Showing posts with label bonds. Show all posts
Showing posts with label bonds. Show all posts
Wednesday, July 31, 2013
Bonds 101
Check out this is a short video on bonds produced by Investopedia!
Investors recieve a bond in exchange for money which serves as a loan to the bond issuer. When the bond matures, you will receive the face value of that bond. The face value is what you initally paid for the bond. The interest of a bond is known as the coupon. The investor is promised to recieve the full par at the maturity date with regular interest payments.
Monday, June 20, 2011
"What This Country Needs Is a Good 5% CPI"
Perhaps what this economy needs is a "serious dose of inflation"? Click here to read the full article from the Wall Street Journal.
Tuesday, May 11, 2010
Bonds explained
By Dr. Jason White
Family Investment Center
One of the bedrock fundamental approaches to successful personal investing is to proper diversify one’s portfolio based on individual factors like age, investment goals and risk tolerance. To diversify means to spread out financial risk by investing in a variety of asset classes including, but not limited to, stocks, bonds and real estate. The focus of today’s column is to provide you with some of the basic terminology from the world of bonds.
A bond represents evidence of a loan made from an investor to government, quasi-governmental agencies or corporations. Bonds are referred to as “fixed-income” securities because they typically pay a fixed rate of interest to the investor. This interest rate is known as the “coupon-rate” of interest.
The face value, known also as the par value of a bond, is paid back to the bondholder at the time of maturity. This is usually $1,000 with many bonds, but it can be just about any amount that the original issuer wished at the time of issuance. At the time of original issue, an indenture contract is put into place specifying the terms of the bond, along with any special provisions the issuer or underwriter think are necessary.
Bonds can be backed by some form of collateral, but many times they are simply debentures, meaning that no specific collateral has been pledged to back that particular bond issue. In the event of default, bondholders who enjoy the protection of specific collateral, such as mortgage bondholders, get paid back before debenture bondholders do. Still, debenture bondholders will be paid before preferred and common stockholders, so their priority claims at least have some chance of recovery.
To assist investors in making informed bond investing decisions, companies like Moody’s Investors Service, Standard and Poor’s Financial Services LLC and Fitch Inc. analyze the financial strength of firms and issue a bond rating for the debt of those companies. The lower the bond rating of a firm is, the higher the risk for the investor. The following chart is a proxy of these rating systems, but I think you’ll get the idea.
Rating Rating Interpretation
AAA Best Quality
AA High Quality
A Upper Medium Grade
BBB Medium Grade
BB Speculative
B Very Speculative
CCC Very Very Speculative
C No Interest being Paid
D Currently in Default
Bonds with a BBB or higher rating are referred to as “investment-grade,” while bonds with a rating below BBB are known as non-investment grade or “junk bonds.” While junk bonds often pay high rates of interest, this is because they are very risky investments and should only make up a very small percentage of your portfolio, at most.
A special feature of some bonds is a call provision. Callable bonds include a provision allowing the issuing company to force early maturity by calling the bonds in. Corporations might issue callable bonds when interest rates are high, hoping to call them in before maturity and refinance the issue if interest rates go down. In the current low interest rate economic environment, I suspect that any bond which can be called already has been, at least where the issuer is financially able to refund debt.
Family Investment Center
One of the bedrock fundamental approaches to successful personal investing is to proper diversify one’s portfolio based on individual factors like age, investment goals and risk tolerance. To diversify means to spread out financial risk by investing in a variety of asset classes including, but not limited to, stocks, bonds and real estate. The focus of today’s column is to provide you with some of the basic terminology from the world of bonds.
A bond represents evidence of a loan made from an investor to government, quasi-governmental agencies or corporations. Bonds are referred to as “fixed-income” securities because they typically pay a fixed rate of interest to the investor. This interest rate is known as the “coupon-rate” of interest.
The face value, known also as the par value of a bond, is paid back to the bondholder at the time of maturity. This is usually $1,000 with many bonds, but it can be just about any amount that the original issuer wished at the time of issuance. At the time of original issue, an indenture contract is put into place specifying the terms of the bond, along with any special provisions the issuer or underwriter think are necessary.
Bonds can be backed by some form of collateral, but many times they are simply debentures, meaning that no specific collateral has been pledged to back that particular bond issue. In the event of default, bondholders who enjoy the protection of specific collateral, such as mortgage bondholders, get paid back before debenture bondholders do. Still, debenture bondholders will be paid before preferred and common stockholders, so their priority claims at least have some chance of recovery.
To assist investors in making informed bond investing decisions, companies like Moody’s Investors Service, Standard and Poor’s Financial Services LLC and Fitch Inc. analyze the financial strength of firms and issue a bond rating for the debt of those companies. The lower the bond rating of a firm is, the higher the risk for the investor. The following chart is a proxy of these rating systems, but I think you’ll get the idea.
