When we deal with new clients, we encounter Premium Bonds frequently, but it's not very often that we see the many other products offered by National Savings and Investments (NS&I). Some NS&I returns are currently looking quite attractive, and so it is worth perhaps looking at two such investments, Premium Bonds and Savings Certificates.
When we deal with new clients, we encounter Premium Bonds frequently, but it's not very often that we see the many other products offered by National Savings and Investments (NS&I).
Some NS&I returns are currently looking quite attractive, and so it is worth perhaps looking at two such investments, Premium Bonds and Savings Certificates.
The purpose for NS&I offering savings accounts and bonds is to raise money for the government. The various offerings range from tax free to taxable, and of course are safe havens for your cash as they are backed by the UK Government.
Around a quarter of all the money invested in NS&I is held in Premium Bonds. Of course, strictly speaking, they are not investments as they are based not on earning interest but effectively a lottery in the form of a monthly prize draw.
Of course this means that you may be lucky, or not. The chance of you winning equates to a rate of 3.8% tax free.
But you are only risking the interest not the capital.
For a higher rate taxpayer assuming income tax at 40%, this is an equivalent rate of 6.33% gross.
Now let's look at Savings Certificates.
One of the problems for higher rate taxpayers is having a large chunk of their gains taxed at 40%. One of the major benefits of Savings Certificates is that they are tax free.
The fixed rate Certificate, for example the 2 year option, pays 3.95%. This comes out at 6.58% for a higher rate tax payer and 4.94% for a basic rate payer. There is also a 5 year option, which is currently paying 3.85%.
Turning to index linked certificates, the picture looks even more attractive. Due to increasing inflation, judged for these purposes to be 4.5%, the 3 year issue returns 1.35% above this. This gives a net return of 5.85% p.a. and a gross equivalent for a higher rate taxpayer of 9.75%! The rate is also the same for the 5 year product.
You can invest from £100 to £15,000 per issue, with no limit on reinvesting matured Certificates.
You can learn more about NS&I at nsandi.com
The Key Considerations:
Ensure that you take into account all the rates and products out there, particularly if you pay higher rate tax. NS&I could be ideal for yous, especially if you are in a phase of your life where you don't need to take any risk with your capital.
Now could be a good time to review all your cash and bond based investments.
ABOUT THE AUTHOR
Ray Prince is an Independent Financial Planner with Rutherford Wilkinson plc, and helps UK Resident Doctors and Dentists get the best deals on mortgages, protection and investments, as well as helping them achieve their financial objectives. Click here for Financial Advice for UK Doctors and Dentists and to get your free retirement guide, How To Avoid The 7 Most Common Retirement Planning Mistakes. Rutherford Wilkinson plc is authorised and regulated by the Financial Services Authority. http://www.medicaldentalfs.com/
Tuesday, July 31, 2018
Monday, July 30, 2018
Are You Missing The Point Of Bond Investing?
If you take a look at any successful portfolio, you will see a mix of stocks and bonds. While perhaps not as sexy as their equity counterparts, the value and importance of bonds is often overlooked by the rags to riches or in many cases, the riches back to rags story of stocks.
In a nutshell, bond investing involves lending money to a corporation, for a fixed term, and getting a fixed rate of return. This return on your investment is called the coupon rate. The key is in knowing how much of your portfolio should be invested in bonds and how much should be invested in the stock market.
Each bond is rated by their risks, and the reward is provided accordingly. Too bad stocks arent rated the same way! This provides a unique advantage over stocks. Also, bonds have a fixed term (2 years, 5 years and 10 years are common terms), at which time, you will get your initial investment back. Another great advantage of investing in bonds is that you will be paid a steady income equal to the return rate. For example, if you were to invest $100 000 in a bond that has a coupon rate of 4% each year, you will receive $4 000 worth of interest payments. During the duration of the term, you get a steady income and you get back your initial investment at the end of it.
Sounds simple, right? Here's where it gets a bit more complicated, but, more profitable. The key is in establishing what is the best strategy when it comes to investing in bonds. The answer of course, is it depends! What types of bonds are you looking at buying? Short term (which are less than 5 years in length of term) usually have a low coupon rate, however, your investment isn't tied up for a longer duration.
