Thursday, February 18, 2010

What are the advantages of holding bonds?

We have seen in this post what bonds are. However have you asked yourself what are the advantages of holding bonds. We are going to have a look at the different uses of bonds for the average investor.

1. Safety investment

One of the most important uses of bonds for the average investor especially in this recession is to secure your portfolio. Investors who anticipates a bear market, turmoil in the stock market or a recession  might not want or have the courage to watch their portfolio’s value fluctuate widely. As a result in anticipation they will want to sell their investment and flee to the safest investment. Some will invest in treasury bonds, treasury bills, high quality corporate bond or money market mutual funds. After the events the investors can sell these safe assets and then reconstitute their portfolio. 

2. To maintain the value of the portfolio

The first use of bonds for the average investor is to maintain the value of the portfolio. Most bonds can be said to be quite safe especially if you invest in government bonds and investment grade corporate bonds. Because bonds are issued at a discount and then redeemed at face value the investor is certain that he will obtain more than he invested initially. Furthermore some bonds will pay coupons twice a year. So even if the return on bonds are small, the investor is assured to end up with more that he started with. If you invest in treasury inflation protected securities then your principal will be adjusted so that you will not be hurt by inflation. thus your return will always be greater than inflation.

3. Diversification

Diversification a strategy whereby you invest in a range of securities and in various sectors so that they will not be affected equally. If your portfolio is equally diversified it is possible that some of them will increase in value while while some of them will decrease in value thereby offsetting each other. Bonds are the best asset to hedge against stocks. As you the value of stocks increases and decreases while that of bonds will remain the same. Hence when the stock market is down the presence of bonds will reduces the loss of value of the portfolio. Now when the stock market is up the percentage of stocks in the portfolio increases as a result to keep the value of bonds in the portfolio constant you will have to rebalance. You will thus sell stocks to buy bonds. This will ensure that you lock the gain in stock market by buying bonds.

4. Fixed income generation

Some people, especially retirees need a regular source of income. Because bonds pay regular coupon every six months a portfolio that has a sufficient number of bonds in it will provide income to the retiree on a regular basis. Stocks on the other hand pay dividends but it is not compulsory for companies to pay dividends so an investors that have stocks in his portfolio is not certain of receiving dividends on a regular basis. However since on the long run the stock market rises then the investor is sure that the value of his stocks will increase with time.

As you can see it is very important to have a certain percentage of you money invested in bonds for the presence of bonds will help to stabilise your portfolio. 20 % for the aggressive investor up to 40 % for the prudent investor is an appropriate allocation. However make sure that your bonds are sufficiently diversified ranging from safe government bonds to slightly yieldy corporate bonds. If you are adventurous you can invest in municipal bonds.

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Wednesday, February 17, 2010

What is a Negotiable Certificate of deposit?

A certificate of deposit(cd) is a short-term investment whereby an investor will deposit a sum of money in a bank and at maturity the investor will obtain his money back with interest. The cd is issued at a discount to the face value and at the maturity date the investor will thus redeem the face value of the CD.  The investor cannot get his money back before the maturity date.

The negotiable certificate of deposit (NCD) however can be sold in the secondary market by the initial investor. He can thus get back his money before the maturity date. He will however have to accept a reduce interest. The negotiable certificate of deposit can thus be traded in the secondary market until it reaches maturity. At that point the last person that hold the NCD can redeem the face value of the NCD.

Since the NCD is issued by a bank then the return on it must be greater than on the treasury bill. This is because the treasury bill is a safe investment and has no default risk. The return on the NCD will thus be slightly greater than the return of the treasury bill to compensate the investor for the additional risk However since it is issued for a short period of time the solvency of the bank can be predicted. As a result the extra premium is quite small.  As a result the return on the NCD is quite small compared to other money market instrument. Furthermore the NCD is issued at high denomination as a result the retail investor cannot have access to NCDs. Average investor can only access them through a money market  mutual fund unless he has a lot of money to be able to buy individual NCD from banks or through his broker.

However despite these disadvantages there are two advantages that makes the NCD worth while investing in. First of all if you have some money in a bank account the return will mostly be small. Then investing in an NCD will give a slightly higher return than the average savings account. Furthermore if you cannot afford to lose your money but want to obtain higher return then the NCD is the way to go since the chance of the bank defaulting on the NCD is negligible.  

