Simple Pound

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I was grocery shopping the other day when the woman in front of me in the queue handed the cashier a piece of paper and got a payout of £100. Lottery ticket – as you might have guessed. I immediately felt the urge to buy some tickets myself to try out my luck, maybe do the unthinkable – get an immediate return from just one random lottery ticket. I resisted.

Most people would surely not consider playing the lottery a sound financial decision as the odds are phenomenally against you. Yet so many people seem to do it regardless and while fully aware of the fact they’re effectively throwing their (hard-earned) money out of the window.

Technically, premium bonds belong to the same category unsound investment you would associate lottery tickets with, nevertheless roughly half the UK owns them. An estimated £36 billion (that’s £36,000,000,000 !) is held in these “investment” vehicles that are guaranteed by the government.

The idea is that you buy a number of bonds of £1 nominal value (minimum £100, maximum £32,000) each of which is entered into a prize draw once a month. Depending on whether you’re lucky or not, you’ll get a cash prize of between £50 and £1,000,000. The catch is there is no guarantee that you will receive any payout whatsoever… so in the worst case, you could be owning £32,000 worth of bonds for years and never see a single pound return on your investment. In the best case you buy 100 bonds tomorrow and win £1,000,000 in the prize draw next month… I’ll leave it to you to work out which scenario is more likely to happen.

But to be honest with you, I’m still thinking about buying a few of those bonds – just to see whether I can win anything. It might not be the wisest thing to do with my cash, but then I already have all of my savings in accounts that earn between 6.30 – 6.76% AER which is quite possibly the highest return you can get in the market at the moment. So why not be just a tiny bit irresponsible?

I guess the moral of the story is that you should always fully understand the investments you pursue and only proceed if you are completely happy to accept the risks that come with it.

If you are considering joining the crowds to put your money to work in a Premium Bond, I strongly suggest you read the following article (twice): Premium Bonds - Are they worth it? If you’re still convinced Premium Bonds are the way forward, I’ll keep my fingers crossed that you’ll experience lots of happy months with decent returns accompanied by the excitement of having “beat the system”.

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I don’t know about you but I’m starting to feel a little dizzy with all these investment options available. Until I’ve properly tackled all the options I’ve covered so far, I decided to not add any more to the (already) extensive list.

Of course I could go on talking about options, futures, exotic derivatives, commodities, currencies, real estate… but since I don’t see myself investing in any of those very soon, I won’t bother researching any details on them - yet.

In case you’ve missed a post of the “Investment Choices” series, here a brief overview:

• Shares: a very gentle introduction to what shares/stocks are
• ETFs: a first dive into the world of funds with exchange traded funds
• Index funds: passively-manged funds that aim to track the performance of a stock index. Commonly called “tracker funds” in the UK.
• Mutual funds: actively-managed funds where the fund manager picks shares in order to beat the stock market or achieve a certain objective. In the UK referred to as “investment trusts”.
• Bonds - part 1 and part 2: an excursion into debt securities with a gentle reminder that - assuming you’re young - this investment should by no means dominate your portfolio since the associated low risk won’t earn you decent (enough) returns.
• Bond funds: through the advantages of debt securities joined with the advantages of funds, bond funds are a good way of generating passive income.
• Unit trusts: UK investment jargon explained - part 1
• Investment trusts: UK investment jargon explained - part 2
• OEICs: UK investment jargon explained - part 3

Reading through the above list I feel re-confirmed that there are plenty of options to choose from when building a first portfolio. Let me know if you disagree or want to know more about anything else I haven’t covered so far!

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A bond fund works very similar to a share fund (i.e. mutual funds), in that someone else will buy and manage bonds for you. This means you won’t have to worry about inflation, interest rates, credit ratings of firms, etc. because the fund manager is there to take that responsibility from you. Obviously to be able to lean back and enjoy all the benefits, you will have to do some initial research on the different funds available in order to make sure your chosen fund manager shares your investment objective, and obviously does so well. Bear in mind that past performance is at best an indicator of quality - not a guarantee!

So why should you rather buy a bond fund as opposed to just simple buying the individual bonds yourself? There are a variety of advantages, some of which include:

• Diversification: Bond funds usually cover a number of different bonds, with different coupon rates and maturity dates so the performance of one bond (i.e. should the issuer not be able to pay the coupon rate or (upon maturity) the par value) does not impact the overall performance too heavily. Moreover, you’ll often find bond funds that are also diversified across different bond types, i.e. funds that cover both government and corporate bonds. Therefore you can achieve a great deal of diversification with only a fraction of the investment you’d have to sacrifice in order to re-build this diversity yourself.
• Professional management: I went on and on about how mutual fund managers earn their living by picking shares for you and spend hours and hours researching each and every company represented in their fund. Bond funds and their professional managers are no exception to this, which also means that you will have to pay some fees in order to support your fund manager’s salary. So make sure you pick a good one, to justify the extra expense.
• Liquidity: The great thing about investing in bond funds is that you are not tied down by a maturity date. If you want your money tomorrow, you can sell your fund shares and get your cash out at any time. Your shares will either be bought by someone else wishing to invest in this particular bond fund, or will simply by the company that is managing the fund.
• Regular income stream: Buzzword passive income. Passive income is income generated without requiring any action from you. In the case of bond funds this will be your fraction of the coupon rate that is paid monthly. But since the bond fund covers a number of bonds which all potentially pay out on different days of the month, you might generate income every single day of the week (even though it might still only be paid out monthly). If you don’t want the additional monthly income (because you’d spent it anyway…), you will have the option of automatically re-investing those payments. Therefore the amount you’ve originally invested will grow steadily - thus earning you bigger portions of the coupon rates, which in turn will give you higher income… The power of compounding at its finest!

To analyse the performance of a bond fund, you should look at three important values: its share price, its yield and its total return.

The bond’s share price represents the bond’s net asset value, which is based on the value of all securities in the bond - i.e. the share price reflects how well the bonds are rated and whether most of them are priced above or below their par value.

The yield tells you how much additional monthly income you would have had in the past 30 days if you’d have owned shares in the fund.

And finally, the total return is almost a mixture of the above values in that it shows the fund’s overall gain (or losses) based on the income generated and the price gains (or losses) of the bonds in the portfolio. Fidelity suggests you should concentrate on the last value when making decisions about which bond funds to invest in.

Alright, I hope this wasn’t too dense. I just sat my Finance exam this morning, so all this jargon sounds fairly familiar to me - admittedly only after six weeks of solid revision. As always, let me know whether you have any questions by leaving a comment and I will do my best to find an answer…

Read part 8 of “Investment Choices” on unit trusts >>

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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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