This may prove helpful if there is a chance that you may need access to your funds in the case of an emergency, as odds are, you will have a bond maturing around the time you'll need it most. Medium bonds can tie up your money for 5-10 years, while long term bonds can enjoy a term of 10-30 years.
The coupon rate will also vary depending on the credit worthiness. A lower credit rating often means a higher coupon rate (to match the higher risk involved), while a high credit rating is rewarded with a lower coupon rate (and less volatility and risk).
While the coupon rate is the most understand concept in bond investing, its not necessarily where all the money is made. Remember, people buy and sell bonds well before their maturity date. As such, when the interest rate moves lower, the price of an existing bond moves higher, thanks to its higher rate of return than a newer bond would provide. On the flip side, if interest rates move higher, the bond price moves lower, simply because new bonds will now provide a higher rate of return than your existing ones. If you make the call on the direction of interest rates correctly, you'll find yourself in the money by a few percentage points. That can make a huge difference in your portfolio.
Finally, there's the yield of the bond, which is a bit more involved, but simple to calculate. The yield rate is the ratio of the annual return of the coupon rate divided by the current purchase price of the bond. For example, that $100 000 bond with an annual payout of $3 500 has a yield of 3.5% if it's bought at $100 000. If it were purchased at $90 000 (due to an increase in interest rates), it would still return $3 500 per year, and would have a yield of $3 500/$90 000 = 3.8%. Just like the purchase price varies inversely with the interest rate, so does the yield.
By: Christopher Smith
ABOUT THE AUTHOR
Want to improve your stock market returns? Get tips on penny stocks, investing in bonds and what the buzz about the mutual fund store at 1source4stocks.
In a nutshell, bond investing involves lending money to a corporation, for a fixed term, and getting a fixed rate of return. This return on your investment is called the coupon rate. The key is in knowing how much of your portfolio should be invested in bonds and how much should be invested in the stock market.
Each bond is rated by their risks, and the reward is provided accordingly. Too bad stocks arent rated the same way! This provides a unique advantage over stocks. Also, bonds have a fixed term (2 years, 5 years and 10 years are common terms), at which time, you will get your initial investment back. Another great advantage of investing in bonds is that you will be paid a steady income equal to the return rate. For example, if you were to invest $100 000 in a bond that has a coupon rate of 4% each year, you will receive $4 000 worth of interest payments. During the duration of the term, you get a steady income and you get back your initial investment at the end of it.
Sounds simple, right? Here's where it gets a bit more complicated, but, more profitable. The key is in establishing what is the best strategy when it comes to investing in bonds. The answer of course, is it depends! What types of bonds are you looking at buying? Short term (which are less than 5 years in length of term) usually have a low coupon rate, however, your investment isn't tied up for a longer duration.
This may prove helpful if there is a chance that you may need access to your funds in the case of an emergency, as odds are, you will have a bond maturing around the time you'll need it most. Medium bonds can tie up your money for 5-10 years, while long term bonds can enjoy a term of 10-30 years.
The coupon rate will also vary depending on the credit worthiness. A lower credit rating often means a higher coupon rate (to match the higher risk involved), while a high credit rating is rewarded with a lower coupon rate (and less volatility and risk).
While the coupon rate is the most understand concept in bond investing, its not necessarily where all the money is made. Remember, people buy and sell bonds well before their maturity date. As such, when the interest rate moves lower, the price of an existing bond moves higher, thanks to its higher rate of return than a newer bond would provide. On the flip side, if interest rates move higher, the bond price moves lower, simply because new bonds will now provide a higher rate of return than your existing ones. If you make the call on the direction of interest rates correctly, you'll find yourself in the money by a few percentage points. That can make a huge difference in your portfolio.
Finally, there's the yield of the bond, which is a bit more involved, but simple to calculate. The yield rate is the ratio of the annual return of the coupon rate divided by the current purchase price of the bond. For example, that $100 000 bond with an annual payout of $3 500 has a yield of 3.5% if it's bought at $100 000. If it were purchased at $90 000 (due to an increase in interest rates), it would still return $3 500 per year, and would have a yield of $3 500/$90 000 = 3.8%. Just like the purchase price varies inversely with the interest rate, so does the yield.