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What are eurodollars?

The term eurodollar very often tend to confuse investors into believing that the instrument is related to the dollar or the euro. The eurodollar is a deposit, cd or NCD  that a united states bank will have with a bank outside of the united state. Hence if a European bank has a deposit, cd or NCD at a bank in Australia then it will be called a Euroeuro. And finally if a Japanese bank will have a deposit , cd or NCD with a bank in France it will be called a euroyen

The advantage of eurodollars is that because they are less liquid then normal NCDs the return on them is greater. The eurodollar however is only to large institutions so your best et to have exposure to them is through

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Thursday, January 21, 2010

Strategies for the successful investor part 7 : Performance obsession

Many investors are obsessed by performance in that they are always on the alerts for tips, hot stocks or emerging sectors of the economy. These investors always want to be on board of the latest bull market. They always want to buy at the lowest price and sell at the highest price.

However what investors need to know is that assets are mostly cyclical and that their ups and down do not takes place at the same time. Hence while one sector of the economy is down another sector will be down. Hence if you invest too heavily in one sector or in one asset then if their is a downturn or a bull market then you will be too exposed to that sector and as a result your portfolio will be adversely affected and you might lose heavily.

The way to go is to be exposed be a wide variety of assets such that when one asset lose value the decrease will be offset by an increase in the value of another asset. Hence if you are exposed to a wide variety of asset classes you will have your eggs in the same basket. In case their is a loss in one type of assets then it will only be a small part of your portfolio.

Hence the way to go is to through heavy indexing of the market. You will need to be exposed to a wide range of index fund and mutual fund. You will invest in bond fund, mutual fund in stocks, etc.

Hence when you will invest in index fund and mutual fund you will not have the need to chase performance. You will be exposed to every sectors of the economy and all this will be done passively. Hence  you will not need to chase performance. Your return will be close to that of the overall market.

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Wednesday, January 20, 2010

Strategies for the successful investor part 6 :Index the market

Like i said in my previous post trying to outperform the market is a waste of time. The way to go is through index fund or mutual fund since it is rare that someone can outperform the market consistently.

So what would you do if you are investing in traditional assets like stocks and bonds. You have to try to index the market.

What you should do is to invest in companies that are of different sectors of the economy. You will thus select a number of different companies to invest in. What you would do is to add the market capitalisations of all the companies that you want to invest in.

Then if you want to invest in a company X you will have to invest  money in company x acording to the equation below

Money invested = (Market capitalisation of x/total market capitalisation) * money that needs to be invested

You might want to create a spreadsheet to help you determine how much to invest in each company.

Now the indexing will not be similar to a professional index fund but it will approach it if you

1. Choose a large number of sectors of the economy to invest in such the companies you invest in will make your portfolio representative of the economy.

2. in each sector of the economy that you invest in you select a few companies that will be representative of that economy. You will thus invest in a series of mega cap, large cap and small cap companies.

Similarly you will invest in bonds such that you will invest in securities with a wide range of maturities and issuers. Hence your bond portfolio will be spread across municipal bonds, corporate bonds and government bonds. You will also have to invest in the money market and capital market bonds so as to spreads your exposure to different maturities of bonds.

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Tuesday, January 19, 2010

Strategies for the successful investor part 5 :Do not trust experts or fund managers

The one thing that most people think is that they can outsmart the market and have a better return than the overall return of the market. What can happen is that a few person can outperform the market for a few years but over the long run they would most likely either underperform the market or come close to it.

On the long run the best you can do is to equate the average return of the market. Thus the only investment that would come close to the market average rerun would be the index fund or a mutual fund that is invested in a broad range of stocks and bonds.

why is it that no one can outperform the market?

1. Most fund make use of researches and fund managers that are highly paid so that their salaries have to be deducted from the return of the fund. This would thus reduce the fund’s overall return.

2. A lot of these actively managed funds rely on selling and buying of shares so that investors in these funds need to pay capital gains tax. These taxes thus reduce the return of the funds.

3. Actively managed funds rely on timing the market. That is selling high and buy low. This is quite difficult to achieve and and as a result the return is less that anticipated.

Hence the index fund or the passively managed mutual fund is the best bet to achieve a return that is as close to possible to the average return of the market. The fees of these funds are low because the funds do not need to pay a lot of researches and fund managers. They also mostly rely on the buy and hold strategy thus reducing the need to try to time the market.

