Simple Pound

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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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There are tons of possibilities out there to invest and hopefully grow your money and the current obsession with derivatives certainly doesn’t limit that choice. Personally, I will stay away from derivatives until I can be sure that I understand what’s going on.

But let’s start with the basics and give you an overview of the most common investment choices. There’s on simple rule that applies to all of them: More risk, higher return. Whether you decide to keep your money under your mattress (and thus effectively lose money due to inflation) or invest it in a small start-up company depends entirely on you and your risk attitude.

A rule of thumb that is commonly used to determine the ratio of bonds and stocks in your portfolio is 120 - age. This is the proportion you should invest in equity (i.e. shares, equity-based funds, index funds etc.) and reflects the time you have left until you retire (if you are retiring in 5 years you will mind if your portfolio drops by 20% whereas if you have 40 years left you know you have plenty of time to make up for it). In my case this would be 120 - 20 = 100% in stocks, which is what I intend to do - after I’ve got some money sitting in a savings account with a sign round its neck saying “emergency fund”. At which point I can probably already invest 1% in debt-based securities (bonds…)

I intend to break up this post into smaller chunks which should hopefully assure that (a) you don’t fall asleep, (b) you can look up the things you don’t know and (c) I don’t have too many good reasons to procrastinate from doing my revision.

So here we go with probably the most obvious choice: Shares.

Buying shares in a company effectively means you’re buying a tiny part of that company and thus have a right to have your share of their profits. Now with hundreds of thousands (or even millions, depending on the size of the company) of shares in issue this mostly boils down to a few pence per share. The profit is distributed to the shareholders (that is you) through dividend payments. Having said that, there are some companies who are not making any dividend payments but instead are using the profits to re-invest and grow the company. Depending on whether you want a solid income stream or growth from a share, you will have to make your choice.

The former group of shares is often classified as income shares, because they provide guaranteed income on a (semi-)annual basis. These companies are usually large firms whose demand doesn’t depend on economic conditions (utilities or pharmaceuticals come to mind) and you thus distribute their cash reserves to the shareholders. Likewise, these companies usually have a phenomenal market capitalisation (= share price x number of shares), which means that buy and sell transaction don’t affect the share price as much (Microsoft currently has a market cap of $280 billion). This however also implies that the share won’t grow as fast as a smaller share could. In short: the dividend payments are intended to make up for the lack of growth that can be expected.

Therefore, many of the companies classified as growth shares won’t belong to the category of dividend-paying companies (as with everything this is not a black-and-white decision - dividend policies can change and growth shares can also pay the odd dividend, but I’m talking stereotypes here…). These companies usually belong to more volatile market sectors (media, technology) and use all profits that are left over (after interest payments and tax) to fund further investments and thus grow the company. This will (hopefully) be reflected in future income statements (i.e. future profits) which in turn will help convince further investors to join the group of shareholders. Because these companies are usually smaller than income companies they are subject to greater share price movements - and as long as those are in the “right” direction, investors will make money through the increase in value of their shares.

Both income and growth shares belong to the category of common stock, which means that you invest in the ownership (equity) of a company and are allowed to vote for the board of directors every year - who are supposed to represent and act in the shareholders’ best interests. This, however, also means that in case of bankruptcy your claims towards the liquidated assets of the company are subordinated to preferred stockholders.

Owners of preferred stock are owning a part of the company in the same way that owners of common stock do, but with the major difference that dividends paid to preferred stockholders are usually fixed and paid out before the dividends to common stockholders whose dividends are variable (if paid at all). While this promises greater security, the old trade-off kicks in that determines “where there’s lower risk there must be lower return”: preferred stockholders don’t benefit from any growth in profits in much the same way as they don’t lose when profits plummet (as long as the company remains profitable - if it doesn’t, dividends are usually accumulated over time and paid as soon as profits allow).

This was surely a fairly lengthy introduction to the concepts, but I hope it was nevertheless helpful. If you want to read even more about shares and share categories now, I recommend you start here and here.

Read part 2 of “Investment Choices” on exchange traded funds >>

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