By: Christopher Smith
ABOUT THE AUTHOR
Want to improve your stock market returns? Get tips on penny stocks, investing in bonds and what the buzz about the mutual fund store at 1source4stocks.
Sunday, July 29, 2018
All About Bonds
In finance, a bond is some sort of a debt security, where an authorized issuer owes the holders a debt and, depending on the legal terms of the bond, is forced to pay interest (the coupon) and/or to repay the main value at a later date, called maturity. A bond is simply a formal contract to repay borrowed money with interest at constant intervals.
Thus a bond is similar to a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the form of interest. Bonds give the borrower external funds to finance long-term investments, or, in the case of government bonds, to finance running expenses. Certificates of deposit (CDs) or commercial paper are considered to be instruments of money market not bonds. Bonds must be paid back at constant intervals over a period of time.
Bonds and stocks are both securities, but the main difference between the two is that stockholders have an equity share in the company (i.e., they are owners), whereas bondholders have a creditor share in the company (i.e., they are lenders). Another difference is that bonds usually have a defined maturity, after which the bond is exchanged, whereas stocks may be stay indefinite. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity(
Issuing bonds
Bonds are created by official authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of creating bonds is through underwriting, where one or more securities firms or banks, forming a syndicate, buy an entire lot of bonds from an issuer and re-sell them to investors. The security firm takes the risk of probable failure in selling on the issue to end investors. On the other side government bonds are typically auctioned. In reality, the current financial crisis tested the willingness of the securities firms to actually perform underwriting. Bookrunners arrange Primary issuance, so they arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners ability to underwrite must be discussed prior to opening books on a bond issue as there may be limited desire to do so.
Bond indices
Many bond indices exist in order to manage portfolios and measure performance, just like the S&P 500 or Russell Indexes for stocks. The most famous American benchmarks are the (ex) Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. The major amount of indices are parts of families of broader indices that are used to measure global bond portfolios, or may be further sub categorized by maturity and/or sector for managing specialized portfolios.
ABOUT THE AUTHOR
James Khan is an expert in writing about legal forms and documents that may help you when your in the search of the right legal document. He writes many articles about forms ranging from, power of attorney forms, landlord tenant forms, and almost any legal form that your searching for. http://www.forms.com/
Thus a bond is similar to a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the form of interest. Bonds give the borrower external funds to finance long-term investments, or, in the case of government bonds, to finance running expenses. Certificates of deposit (CDs) or commercial paper are considered to be instruments of money market not bonds. Bonds must be paid back at constant intervals over a period of time.
Bonds and stocks are both securities, but the main difference between the two is that stockholders have an equity share in the company (i.e., they are owners), whereas bondholders have a creditor share in the company (i.e., they are lenders). Another difference is that bonds usually have a defined maturity, after which the bond is exchanged, whereas stocks may be stay indefinite. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity(
Issuing bonds
Bonds are created by official authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of creating bonds is through underwriting, where one or more securities firms or banks, forming a syndicate, buy an entire lot of bonds from an issuer and re-sell them to investors. The security firm takes the risk of probable failure in selling on the issue to end investors. On the other side government bonds are typically auctioned. In reality, the current financial crisis tested the willingness of the securities firms to actually perform underwriting. Bookrunners arrange Primary issuance, so they arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners ability to underwrite must be discussed prior to opening books on a bond issue as there may be limited desire to do so.
Bond indices
Many bond indices exist in order to manage portfolios and measure performance, just like the S&P 500 or Russell Indexes for stocks. The most famous American benchmarks are the (ex) Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. The major amount of indices are parts of families of broader indices that are used to measure global bond portfolios, or may be further sub categorized by maturity and/or sector for managing specialized portfolios.
ABOUT THE AUTHOR
James Khan is an expert in writing about legal forms and documents that may help you when your in the search of the right legal document. He writes many articles about forms ranging from, power of attorney forms, landlord tenant forms, and almost any legal form that your searching for. http://www.forms.com/
Saturday, July 28, 2018
Private Bond Activity
How to use private bonds to your advantage, as well as little known facts about private bonds and tax credit properties.
Private Bond Activity Appraisals
Private bond activity appraisals are prepared for apartment complexes in the Low Income Tax Housing Tax Credit program which are obtaining private bond financing. The owners of these apartment projects receive a lower level of tax credits (versus traditional Low Income Housing Tax Credit apartment complexes). However, they receive lower cost financing (since the bonds are not subject to federal income tax).
