Bond investment
People work very hard for their money and as they invest it, they expect to earn satisfactory rates of return. Money that is not spent is saved. There are a great number of investment alternatives, but many investors end up with the same few choices. Investments are made to generate future purchasing power that will keep ahead of inflation and provide investors with a sense of financial security. However, if rates of return earned on these investments are meager, this sense of security can quickly turn to a sense of frustration. Rates of return need to exceed the rate of inflation and cover the taxes paid on the earnings to produce positive purchasing power for investors. Should rates of return not exceed those of inflation and the taxes paid, then the investments are earning negative rates of return and are losing future purchasing power.
After buying a house, the average investors savings go into low-yielding bank savings accounts, money market funds and certificates of deposit. The record bull market of the last three years has enticed many individual investors, who have never previously invested in stocks, to jump into the stock market. This is evidenced by the frenzy to invest in the internet stocks, which have defied gravity in their ascent to dangerously high valuations. The staggeringly high returns earned in relatively short periods of time of these internet stocks have prompted investors to disregard the risks of investing in these expensive stocks. Stocks that can rise over twenty points in one day have the potential to fall by that amount and more in a downturn. Ignoring the volatility of the stock market in pursuit of higher returns may be disastrous for investors who do not weigh the overall risks of their individual investments. On the other side of the spectrum, there are many investors who completely shun the stock market because of the volatility.
Investing the bulk of savings in low-yielding savings accounts translates into lower rates of return, higher income taxes and the loss of capital appreciation. Bank accounts and money market mutual funds tend to pay interest at the low end of the yield scale without providing the tax advantages and capital appreciation opportunities of some of the other investment alternatives.
Despite these disadvantages of keeping money in low yielding bank accounts, many investors persist with this strategy, because they find the complexities of other investments such as stocks and bonds overwhelming. There is also the worry that with the increased volatility of the stock and bond markets, a downturn in either market could result in a loss of their savings. Therefore, these investors are paralyzed into keeping their money invested in low yielding accounts.
There are a number of reasons, one of which has to do with the variability of the returns. The standard deviation of the returns measures the riskiness of the portfolios. Bonds have always been less risky than stocks and this is shown by the standard deviation of the returns. Treasury bills have the least risk due to their relatively short maturities and the fact that there is almost no chance.
EVALUATING BOND CHARACTERISTICS.
All bond issues have a master loan agreement, called a bond indenture which contains the information for the issue. The following terms of a bond issue would be included in the indenture:
The amount of the bond issue.
The coupon rate.
Frequency of interest payments.
Maturity date.
Call provision, if any. This provision allows the issuer of the bonds to call them in and repay them before maturity.
Refunding provision, if any. This provision allows the issuer to obtain the proceeds with which to repay the bondholders when the issue matures by issuing new securities.
Sinking fund provision, if any. This provision offers bondholders greater security in that the issuer sets aside earnings to retire the issue.
Put option, if any. This provision allows the bondholders to sell the bonds back to the issuer at par value.
The main advantages of investing in bonds are that, investors can count on a steady stream of interest income and if the bonds are held to maturity, investors will receive the face value of the bonds back. However, with the wide fluctuations in market rates of interest in the past two decades, bond markets have become more volatile. Investors should become more cautious regarding the types of bonds they choose and the timing of their buying and selling. There are different types of bonds to choose from each having its own set of characteristics. For instance, bonds vary in their safety, marketability, return, liquidity, tax treatment, maturity and the frequency with which interest is paid.
Investors can improve their returns and lessen their risk of loss by examining and understanding the varying characteristics of bonds before investing. A good starting point is to match bond maturities to financial needs, which can limit the loss of principal. Maturities of bonds range from less than a year 50 years. For example, an investor who has funds to invest for six months would not want to invest in 30 year United States Treasury bonds, because if interest rates rise during that period, the investor will lose a portion of his principal as bond prices of existing issues go down. However, if interest rates go down during that period, the investor will be able to sell the bonds at a profit because prices of existing bonds will rise. By matching the bond maturities to financial needs, investors can limit their losses due to market interest rate flux.
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