Simple Pound

Having read yesterday’s post, you should now know what bonds are and that their price can differ from their par (face) value depending on various (mysterious) external circumstances. You have also read that after you’ve bought a bond its price only really concerns you if you’re planning to get rid of it before the maturity date. That’s a major difference to shares, whose price determines the value of your investment. With a bond on the other hand you can be certain that you will always get the bond’s par value back (assuming the issuer doesn’t default) plus any interest that might be payable ‘along the way’. This is the major reason why bonds should only constitute a small percentage of your portfolio while you’re young (i.e. you should make the most of your money rather than sit on a close-to risk-free bond)…

So what is it that influences the price you can sell your bond for?

• Interest rates: Rising interest rates mean you could potentially get a higher return even if your money is only sitting in a savings account. Therefore, bonds that issue after a rise in interest rates will offer a higher annual return (yield) in order to keep up with your savings account (and thus your bank!). This also means, the price for existing bonds might drop because their yield has now become less competitive and thus investors are willing to pay less. The only way to ‘convince’ investors to buy a bond with a low coupon rate, is by offering it at a discount. The same logic applies when interest rates drop - already issued bonds become more attractive and demand can only be limited via an increase in price.

• Inflation: When inflation increases, bond prices will decrease because the coupon rate might not be high enough to keep up with inflation. Especially with bonds that have a long maturity you will often find higher coupon rates to keep the bond attractive even if inflation might change substantially over the long run.
• Financial health of issuer: If the market believes that there is almost no risk of the issuer defaulting, the bond’s price will increase to reflect a high-quality security. On the other hand, if the investor is in some financial difficulties, not many people will be willing to accept the associated risk and the price will drop.

If you are keen to find out more about bonds (there is so much more material out there, trust me), I suggest you start here. There are many varieties of bonds available plus the option of investing in bond funds - i.e. a collection of bonds administered by someone who (hopefully) knows what they’re doing. The concepts are fairly similar to mutual funds so I will only cover them briefly next time.

Read part 7 of “Investment Choices” on bond funds >>

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All of the investment choices covered so far concern equity securities where the investor, after buying shares in one form or the other, owns part of a company. Debt securities constitute an alternative way for corporations (or governments!) of raising finance - without having to give up part of their company.

When you buy a bond you essentially make a loan to the corporation, the government or whoever else the bond’s issuer might be. Just like when you take out a loan with your bank, the issuer of the bond has to pay interest for being allowed to use your money.

Bonds are determined by three components: the par (or face) value, the coupon rate and the maturity. If an issuer wants to borrow £20,000 for 5 years and is willing to pay 7% interest on this money, the available bond will have a par value of £20,000, a coupon rate of 7% and a maturity of 5 years.

Issuers who want to keep the option of paying back back the face value before maturity, issue a callable bond, while issuers who don’t want to pay interest annually (or quarterly, monthly…) can create a zero-coupon bond. With this type of bond, no interest payments are being made during the loan period but the cumulated interest is paid together with the par value of the bond upon maturity. The advantage of the latter is that these bonds are usually priced at a discount to balance out the fact that no (interim) interest payments are made. This means, to buy a £1,000 bond you might only have to provide funds of £900, but the cumulative interest that you will receive upon maturity is based on the bond’s par value.

The coupon rate of the bond is mainly influenced by the current interest rate, the length of the term and the creditworthiness of the issuer. A company that has a relatively high risk of defaulting (i.e. not being able to pay back the loan) will have to pay higher coupon rates to balance this risk.

Because all of the above determinants can change after a bond is issued, the market value of a bond can and will vary over time. This variation is expressed as a percentage of the par value (i.e. 95% or 102%). Close to maturity, when interest rates and creditworthiness of the issuer won’t have sufficient time to adjust, the bond’s price will converge to 100% par value.

The good news is: if you buy a bond and plan to hold it until it matures, none of the above does affect you in any way. It just gets interesting once you’re trying to sell the bond on the secondary market (i.e. sell the right to receive interest payments from the issuer to some other investor).