Private bond activity apartment complexes are approved subject to complying with a series of inflexible rules and are contingent on tax credits being available. Identifying sites for which private bond activity apartment complexes are financially feasible is difficult.
Private bond activity complexes are subject to approval by both the state housing agency and bond issuer.
Appraisals for private bond activity apartment complexes vary in several regards from appraisal for conventional apartments. The value is subject to a land use restriction agreement (LURA). Further, there are typically several definitions of market value (as completed, as stabilized and as though LURA does not apply).
O’Connor & Associates is the largest independent appraisal firm in the southwestern United States and has over 40 full-time staff members engaged full-time in valuation and market study assignments. Their expertise includes private bond activity appraisals, feasibility studies, valuing real estate, business personal property, business enterprise valuation, purchase price allocation for business, valuation for property tax assignments, partial interest valuation, estate tax valuation, expert witness testimony and valuation for condemnation. They have performed hundreds of feasibility studies.
To obtain a quote or further information on private bond activity appraisals, contact George Thomas or Craig Young at 713-686-9955 or fill out our online form.
ABOUT THE AUTHOR
O'Connor & Associates is a national provider of commercial property real estate consulting services including federal tax reduction, income tax, business valuation, tax deduction, property appraisal, & lease audits.Our services benefit owners of all commercial property types including multi-family housing, retail stores, hospitals, hotels, industrial properties, manufacturing facilities, medical offices, commercial offices, restaurants, self-storage units, shopping malls, shopping plazas & warehouse/distribution centers.
Private Bond Activity Appraisals
Private bond activity appraisals are prepared for apartment complexes in the Low Income Tax Housing Tax Credit program which are obtaining private bond financing. The owners of these apartment projects receive a lower level of tax credits (versus traditional Low Income Housing Tax Credit apartment complexes). However, they receive lower cost financing (since the bonds are not subject to federal income tax).
Private bond activity apartment complexes are approved subject to complying with a series of inflexible rules and are contingent on tax credits being available. Identifying sites for which private bond activity apartment complexes are financially feasible is difficult.
Private bond activity complexes are subject to approval by both the state housing agency and bond issuer.
Appraisals for private bond activity apartment complexes vary in several regards from appraisal for conventional apartments. The value is subject to a land use restriction agreement (LURA). Further, there are typically several definitions of market value (as completed, as stabilized and as though LURA does not apply).
O’Connor & Associates is the largest independent appraisal firm in the southwestern United States and has over 40 full-time staff members engaged full-time in valuation and market study assignments. Their expertise includes private bond activity appraisals, feasibility studies, valuing real estate, business personal property, business enterprise valuation, purchase price allocation for business, valuation for property tax assignments, partial interest valuation, estate tax valuation, expert witness testimony and valuation for condemnation. They have performed hundreds of feasibility studies.
To obtain a quote or further information on private bond activity appraisals, contact George Thomas or Craig Young at 713-686-9955 or fill out our online form.
ABOUT THE AUTHOR
O'Connor & Associates is a national provider of commercial property real estate consulting services including federal tax reduction, income tax, business valuation, tax deduction, property appraisal, & lease audits.Our services benefit owners of all commercial property types including multi-family housing, retail stores, hospitals, hotels, industrial properties, manufacturing facilities, medical offices, commercial offices, restaurants, self-storage units, shopping malls, shopping plazas & warehouse/distribution centers.
Friday, July 27, 2018
When Is It Safe To Get Back Into Bonds?
Investors who are wondering when it's safe to get back into bonds have one thing going for them: They recognize a real risk that many don't.
But the question still heads down the wrong path. Generalizations about the timing of getting into and out of asset classes are rarely accurate, and they distract from the more productive goal of focusing on what you can do to maintain your long-term financial health. The answers to several other questions about bonds, however, may help in determining an appropriate investment strategy to meet your goals.