Although funds that try to actively time the market and employs famous fund managers are quite attractive, history tell us that they always underperform the market so keep away from them.

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Strategies of the successful investor part 4: Rebalancing

One of the most important aspect of your investing life is rebalancing. As you know a portfolio must be diversified in that the portfolio is composed of a wide variety of asset types such as bonds, stocks, etc. Depending on your investment plan and your risk tolerance the different asset classes will be a certain percentage of the portfolio. And in each asset class their would also be some diversification.

You would probably have stocks that are in different sectors of the economy or bonds that are from different types of issuers such as corporate bonds, municipal bonds or government bonds.

Hence it is important that your portfolio composition be as close as possible to that that your plan states. However the economy is not static. Depending on the state of the economy some stocks might increase in value while others decrease in value. This will cause your exposure to these sectors to change. The percentage of the stocks of some sectors of the economy will increase or decrease in your portfolio.

The change in price might also change your exposure to some asset classes. A bull market might increase the percentage of stocks in your portfolio while reducing the percentage of bonds in your portfolio. If left unchecked the asset allocation of your portfolio will change with time and also the riskiness of your portfolio will change. This might thus reduce your chance of reaching your goals.

Thus you need to rebalance regularly. At least once a year is sufficient. Your aim is to reduce your exposure to certain asset classes that have increased in value while increasing your exposure to those that has decreased in value. You will thus return your asset allocation to that that is stated in your investment plan.

You will thus have to sell securities and buy others. This is the most difficult part for some investors because of the cost involved in selling and buying securities. Also some investors may not like selling performing stocks and buying poor performing stocks. However history tells us that a portfolio left to fluctuate with the market always perform poorly.

So keep rebalancing and your portfolio and you will be on course to riches.  

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Tuesday, January 12, 2010

What are treasury inflation protected securities(or tips)?

Treasury Inflation-Protected Securities (or TIPS) are bonds that are issued by governments. The advantage that you get with this security is that the principal of the bond is adjusted yearly with inflation.Thus the principal increases every year and its real value will remain the same. This is contrary to other bonds whose nominal value remain constant whereas their real value decreases.

Since the principal is adjusted yearly with inflation, its value will increase and as a result the coupon payment will increase. This bond is thus a good investment in times of high inflation. The value of your investment will keep its real value with time. This compares to the normal bonds whose principal and the coupon remain the same thus losing its real value with time.

However in case of deflation like in Japan, where inflation turns negative, the value of the principal and coupon decrease with time. In this case a normal bond would have maintain its nominal value but would have its real value increasing.

So investing in tips is just about deciding whether the future will bring deflation or inflation.

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Monday, January 11, 2010

What are treasury notes?

Treasury notes are securities that are issued by governments in order to raise funds to finance deficits. It has a maturity that ranges from 2 to 10 years. Hence it is a security that is traded in the capital market. the capital market is the market in which securities that has a maturity of more than 2 years are traded. treasury bonds is also a security that is traded in the capital market.

The treasury notes are issued at a discount and at maturity the face value is paid to the holder of the notes. The holder of the notes is also entitles to a coupon which is like an an interest paid on a certificate of deposit. This coupon is paid according to a coupon rate which  is merely the percentage of the face value of the note that would be paid as the coupon.

The 10 year note is often used to have an indication of future inflationary expectation. It is often used in the bond spread which is the difference in yield between the 10 year note and the three month treasury bill. The three month maturity date is considered to be so close in the future that the inflation in three month will be close to the actual inflation. The 10 year maturity date however is sufficiently far in the future that the inflation at that time cannot be known. However investors will want to ensure that the yield on the ten year note is adjusted for inflation. Hence the difference between two will be the expected inflation in ten years. The difference in the two yield cannot include a  risk premium like the corporate or municipal bond yield because government treasuries are considered to be the safest of securities.

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What are treasury bonds ?

A treasury bond is a government security that has a maturity that ranges from 10 years to 30 years. It is thus a security that is traded in the capital market.

Like the treasury note it is issued at a discount. It also pays a coupon every six months according to a coupon rate. This security is mostly held by institutions that have long term liabilities like pension funds, long term insurers, etc. 

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