Rating Rating Interpretation
AAA Best Quality
AA High Quality
A Upper Medium Grade
BBB Medium Grade
BB Speculative
B Very Speculative
CCC Very Very Speculative
C No Interest being Paid
D Currently in Default
Bonds with a BBB or higher rating are referred to as “investment-grade,” while bonds with a rating below BBB are known as non-investment grade or “junk bonds.” While junk bonds often pay high rates of interest, this is because they are very risky investments and should only make up a very small percentage of your portfolio, at most.
A special feature of some bonds is a call provision. Callable bonds include a provision allowing the issuing company to force early maturity by calling the bonds in. Corporations might issue callable bonds when interest rates are high, hoping to call them in before maturity and refinance the issue if interest rates go down. In the current low interest rate economic environment, I suspect that any bond which can be called already has been, at least where the issuer is financially able to refund debt.
Friday, April 9, 2010
Modern Portfolio Theory Applied
By Dr. Jason White
Director of Investments
Family Investment Center
In my most recent column for the Maryville, Mo., newspaper, I discussed the scientifically-proven, Nobel prize-winning method of investment management known as Modern Portfolio Theory (MPT). I use this time-tested approach religiously in managing about $60 million of client investments.
From a macro point of view, MPT has just two goals: maximize return and minimize risk. This is a tricky benchmark. Most of us recognize that risk and return are highly correlated. The more risky a particular investment, the more return investors demand as compensation for that higher risk.
While this relationship is sometimes hard to see in investment management, it is readily apparent in consumer finance. Let’s take mortgages as an example. Low risk borrowers, those with high credit scores, good salaries, reasonable levels of debt, long employment history, etc., borrow money at the lowest market interest rate. These borrowers are low risk, thus lenders earn a relatively low rate of return on loans to them.
Consider a second borrower who is a credit nightmare. High risk borrowers may be past due on credit card and other debt service payments. They may be unable, or unwilling, to hold down a job. They have low FICO credit scores. Maybe they have even declared bankruptcy previously.
Intuitively, we know that the second borrower is going to have to pay a much higher mortgage interest rate than the first, because there is a much higher level of risk associated with the loan.
The same risk and return characteristics can be observed in the market. Utility stocks, often referred to as “widow and orphan” investments because of the lower risk level associated with them, have smaller but steadier returns than a biotechnology company or a wildcat oil speculator.
So, in MPT investing, we rely heavily on the idea of asset diversification to maximize return while minimizing risk. We want to spread dollars across various market securities to develop a balanced investment “scorecard.” We want to own bonds, stocks and real assets most efficiently by using mutual funds. A general rule of thumb for the average risk tolerant investor is to own a percentage of bonds in his portfolio that is equal to his age, with 20 as a minimum and 80 as a maximum. Thus a 40-year old investor would allocate 40 percent of his portfolio in fixed income mutual funds and/or individual government, agency and corporate bonds.
Another 10 to 15 percent of the portfolio should be in diversified holdings of international stocks and bonds. These should be mid-to-large size firms in countries that do not have excessive political risk. For example, I am much more comfortable with a Brazilian firm than a Venezualan one because of the political risk from Hugo Chavez.
About 5 to 10 percent of the portfolio should be in real (commodity) assets like real estate, precious metals and natural resources.
The remaining 40 percent or so goes into diversified stock mutual funds. For our 40-year old average investor example, about half of the stock investment should be in an ultra-low cost S&P 500 index stock fund, with the remainder actively managed in the mid-size and small-size company space. I like to use managers who blend both value (bargain-hunting) and growth (momentum) strategies.
There you have it. A broadly diversified portfolio spread over multiple asset classes in safe markets all around the globe. Modern Portfolio Theory is the investment strategy that never falls out of favor!
Director of Investments
Family Investment Center
In my most recent column for the Maryville, Mo., newspaper, I discussed the scientifically-proven, Nobel prize-winning method of investment management known as Modern Portfolio Theory (MPT). I use this time-tested approach religiously in managing about $60 million of client investments.
From a macro point of view, MPT has just two goals: maximize return and minimize risk. This is a tricky benchmark. Most of us recognize that risk and return are highly correlated. The more risky a particular investment, the more return investors demand as compensation for that higher risk.
While this relationship is sometimes hard to see in investment management, it is readily apparent in consumer finance. Let’s take mortgages as an example. Low risk borrowers, those with high credit scores, good salaries, reasonable levels of debt, long employment history, etc., borrow money at the lowest market interest rate. These borrowers are low risk, thus lenders earn a relatively low rate of return on loans to them. Consider a second borrower who is a credit nightmare. High risk borrowers may be past due on credit card and other debt service payments. They may be unable, or unwilling, to hold down a job. They have low FICO credit scores. Maybe they have even declared bankruptcy previously.