Before we talk about the state of the bond market, it is important to discuss what a bond is and what it does. Although there are some technical differences, it is easiest to think of a bond as a tradable loan. Bonds are obligations of the issuer, acting as a borrower, to repay a certain sum with interest to the lender, or bondholder. Bonds are generally issued with a $1,000 "par" or face value, and the bond's stated interest rate is the total annual interest payments divided by that initial value of the bond. If a bond pays $50 of interest per year on an initial $1,000 investment, the interest rate will be stated as 5 percent.
Simple enough. But once the bonds are issued, the current price or "principal" value, of the bond may change because of a variety of factors. Among these are the overall level of interest rates available in the market, the issuer's perceived creditworthiness, the expected inflation rate, the amount of time left until the bond's maturity, investors' general appetite for risk, and supply and demand for the particular bond.
Though bonds are typically perceived as safer investments than stocks, the reality is slightly more complex. Once bonds trade on the open market, an individual company's bonds will not always be safer than its stocks. Both stock and bond prices fluctuate; the relative risk of an investment is largely a factor of its price. If all types of markets were completely efficient, it is true that a bond would always be safer than a stock. In reality, this is not always the case. It's also entirely possible that a stock of one company may be safer than a bond issued by a different company.
The reason a bond investment is perceived as safer than a stock investment is that bondholders are ranked more highly than shareholders in the capital structure of an organization. Bondholders are therefore more likely to be repaid in the event of a bankruptcy or default. Since investors want to be compensated with added return for taking on additional risk, stocks should be priced to provide higher returns than bonds in accordance with this higher risk. As a result, the long-term expected returns in the stock market are generally higher than the expected return of bonds. Historical data have borne out this theory, and few dispute it. Given this information, an investor looking to maximize his or her returns might think that bonds are only for the faint of heart.
Why Invest In Bonds?
Even an aggressive investor should pay some attention to bonds. One benefit of bonds is that they have a low or negative correlation with stocks. This means that when stocks have a bad year, bonds as a whole do well; they "zag" when stocks "zig." In every calendar year since 1977 in which large U.S. stocks have had negative returns, the bond market has had positive returns of at least 3 percent.
Bonds also have a higher likelihood of preserving the dollar value of an investment over short periods of time, since the annual return on stocks is highly volatile. However, over longer periods of 10 years or more, well-diversified stocks virtually guarantee investors a positive return. If an investor will need to withdraw money from his or her portfolio within the next five years, conservative bonds are a sensible option.
Even if you are not going to withdraw from your portfolio, conservative bonds provide an option on the future. In a downturn, you can redeploy the preserved capital into assets that have effectively gone on sale during the market decline. Bonds in a portfolio reduce volatility, cover short-term cash needs and preserve "dry powder" to deploy opportunistically in a market downturn. These are all sensible uses. On the other hand, over investing in bonds can pose more risks than investors may realize.
What Are The Risks Of Bonds?
Imagine bonds' current values and interest rates sitting on opposite sides of a seesaw. When interest rates go up, bond prices go down. The magnitude of the decrease in bond values increases as the bond's duration increases. For every 1 percent change in interest rates, a bond's value can be expected to change in the opposite direction by a percentage equal to the bond's duration. For example, if the market interest rate on a bond with a two-year duration increases to 1.3 percent from 0.3 percent, the bonds should decrease in value by 2 percent. If rates normalize to the historical average of 4.2 percent, the two-year bond should decrease in value by about 7.8 percent.
While such negative returns are not appealing, they are not unmanageable, either. However, longer-term bonds pose the true risk. If interest rates on a 10-year duration bond increased by the same 4 percent, the current value of the bond would decrease by 40 percent. Interest rates are still not far from historic lows, but at some point they are bound to normalize. This makes long-term bonds in particular very risky at this time. Bonds are often referred to as fixed-income investments, but it is important to recognize that they provide a fixed cash flow, not a fixed return. Some bonds may now provide nearly return-free risk.
Another major risk of over investing in bonds is that, although they work well to satisfy short-term cash needs, they can destroy wealth in the long term. You can guarantee yourself close to a 3 percent annual return by buying a 10-year Treasury note today. The downside is that if inflation is 4 percent over the same time period, you are guaranteed to lose about 10 percent of your purchasing power over that time, even though the dollar balance on your account will grow. If inflation is at 6 percent, your purchasing power will decrease by more than 25 percent. Conservative bonds have historically struggled to keep up with inflation, and today's low interest rates mean that most bond investments will likely lose the race. Having a traditionally "conservative" asset allocation of 100 percent bonds would actually be riskier than a more balanced portfolio.
