Bond that pays interest loses the feature of compound interest? Find out – 07/14/2023 – From Grain to Grain

We’ve all heard that one of the great marvels in the financial market is interest on interest, or compound interest. However, most fixed income securities pay interest periodically and do not have this automatic reinvestment. This occurs both in Brazil and internationally. Hence comes the question, do these interest-paying bonds lose the advantage of compound interest?

Among the various forms of payment of flows in fixed income securities, two predominate.

In the most common, fixed income securities pay interest semi-annually or annually and the principal is paid only at maturity. This is the case for most public and private bonds referenced to the IPCA and some public and private prefixed bonds.

In the second most common type of fixed income security, interest is not distributed to investors but accrued and paid together with principal at maturity.

In this second type, the composition of interest is clear. However, how would composition occur in the first type?

Before I explain, I’ll make a comparison to make it clearer.

Comparing to the stock market, the fixed income security that pays intermediate interest would be equivalent to a share that pays dividends.

Now tell me, is a stock that pays dividends worse and wouldn’t have earnings compounding?

How would you make a dividend-paying stock have earnings composition? Maybe you already know, but I’ll clarify.

In a stock, if upon receiving the dividend, you reinvest, the compounding effect materializes.

Fixed income is the same.

Therefore, you can always reinvest the interest earned on fixed-income securities and have a similar earnings compounding effect.

There is an advantage and a disadvantage to a bond that pays interest periodically.

The disadvantage is the payment of Income Tax on intermediate interest in advance on the title that distributes interest. However, this is not a general downside to fixed income. It does not affect IR-exempt private securities, due to their exempt nature.

The advantage of receiving intermediate interest is being able to select the best investment at the time. Remember that when you go shopping at the supermarket more often, you end up taking more opportunities? Here the same thing happens.

If you reinvest in any other investment, the earnings compounding effect remains. It is not necessary to reinvest in the same security.

The fact of receiving the resource compulsorily, takes us out of the inertia of doing nothing and makes us think of the best alternative at every moment.

So, as you continue to reinvest any payouts you receive, the earnings compounding always materializes. It just doesn’t happen when you withdraw from the account and spend.

I am in favor of both types of fixed income securities and each has its advantages and disadvantages. But both have the same earnings compounding feature when we reinvest any cash received. But, at the moment, I prefer long-term, IR-free private bonds.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

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