Basics of Investing- 2
By Safghir Aslam
(Continued from last week)
Risk and Reward - Bonds
Bonds are debt securities -- the bondholder is a creditor to the issuing entity. A bond acknowledges that you have made a loan of the face value to the issuer, and represents the issuer's agreement to pay you a specified rate of interest over a specified period (hence the term "fixed-income investment"), after which the face value will be repaid to you.
Whereas stocks are ordinarily chosen for their growth potential, bonds are ordinarily chosen for potential fixed-income and capital preservation. This doesn't mean that bonds are without risk, however. When considering bond investments, think about each of the following types of risk:
· Credit risk/quality. If the issuer is unable to pay interest and principal when due, the bond is in default. The smaller the chance that the issuer will go into default, the higher the bond's quality rating. Thus a bond rated AAA offers a higher degree of safety -- but it will probably also yield lower interest -- than a bond rated A.
· Maturity risk. Some bonds have call provisions. This means the issuer can call (repurchase) the bond from you at a specified price after a stated amount of time. If the issuer chooses to call the bonds, it's usually because prevailing interest rates have fallen since the bond was issued. The call provision allows the issuer to pay you off and re-borrow the face value at a lower interest rate. This leaves you with an unhappy choice between re-lending it at the lower rate or trying to find a better rate elsewhere. To compensate investors for this risk, bonds with call provisions ordinarily offer higher interest rates than bonds that can’t be called.
· Liquidity risk. This is the risk that you won't be able to find a buyer should you want to sell your bonds before maturity. For example, a bond from a fairly obscure issuer will not be as liquid -- as easy to sell -- as a U.S. Treasury bond; a bond with complex features will not be as liquid as a simpler bond. Other things being equal, less liquid bonds should offer higher yields to compensate the investor for the added risk.
· Interest-rate risk. If you invest long-term and interest rates rise, you may have missed the chance to invest the money at the new higher rates. If you try to sell your bond before maturity in order to reposition the money, you may find that the bond's principal value has fallen (to bring its effective return in line with new bond issues). Similarly, if you invest short-term and interest rates fall, you've missed the chance to invest the money long-term at the old higher rates. Since the long-term investor bears interest-rate risk over a longer period, long-term bonds ordinarily yield more than short-term bonds.
· Reinvestment risk. The yield-to-maturity calculation assumes reinvestment of semi-annual income at the stated or coupon rate. A zero-coupon bond is exempt from reinvestment risk, because it is structured to compound at the stated rate of return. (More on zero-coupon bonds below.) On the other hand, a conventional bond with a high rate involves greater risk of not being able to invest the interest payments at that same high rate of return.
Yields on municipal bonds issued by government entities are lower than those for taxable bonds, because the interest on municipals is generally free of federal income tax (and often free of income tax in the state where they are issued). Capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).
In dealing with bonds, keep three general axioms clearly in mind:
· As yields rise, dollar prices (market values of bonds sold before maturity) decline; as yields fall, dollar prices rise.
· For equal changes in yields, prices on longer-term bonds change more than prices on shorter-term bonds.
· For equal changes in yields, discounted bonds (bonds purchased at less than face value) undergo a larger percentage change in dollar price than par bonds (bonds bought at face value) or premium bonds (bonds bought at more than face value).
Zero-coupon bonds or "zeros" represent U.S. Treasury obligations. They work much like U.S. Savings Bonds: they are sold at a deep discount and compound at a stated rate until they mature at full face value. Since they do not pay current income, their market value fluctuates with interest rates even more widely than the market value of conventional (coupon) bonds. Thus a drop in interest rates may produce a quick rise in the market value of a long-term zero, offering the potential of a capital gain. However, this upside has a downside: if you take the quick gain, the interest rates at which you can reinvest are lower.
It's also important to note that the assumed growth of zeros is taxable each year, even though you don't receive it until maturity. As with nearly all fixed-income investments, if you sell the zero before it matures, it may be worth more or less than your initial cost.
Risk and Reward: Mutual Funds
Mutual funds pool the money of many investors and invest in diversified portfolios of stocks and/or bonds to help manage the risk of single investments. Funds provide professional investment management, research and record-keeping. If you are considering a mutual fund, request the fund's prospectus and its Statement of Additional Information, and read these materials carefully before making a decision. Study the fund's performance record over the last ten years, and compare it with the performance of other funds of the same type.
If the fund has been successful, see whether the senior managers responsible for its success are still there. Make sure the fund's investment objectives and philosophy are compatible with your own. Keep in mind that past performance is not a guarantee of future results.
Making Interest-Rate Fluctuations Work for You
Changes in inflation and interest rates have major effects on both stock and bond prices. Predictions about their movements are a major focus of market analysis and business journalism, but are not always reliable. One way to make interest-rate and price changes work for you is through time diversification.
For stocks, time diversification can take the form of dollar-cost averaging. This means investing the same number of dollars in the chosen security at regular intervals, without regard to current prices. The result is that you buy more shares when prices are low, fewer shares when prices are high. Over time, the average purchase price of your shares is lower than if you had bought an equal number of shares at each interval. You're protected against the risk of buying the entire investment at the top of the stock's price range. (Of course, you also give up the chance of buying the entire investment at the bottom of the price range.)
Dollar-cost averaging, though a beneficial strategy for many investors, does not guarantee a profit and does not protect against a loss in declining markets. Such a strategy involves continuous investment -- so before starting a program, consider your ability to continue purchases through periods of low price levels.
For bonds, time diversification can take the form of a bond ladder. If new money becomes available each year, this works much like dollar-cost averaging for stocks, as you can invest roughly the same number of dollars in new bonds at current interest rates.
But even without new money, you can diversify over time by staggering the maturities of your bonds. As a portion of your portfolio matures each year, the face value is reinvested in new bonds at current interest rates.
In a five-year ladder, for example, the portfolio is divided evenly among bonds maturing in each of the next five years. As each year's bonds mature, the proceeds are invested in new five-year bonds. The strategy depends on a normal interest-rate environment, one in which short-term issues have lower coupons than longer-term issues.
All these forms of time diversification can help you smooth out the effects that interest-rate and market fluctuations have on your portfolio.
For more information, or for assistance managing personal or business finances, talk with your Financial Advisor.