The Federal Reserve's decision to maintain low interest rates for an extended period was meant to spur investment and the broader economy, but it comes at the expense of conservative investors. In the face of low interest rates, many risk-averse investors have moved to riskier areas of the bond market in search of higher incomes, rather than changing their overall investment approaches in a more disciplined, balanced way.
Risk in fixed income comes in a few primary varieties: credit risk, interest rate risk, currency risk and liquidity risk. Some investors have shifted their investments to bonds from lower-quality issuers to earn more income. This strategy can backfire if the company's ability to meet its obligations decreases. Longer-term bonds also pay higher incomes than their shorter-term counterparts, but will lose substantial value if interest rates or inflation rise. Foreign bonds might have higher interest rates than domestic bonds, but the return will ultimately depend on both the interest rates and the changes in currency exchange rates, which are hard to predict. Bondholders might also be able to generate more income by finding an obscure bond issuer. However, if the bond owner needs to sell the bond before its maturity, he or she may need to do so at a large discount if the bonds are thinly traded.
The growing list of municipalities that have defaulted on bonds serves as a reminder that issuer-specific risk should be a real concern for all bond investors. Even companies with good credit ratings experience unexpected events that impair their ability to repay.
Taking on more risk in a bond portfolio is not inherently a poor strategy. The problem with it today is that the price of riskier fixed-income investments has been driven up by so many investors pursuing the same strategy. Given how many investors are hungry for increased income, taking on additional risk in bonds is likely not worth the increased return.
Given The Risks, What Do We Suggest?
We recommend that investors focus on maximizing the total return of their portfolios over the long term, rather than trying to maximize current income in today's low interest rate environment. We have been wary of the risk of a bond market collapse because of rising interest rates for a long time, and have positioned our clients' portfolios accordingly. But that does not mean avoiding fixed-income investments altogether.
While it may be counter intuitive to think that adding equities can actually decrease risk, based on historical returns, adding some equity exposure to a bond portfolio provides the proverbial free lunch - higher return with less risk. For individuals and families who are investing for the long term, the most significant risk is that changed circumstances or a severe market decline might prompt them to liquidate their holdings at an inopportune time. This would make it unlikely that they could achieve the expected long-term returns of a given asset allocation. Therefore, it is important that investors develop an approach that balances risks, but they must also understand and accept the inherent volatility that accompanies a growth-oriented portfolio.
Conservative investments are meant to preserve capital. Therefore, we continue to recommend that clients invest the majority of their fixed-income allocations in low-yield, safe investments that should not be too adversely affected by rising interest rates. Such securities may include money market funds, short-term corporate and municipal bonds, floating-rate loan funds and funds pursuing absolute return strategies. Although these investments will earn less in the short term than a riskier bond portfolio, rising rates will not hurt their principal value as much. Therefore, more capital will be available to reinvest at higher interest rates.
Investors should also achieve some tax savings by focusing on total return rather than on generating income, as long-term capital gains realized from the sale of appreciated positions will receive more favorable tax treatment than will interest income that is subject to ordinary income tax rates. Moreover, focusing on total return will also mitigate exposure to the new tax on net investment income.
So When Is It Safe To Get Back Into Bonds?
Despite my initial claim that this is not the best question to ask, I will give you an answer. Once bond yields begin to approach their historical averages, we will recommend that investors move certain assets into longer duration fixed-income securities. But you cannot wait for the Federal Reserve to change interest rates. Like any other market, values in the bond market change based on people's expectations of the future. Even in normal interest rate environments, however, we typically advise clients that the majority of their fixed-income allocation be invested in short- and intermediate-term bonds. Bonds are for protecting your wealth, not for risking it.
By: Benjamin C. Sullivan
For more articles, please visit the Palisades Hudson Financial Group LLC newsletter or subscribe to the blog.
Newsletter: http://palisadeshudson.com/sentinel/
Blog: http://palisadeshudson.com/current-commentary/
But the question still heads down the wrong path. Generalizations about the timing of getting into and out of asset classes are rarely accurate, and they distract from the more productive goal of focusing on what you can do to maintain your long-term financial health. The answers to several other questions about bonds, however, may help in determining an appropriate investment strategy to meet your goals.