More about the factors influencing bond prices soon (in case you don’t intend to hold on to the same bond for 20 years…).

Read part 6 of “Investment Choices” for more on bonds >>

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What is the most difficult thing about investing? Picking shares? Timing the market? Evaluating funds?

Actually, probably neither of those. This time the golden buzzword is not diversification, but patience. Hanging in there and trusting your own decisions. If you are investing for the long(er) term, you will probably have researched whatever investment you thought was best for you. Leave it at that and relax.

Kevin @ Fool.co.uk suggests a holiday in Barbados.

Yes, the market might experience a downwards trend for a few weeks, sometimes even months. But thinking back to stock indices, which are commonly seen as indicators for a country’s economy, you should now know that in the long run you’ll gain - if you can keep a cool head.

Even if one of your investment options should go bust, you obviously have a diversified portfolio that evens out the losses you’ve made in that particular position… And optimistically seen, you can even learn from your mistakes, understand why you made the wrong choice (accepting that sometimes particular circumstances that made a share crash could not have been foreseen) and avoid it in the future…

In my case the experience I take away from such a mistake is not to blindly trust someone else’s advice without double-checking it is built on solid grounds. In April 2000 Nokia’s shares underwent a stock split of 1:4 which meant that a share previously priced at 200€ could now be bought for the bargain price of 50€ (every investor who had owned shares in the company before the stock split found the 4-fold amount of shares in his investment account the next morning…).

My mum told me that I simply had to buy now. Since one of the bonds my parents had bought for me previously had just matured I followed her advice (blindly). Initially happy to see my new shares increase to 65€, I soon had to learn what it feels like to observe a solid value decrease. Suddenly priced at 10€, my shares had lost 80% of their (original) value - but I held on to them.

Today they are still trading at under 20€ but for some reason I just can’t let go of my very first investment mistake… I’ll report back in 10 years time whether I am still making losses…

Note: The scale of the chart is logarithmic which makes the losses look much less dramatic than they really were (or felt?). Also, the chart prices are stated in US-$ rather than Euros (thus the current closing price is approaching $25).

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After I diverged a little bit from my original investigation into investment choices, let’s return and have a closer look at mutual funds this time.

I have already discussed index (tracker) funds in great detail, and while mutual funds and index funds do share some features, in most ways they differ significantly. You’ll hopefully soon see why.

Just as index funds, a mutual fund is essentially a collection of shares bought and administered by a fund manager. Mutual funds can be either bought with the fund company directly or through a normal broker and thus simply like you would buy any other share. While the shares of exchange traded funds (ETFs) are priced throughout the day (which is why they are often compared to ordinary shares) and can thus vary in value throughout the day, mutual funds are only priced once - at the end of the market day.

So why invest in mutual funds? The answer is simply - and you probably would have guessed - diversification. If many people invest in the same fund, large sums of money are made available to spread the investment over a variety of sectors, shares, countries and markets - something you clearly couldn’t achieve on your own, at least not if you don’t belong to Britain’s richest 5. Moreover, mutual funds are actively managed (remember that index funds where what is called “passively managed”), which means that some people devote their entire careers to picking stocks for you. That means they spent their entire days researching companies to find the next winner, the one company that is going to outperform the market in the long run (if it exists).

The advantage that should come with a dedicated fund manager is generally a better performance than e.g. an index like the FTSE 100. Since these people should be able to eliminate the companies whose shares are going to go down, right? Well… sort of. But even those fund managers are human after all, so in the end they are probably bound to make a mistake at some point. The truth is, that only about 15% of available mutual funds outperform the market in the long run. Therefore you will need to do your homework for funds just as you would for company shares.

The downside of actively managed investments is that you will need to pay the person who is doing all the work for you - after all, they want to pay off their mortgage too. This implies that the expense ratio of mutual funds will generally be higher than that for index (tracker) funds, and commonly accompanied by advertising expenses and a high turnover through a more frequent buying and selling of shares than mirroring an index would require. Since every buy- or sell-transaction incurs additional costs the most amazing gains could be eaten away by these additional expenses - a fairly good reason to do your homework properly.

