Investors Times -How to invest,survive and prosper in the stock market: January 2009

Wednesday, January 28, 2009

What is a bond?

A bond is a an investment instrument that is simply a debt. There is someone who has the money and that is you, and an entity that needs the money. This entity will borrow the money from you and in return you will obtain interest.

Companies and governments needs money for a variety of purposes and one of the way they can get the money is to issue bonds. As a result when an entity issues bonds, investors like you will buy these bonds and the company will get the money. Hence a bond is simply an IOU that the entity will give to you so that later on you will get your money back.

Before buying the bonds, we need to know about some characteristics of bonds.

Face Value OR Par Value OR Principal

This is the amount that you will get when you present your bond when it matures. The result it is called the face value is because this value will be written on the bond certificate. So if you have a bond that matures in ten years and that its par value is $ 1000, it means that you will get $1000 when it matures.

However bonds are not sold at par value. It can be sold at a discount, at par or at a premium.

1. At a discount. These bonds will be issued at a price lower than the par value.

Bonds are usually discounted at a percentage called the discount rate. Now suppose that a bond of par value $1000 is issued at a discount rate of 5%. At what price would you buy it?

Buying price = (100 - Discount rate)/100 * Par value
= (100 - 5) /100* 1000
=95/100*1000
=$ 950

So this bond will be sold at $950.

2. At par. These bonds will be issued at a price that is the same as the par value that is $ 1000.

3. At a premium. Some bonds that are in great demand will be sold higher than the par value. Now suppose that a bond of par value of $1000 is issued at a premium rate of 10%. At what price would you buy it?

Buying price = (100 + premium)/100 * Par value
= (100 + 10) /100* 1000
=110/100*1000
=$ 1100

So this bond will be sold at $1100.

Coupon Rate or The Interest Rate

The coupon is the amount that you would receive year until the maturity date. The bond will then have a coupon rate that may or may not be the same as the discount rate. However most bond pay twice a year and as a result the bondholder will receive a payment twice a year.

Let say that you have a bond of par value $1ooo with coupon rate 6%.

Coupon or interest received = interest rate/100* par value
= 6/100*1000
$60

Hence the coupon payment is $60. If the payment is done twice a year then you would receive $30 every six months.

Maturity Date

The maturity date is the date when the issuer will repay you your money. As mentioned above you will get an amount equal to the par value.This will range from a few months to 30 years.

Note that for government bonds special names are used depending on the time to maturity.

Treasury bills - maturing in less that one year
Treasury notes -maturing from 1 year to 10 years
Treasury bonds -Maturing in more than 10 years

Why invest in bonds?

1. Bonds are less risky than other instruments. Read this post on risk to understand why. However keep in mind that bonds have lower return and that some bonds may be riskier depending on the issuer.

2. Some people need a regular source of income. Because some stocks may not pay dividends on a regular basis then bond coupon payment will offer a regular income.

3. Because bonds are safe investments, you may invest your money in them if you do not want to lose your money. Especially if you need it in the near future.

4. Bonds are also a major part of the investment portfolio of people that have a low risk tolerance.

What is a bond?
Stocks have higher return than bonds
Introduction to diversification
What is a bond ladder?

Tuesday, January 13, 2009

Stay away from credit cards !

As my old dad usually says everybody do things for their own interests. Its rare for companies to to things for the benefits of society. The same applies to credit card companies. They says that a credit card can improves your life, but if you look closely it may have a large share in the recession that is ravaging the world.

If you are lucky enough to have escaped the credit card craze, you can thank god even if you are an atheist, for you are a the lucky few.

Before the advent of the credit card, people lived within their means and rarely take credit. They worked honestly and with their wages they would buy things that they need with cash. However time has changed. Everyone who has some intelligence is trying to lure the poor worker to take a credit. Overdraft, loan, credit card, revolving credit, hire purchase, equity line, car loan, student loans, etc. It seems that everything that was purchased with cash must now be purchased on some form of credit.

There is no doubt that now that this credit craze is over life would never be the same. Those politicians that are betting a return to normal are probably kidding themselves. In order to get out of this situation the bubble of credit has to be deflated completely. This would then leave people with a reasonable amount of credit. However things would not be as good as before. No more fun. No more partying. Hard work like in the old days. Smaller houses. Smaller cars. Less latest gadgets and appliances.

Its going to be difficult but soon you will get used to it. Our parents did it.

Saturday, January 10, 2009

A long and deep recession ?

As was said on the Wall Street Journal lately, this recession is not like the previous ones. Hence one should be careful when hearing politicians say that the recession would be over in 2009.

The reason is that the western world has no money. The government, household and companies had been relying lately on the generosity of China, Japan, South Korea and the Oil producing nation for credit. To understand why this is bad lets recapitulate on the different forces acting in a recession that push it towards a recovery.

1. Government spending

As the economy worsens, the aggregate spending in the economy falls. This is due mainly to reduced spending by household and by reduced investments by companies. In theory, as Keynes would recommend, the government would have to increase spending and decrease taxes so that household would have more disposable income.

In a "normal " recession the government would borrow the money and things would be OK. But in this case many countries have large public debt and increasing it would cause debt repayment to reach unsustainable level. Countries that used to lend to developed countries( named above) are more and more unwilling to lend so even if government want to borrow, they might not get the money.

2. Household savings

In a "normal" recession people have a lot of savings. So if they are out of work they are able to tap into the rainy day fund. This would cause them to continue spending. As a result the downturn would be softened a little bit. However in this recession the people have mostly dept. As unemployment increases, these people will have no money. They would then be a burden on the government as unemployment benefits increases. They would also most likely spend as little as possible worsening the recession.

These two factors would most likely cause an upswing to be less likely in the next six month. I would think that everyone would have to clean their houses before a recovery can kick in. Throwing money at it would most likely not help.