Before we talk about the state of the bond market, it is important to discuss what a bond is and what it does. Although there are some technical differences, it is easiest to think of a bond as a tradable loan. Bonds are obligations of the issuer, acting as a borrower, to repay a certain sum with interest to the lender, or bondholder. Bonds are generally issued with a $1,000 "par" or face value, and the bond's stated interest rate is the total annual interest payments divided by that initial value of the bond. If a bond pays $50 of interest per year on an initial $1,000 investment, the interest rate will be stated as 5 percent.
Simple enough. But once the bonds are issued, the current price or "principal" value, of the bond may change because of a variety of factors. Among these are the overall level of interest rates available in the market, the issuer's perceived creditworthiness, the expected inflation rate, the amount of time left until the bond's maturity, investors' general appetite for risk, and supply and demand for the particular bond.
Though bonds are typically perceived as safer investments than stocks, the reality is slightly more complex. Once bonds trade on the open market, an individual company's bonds will not always be safer than its stocks. Both stock and bond prices fluctuate; the relative risk of an investment is largely a factor of its price. If all types of markets were completely efficient, it is true that a bond would always be safer than a stock. In reality, this is not always the case. It's also entirely possible that a stock of one company may be safer than a bond issued by a different company.
The reason a bond investment is perceived as safer than a stock investment is that bondholders are ranked more highly than shareholders in the capital structure of an organization. Bondholders are therefore more likely to be repaid in the event of a bankruptcy or default. Since investors want to be compensated with added return for taking on additional risk, stocks should be priced to provide higher returns than bonds in accordance with this higher risk. As a result, the long-term expected returns in the stock market are generally higher than the expected return of bonds. Historical data have borne out this theory, and few dispute it. Given this information, an investor looking to maximize his or her returns might think that bonds are only for the faint of heart.
Why Invest In Bonds?
Even an aggressive investor should pay some attention to bonds. One benefit of bonds is that they have a low or negative correlation with stocks. This means that when stocks have a bad year, bonds as a whole do well; they "zag" when stocks "zig." In every calendar year since 1977 in which large U.S. stocks have had negative returns, the bond market has had positive returns of at least 3 percent.
Bonds also have a higher likelihood of preserving the dollar value of an investment over short periods of time, since the annual return on stocks is highly volatile. However, over longer periods of 10 years or more, well-diversified stocks virtually guarantee investors a positive return. If an investor will need to withdraw money from his or her portfolio within the next five years, conservative bonds are a sensible option.
Even if you are not going to withdraw from your portfolio, conservative bonds provide an option on the future. In a downturn, you can redeploy the preserved capital into assets that have effectively gone on sale during the market decline. Bonds in a portfolio reduce volatility, cover short-term cash needs and preserve "dry powder" to deploy opportunistically in a market downturn. These are all sensible uses. On the other hand, over investing in bonds can pose more risks than investors may realize.
What Are The Risks Of Bonds?
Imagine bonds' current values and interest rates sitting on opposite sides of a seesaw. When interest rates go up, bond prices go down. The magnitude of the decrease in bond values increases as the bond's duration increases. For every 1 percent change in interest rates, a bond's value can be expected to change in the opposite direction by a percentage equal to the bond's duration. For example, if the market interest rate on a bond with a two-year duration increases to 1.3 percent from 0.3 percent, the bonds should decrease in value by 2 percent. If rates normalize to the historical average of 4.2 percent, the two-year bond should decrease in value by about 7.8 percent.
While such negative returns are not appealing, they are not unmanageable, either. However, longer-term bonds pose the true risk. If interest rates on a 10-year duration bond increased by the same 4 percent, the current value of the bond would decrease by 40 percent. Interest rates are still not far from historic lows, but at some point they are bound to normalize. This makes long-term bonds in particular very risky at this time. Bonds are often referred to as fixed-income investments, but it is important to recognize that they provide a fixed cash flow, not a fixed return. Some bonds may now provide nearly return-free risk.