Intuitively, we know that the second borrower is going to have to pay a much higher mortgage interest rate than the first, because there is a much higher level of risk associated with the loan.
The same risk and return characteristics can be observed in the market. Utility stocks, often referred to as “widow and orphan” investments because of the lower risk level associated with them, have smaller but steadier returns than a biotechnology company or a wildcat oil speculator.
So, in MPT investing, we rely heavily on the idea of asset diversification to maximize return while minimizing risk. We want to spread dollars across various market securities to develop a balanced investment “scorecard.” We want to own bonds, stocks and real assets most efficiently by using mutual funds. A general rule of thumb for the average risk tolerant investor is to own a percentage of bonds in his portfolio that is equal to his age, with 20 as a minimum and 80 as a maximum. Thus a 40-year old investor would allocate 40 percent of his portfolio in fixed income mutual funds and/or individual government, agency and corporate bonds.
Another 10 to 15 percent of the portfolio should be in diversified holdings of international stocks and bonds. These should be mid-to-large size firms in countries that do not have excessive political risk. For example, I am much more comfortable with a Brazilian firm than a Venezualan one because of the political risk from Hugo Chavez.
About 5 to 10 percent of the portfolio should be in real (commodity) assets like real estate, precious metals and natural resources.
The remaining 40 percent or so goes into diversified stock mutual funds. For our 40-year old average investor example, about half of the stock investment should be in an ultra-low cost S&P 500 index stock fund, with the remainder actively managed in the mid-size and small-size company space. I like to use managers who blend both value (bargain-hunting) and growth (momentum) strategies.
There you have it. A broadly diversified portfolio spread over multiple asset classes in safe markets all around the globe. Modern Portfolio Theory is the investment strategy that never falls out of favor!
Thursday, February 19, 2009
Bond market presents challenge to conservative investors
The Fixed Income Challenge
One of the biggest challenges in the markets today comes from an unlikely source – bonds. Traditionally, bonds are the boring part of a portfolio, generating a bit of interest income while offsetting volatility from stocks.
Bonds run the gamut from extremely safe to highly speculative. For most portfolios, we recommend safe bonds with shorter maturity dates. We often use managed bond funds for added diversity and expertise. At different times, we might use bond substitutes - bank certificates or commercial money market funds - in this portfolio segment. These are rarely a good long-term solution, however.
Rates have fallen to ridiculous levels. Treasury bonds – often considered the safest investment of all – are paying less than one percent. Money market funds, comprised of the shortest possible maturities, slipped into that range as well. Obviously, it’s hard to stomach a large portfolio segment locked into such dismal annual returns.
And, yet, what’s the alternative?
There are genuine dangers in reaching out for higher rates. With bonds, higher rates come directly from higher risks. You either extend maturities or seek lower-rated bonds. Lower-rated bonds carry some risk of default (especially in today’s environment), and longer bonds will suffer when rates eventually rise again. It might pay to speculate in those arenas, but it’s too dangerous for large amounts or most of our clients.
No simple solutions
In some ways, the bond market is more complex than the stock market. First of all, there are tens of thousands of issuers. Virtually every level of government from Washington, D.C. to the sewer districts of rural Missouri creates and sells bonds. School districts, universities, and library systems, along with thousands of corporations and churches, issue bonds.
The terms of those bonds differ from issuer to issuer. The stated interest rates, payment schedules, and maturity from the very same issuer can range from six months to 30 years. There are insured bonds, uninsured bonds, revenue bonds, and general obligation bonds.
Navigating these treacherous waters requires a sure and steady hand, with considerable experience and understanding. Multiple bond variables – issuer, maturity, credit quality, and type of bond or deposit – interact with the extreme economic environment in unique and peculiar ways. The 2008 “Credit Crunch” was largely the result of some widespread peculiar pricing anomalies with mortgage-backed bonds.
Because of all of these variables, we’ve been recommending bond funds to our clients. Bond funds, when run by experience managers, give the same advantages as a stock mutual fund. No one investment can tank the fund if it is properly diversified.
If you’re looking at bond funds, examine the track record of the funds against the track record of bond indexes. Look at the quality of the firm and the length of employment of its management. And know, that like everything else, there are no guarantees. There are no silver bullets, especially in this market.
Some final points to consider
One knock against bond mutual funds is that they never mature. A fund manager either trades the bonds or reinvests the proceeds when they mature. Some folks prefer the simplicity of a single bond with a guaranteed maturity. It is simpler to use that approach, but it’s a limited solution with limited investment potential.