Read part 5 of “Investment Choices” on bonds >>

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I have recently come across the Zopa website, which claims to connect lenders and borrowers without involving banks - thus guaranteeing both parties better rates. The whole site is built around a community of people either willing to lend or people seeking to borrow money - from each other directly, rather than going to their local bank and thus making these institutions even richer than they already are.

And it seems to work as they are quoting quite competitive rates of 5.95% APR for a £5000 loan over 36 months, while promising lenders an average of 6.75% pa for their money (after bad debt and fee, before tax). Since I am not planning to take out a loan very soon, I was more interested in the lender aspect of this. It is essentially a bond based on an individual (and his credit rating) rather than a government or corporation - only with a much better return.

And here’s how it works: If you decide you have got some money left over that you wish to temporarily make available to someone else, you create an account with Zopa and transfer your money in, specifying which credit rating you will accept and for how long you want to lend the money. Their credit scores range from A* (very reliable) to C (still reliable, but less credit history - e.g. a student), which is based on an extensive identity-, credit- and risk-check. According to them, a person with a credit rating of “C” is still more creditworthy than the majority of the population. Well, that sounds good, but is obviously very difficult to prove…

The interest you get for your money depends upon the duration you’re intending to lend money and the people you’re happy to lend to. Since the website essentially functions like a market, the actual interest rate you are receiving will be based on supply and demand. So in order to get a decent return, you should put down your money for as long as possible (5 years) and ideally to C-rated people, because for these categories demand will potentially be highest. Obviously decisions like that depend upon you’re own risk attitude!

There is no lower limit for how much money you can put in the Zopa account - people start at sums of £10 or use Zopa as a regular savings account and make small monthly contributions. In most cases you won’t be lending to a single person, but your money will be spread across various people seeking a loan. This is an in-build protection mechanism based upon the wisdom that diversification limits risk. And if the conditions of your lending aren’t appealing to anyone in the market-place (for instance, your lending period is too short), you will still earn 4.5% interest on the money in the Zopa account - which is more than I am making with my savings at the moment!

As I said at the beginning, I’m beginning to really like this idea. Especially since you will know where your money is going and in most cases people also share what they are using the money for. In short this means that whenever you decide not to spend your money but put it in your Zopa account, you could potentially help fulfilling someone else’s dream!

Head over to their website for more information! And please, if you’ve had any experience with Zopa at all, leave a comment and have the rest of us benefit from your knowledge!

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After I have talked you through many, many, many indices in various countries and on various continents, we need to draw some conclusions to actually make all of this worthwhile.

The main criteria for the list will simply be the medium-term growth rate (I consider 5 years to be medium-term since long-term investing is usually assumed to be > 10 years). The 5 year span should be sufficient to expose a growth trend, but there’s obviously no guarantee - especially if you’re looking at countries like India, which have become very fashionable in the last few years. If you remember the last “fashion trend” and what happened (I’m talking dot.com bubble…), you should know what I am talking about. On the other hand, most of you will be young and far away from retirement, so there’s nothing wrong with a little risk in your investment - if you’re that sort of person.

So here we go - the Top 5 indices of the “What are we tracking” series:

1. India - BSE Sensex (BSE 30): 5 year growth rate of 400.88%
2. UK - FTSE Fledgling: 5 year growth rate of 126.66%
3. UK - FTSE 250: 5 year growth rate of 92.65%
4. Hong Kong - Hang Seng: 5 year growth rate of 90.28%
5. Spain - IBEX 35: 5 year growth rate of 84.53%

I don’t know about you, but I’m quite impressed with these numbers. Most of them would have doubled your capital since 2002! The next challenge, however, is going to be to find index funds that are actually tracking these indices. I will keep you posted on my research, but you are obviously more than welcome to share your experiences and/or tips with the rest of us in the comments!

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