Another major risk of over investing in bonds is that, although they work well to satisfy short-term cash needs, they can destroy wealth in the long term. You can guarantee yourself close to a 3 percent annual return by buying a 10-year Treasury note today. The downside is that if inflation is 4 percent over the same time period, you are guaranteed to lose about 10 percent of your purchasing power over that time, even though the dollar balance on your account will grow. If inflation is at 6 percent, your purchasing power will decrease by more than 25 percent. Conservative bonds have historically struggled to keep up with inflation, and today's low interest rates mean that most bond investments will likely lose the race. Having a traditionally "conservative" asset allocation of 100 percent bonds would actually be riskier than a more balanced portfolio.
The Federal Reserve's decision to maintain low interest rates for an extended period was meant to spur investment and the broader economy, but it comes at the expense of conservative investors. In the face of low interest rates, many risk-averse investors have moved to riskier areas of the bond market in search of higher incomes, rather than changing their overall investment approaches in a more disciplined, balanced way.
Risk in fixed income comes in a few primary varieties: credit risk, interest rate risk, currency risk and liquidity risk. Some investors have shifted their investments to bonds from lower-quality issuers to earn more income. This strategy can backfire if the company's ability to meet its obligations decreases. Longer-term bonds also pay higher incomes than their shorter-term counterparts, but will lose substantial value if interest rates or inflation rise. Foreign bonds might have higher interest rates than domestic bonds, but the return will ultimately depend on both the interest rates and the changes in currency exchange rates, which are hard to predict. Bondholders might also be able to generate more income by finding an obscure bond issuer. However, if the bond owner needs to sell the bond before its maturity, he or she may need to do so at a large discount if the bonds are thinly traded.
The growing list of municipalities that have defaulted on bonds serves as a reminder that issuer-specific risk should be a real concern for all bond investors. Even companies with good credit ratings experience unexpected events that impair their ability to repay.
Taking on more risk in a bond portfolio is not inherently a poor strategy. The problem with it today is that the price of riskier fixed-income investments has been driven up by so many investors pursuing the same strategy. Given how many investors are hungry for increased income, taking on additional risk in bonds is likely not worth the increased return.
Given The Risks, What Do We Suggest?
We recommend that investors focus on maximizing the total return of their portfolios over the long term, rather than trying to maximize current income in today's low interest rate environment. We have been wary of the risk of a bond market collapse because of rising interest rates for a long time, and have positioned our clients' portfolios accordingly. But that does not mean avoiding fixed-income investments altogether.
While it may be counter intuitive to think that adding equities can actually decrease risk, based on historical returns, adding some equity exposure to a bond portfolio provides the proverbial free lunch - higher return with less risk. For individuals and families who are investing for the long term, the most significant risk is that changed circumstances or a severe market decline might prompt them to liquidate their holdings at an inopportune time. This would make it unlikely that they could achieve the expected long-term returns of a given asset allocation. Therefore, it is important that investors develop an approach that balances risks, but they must also understand and accept the inherent volatility that accompanies a growth-oriented portfolio.
Conservative investments are meant to preserve capital. Therefore, we continue to recommend that clients invest the majority of their fixed-income allocations in low-yield, safe investments that should not be too adversely affected by rising interest rates. Such securities may include money market funds, short-term corporate and municipal bonds, floating-rate loan funds and funds pursuing absolute return strategies. Although these investments will earn less in the short term than a riskier bond portfolio, rising rates will not hurt their principal value as much. Therefore, more capital will be available to reinvest at higher interest rates.
Investors should also achieve some tax savings by focusing on total return rather than on generating income, as long-term capital gains realized from the sale of appreciated positions will receive more favorable tax treatment than will interest income that is subject to ordinary income tax rates. Moreover, focusing on total return will also mitigate exposure to the new tax on net investment income.
So When Is It Safe To Get Back Into Bonds?
Despite my initial claim that this is not the best question to ask, I will give you an answer. Once bond yields begin to approach their historical averages, we will recommend that investors move certain assets into longer duration fixed-income securities. But you cannot wait for the Federal Reserve to change interest rates. Like any other market, values in the bond market change based on people's expectations of the future. Even in normal interest rate environments, however, we typically advise clients that the majority of their fixed-income allocation be invested in short- and intermediate-term bonds. Bonds are for protecting your wealth, not for risking it.
By: Benjamin C. Sullivan
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