Bond funds offer a couple of advantages. Trading and pricing costs born by individuals are often two to three times higher than institutions. Also, diversification offers more safety, especially with corporate, municipal, or high-yield bonds.
One last observation seems important. There are some unusual moments where bank deposits (certificates or even demand accounts) yield more than bonds. In some cases, that may be true today. Pay special attention to FDIC coverage limits because high promotional rates may signal a bank’s need for capital. Such opportunities may bring brief periods of profitability, but rarely offer a good longer-term solution.
_________________________________
Dan Danford is founder and CEO of Family Investment Center in St. Joseph, Missouri. The firm is a commission-free investment advisor registered with the SEC. Danford and other advisors at the firm specialize in managing large portfolios of traditional investments. They do, however, advise investors on a broad range of financial services. More about Danford and this unique firm can be found at www.familyinvestmentcenter.com. Also, the firm’s family finance blog is found at http://familyinvestmentcenter.blogspot.com. Follow Dan on Twitter @family_finances.
One of the biggest challenges in the markets today comes from an unlikely source – bonds. Traditionally, bonds are the boring part of a portfolio, generating a bit of interest income while offsetting volatility from stocks.
Bonds run the gamut from extremely safe to highly speculative. For most portfolios, we recommend safe bonds with shorter maturity dates. We often use managed bond funds for added diversity and expertise. At different times, we might use bond substitutes - bank certificates or commercial money market funds - in this portfolio segment. These are rarely a good long-term solution, however.
Rates have fallen to ridiculous levels. Treasury bonds – often considered the safest investment of all – are paying less than one percent. Money market funds, comprised of the shortest possible maturities, slipped into that range as well. Obviously, it’s hard to stomach a large portfolio segment locked into such dismal annual returns.
And, yet, what’s the alternative?
There are genuine dangers in reaching out for higher rates. With bonds, higher rates come directly from higher risks. You either extend maturities or seek lower-rated bonds. Lower-rated bonds carry some risk of default (especially in today’s environment), and longer bonds will suffer when rates eventually rise again. It might pay to speculate in those arenas, but it’s too dangerous for large amounts or most of our clients.
No simple solutions
In some ways, the bond market is more complex than the stock market. First of all, there are tens of thousands of issuers. Virtually every level of government from Washington, D.C. to the sewer districts of rural Missouri creates and sells bonds. School districts, universities, and library systems, along with thousands of corporations and churches, issue bonds.
The terms of those bonds differ from issuer to issuer. The stated interest rates, payment schedules, and maturity from the very same issuer can range from six months to 30 years. There are insured bonds, uninsured bonds, revenue bonds, and general obligation bonds.
Navigating these treacherous waters requires a sure and steady hand, with considerable experience and understanding. Multiple bond variables – issuer, maturity, credit quality, and type of bond or deposit – interact with the extreme economic environment in unique and peculiar ways. The 2008 “Credit Crunch” was largely the result of some widespread peculiar pricing anomalies with mortgage-backed bonds.
Because of all of these variables, we’ve been recommending bond funds to our clients. Bond funds, when run by experience managers, give the same advantages as a stock mutual fund. No one investment can tank the fund if it is properly diversified.
If you’re looking at bond funds, examine the track record of the funds against the track record of bond indexes. Look at the quality of the firm and the length of employment of its management. And know, that like everything else, there are no guarantees. There are no silver bullets, especially in this market.
Some final points to consider
One knock against bond mutual funds is that they never mature. A fund manager either trades the bonds or reinvests the proceeds when they mature. Some folks prefer the simplicity of a single bond with a guaranteed maturity. It is simpler to use that approach, but it’s a limited solution with limited investment potential.
Bond funds offer a couple of advantages. Trading and pricing costs born by individuals are often two to three times higher than institutions. Also, diversification offers more safety, especially with corporate, municipal, or high-yield bonds.
One last observation seems important. There are some unusual moments where bank deposits (certificates or even demand accounts) yield more than bonds. In some cases, that may be true today. Pay special attention to FDIC coverage limits because high promotional rates may signal a bank’s need for capital. Such opportunities may bring brief periods of profitability, but rarely offer a good longer-term solution.
_________________________________
Dan Danford is founder and CEO of Family Investment Center in St. Joseph, Missouri. The firm is a commission-free investment advisor registered with the SEC. Danford and other advisors at the firm specialize in managing large portfolios of traditional investments. They do, however, advise investors on a broad range of financial services. More about Danford and this unique firm can be found at www.familyinvestmentcenter.com. Also, the firm’s family finance blog is found at http://familyinvestmentcenter.blogspot.com. Follow Dan on Twitter @family_finances.
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