to be paid in the future, and there are generally provisions to protect lenders in the case of default. Nonetheless, there are Jamaican investors who have suffered losses because borrowers in other jurisdictions have defaulted, and there have been Jamaican bond issuers who have been delinquent in recent years.
Investors may reinvest interest income to cause their portfolio to grow, or they may use it to fund planned expenditure. The level of interest an instrument pays, though important, is not all. The quality of the debt instrument matters.
Oran A Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. Email: finviser.jm@gmail.com
