MONEY and BANKING PAPERS LOW GRAPHICS

 


Why invest in bonds
when there are so many other options?


by Mary Beth Saucier


 

 

Since 1999, the economy has been in a downward trend. The majority of people who had invested in the stock market now known as the great stock bubble or fraud bubble were given a false sense of security and they felt the market would just keep climbing. Were there signs that investors could have looked for to predict the economic downturn? If investors had looked for the signs, maybe they could have changed their direction of investment. This paper will investigate the characteristics of bonds and see if the bond market has proven to be a safe haven for those who were wise enough to invest in it. When the economy is in a downward trend why should more people invest in bonds? A good investment is a timely investment in which people change direction of their portfolio at the beginning of economic swings.

The economists monitor timely reports and determine the direction of the economy by tracking ten economic indicators through a select group of economic categories: employment, consumer spending, industrial production and inflation (Updegrave, Ten Indicators). Key items of the Employment Situation Summary focus in on unemployment rate, number of new jobs and help-wanted index. An increase in the number of new jobs and help wanted advertisements suggest a growing or stable economy. Unemployment rate tells the economists where the economy has been, whereas the number of new jobs predicts where the economy is going (Updegrave, p. 2). One important factor in the unemployment rate is that it tells the analyst that the economy has already changed. For example, an increase in the number of unemployed indicates that employers will not meet earnings or expect reduced earnings due to a slowing economy and a demand for products. These rates are very important because more new jobs means that the economy is growing, while less new jobs means the economy is in a downward trend. Included in consumer spending are consumer confidence, expectation index, and advance retail sales and report.

 

Consumer confidence is a poll of 5,000 people asking how they feel about current and future business conditions for the job market and their own income prospect for six months. A downward trend means less consumer spending. The expectation index which “has to dip below 80 and stay there for two months or so before we consider it a warning of recession,” gives a good reading of what lies ahead (Updegrave, p. 3). The advance retail sales report measures consumer spending by sampling retailers and the results determine the direction of the economy. Again, higher consumer spending means a rise in the economy, while lower consumer spending means a decline in the economy. Industrial production includes purchasing managers’ index, industrial production index, and capacity utilization index. The purchasing managers’ index surveys manufacturing executives to compute an index of industrial activity. When the index level falls below 42.7, the economy is falling (Updegrave, p. 4) The Industrial production index measures how much industries are producing and the capacity utilization index measures the efficiency of production capacity. This is used as an inflation indicator. If the index is up to 85, inflation is increasing because prices will have to increase (Updegrave, p. 4). One of the most important of these indicators is the inflation rate. The Federal Reserve governors adjust inflation or deflation by raising or lowering interest rates. After a year of declined interest rate, the FED made a fifty basis point cut suggesting that it would be the last cut. The FED was concerned with inflation and that the economy was trending downward. Generally as the FED lowers interest rates, stocks begin selling and people invest in bonds. As interest rates fall, bond prices rise because the value of bonds relative to the higher interest rates increases. This price relationship holds for all bonds.

After the first year it should have been fairly obvious that the economy was struggling when stock value decreased, unemployment went up, and the FED lowered interest rates. This should have been a sign for people to transfer funds into a more diversified portfolio with bonds. Investing can be tricky however, because it is hard to know how long the trend will continue. If the indicators continue downward then the poor economy will be longer in duration. Investing varies from individual to individual because age, duration, risk, economic trends, and wealth, however, in poor economic times, the investment should be short in duration, low risk, and perhaps a convertible type bond. A bond is a debt security that can be of short or long-term duration. The bond buyers lend the face value of the bond to the bond issuer. The three main issuers of bonds include the Federal Reserve and its agencies, municipal governments, and corporations. The Federal Reserve funds consist of treasury bills, treasury notes, U.S. savings, and U.S. treasury. They are basically bonds designed for investors who are looking for low risk steady income and reaping long term gains.

 

Treasury bills are the safest investment because maturities are short and there is little risk of the interest rate increasing. They can mature anywhere from three months to a year, but the minimum investment is $10,000 (CNBC money). New treasury bills can be bought at less than par value but redeemed at full face value which means you are paying less than the bond is worth regardless of the interest rate. Another advantage is that they are exempt from taxes allowing the purchaser to receive the entire interest that accumulated on the bond. Treasury securities are liquid and can be sold at any time. Municipal bonds are debt securities issued by various forms of the government such as states and cities, to build new highways, schools, hospitals, and other public projects. As with most bonds, when investors purchase a municipal bond they are lending money to the seller who has promised to pay back with a certain interest at the maturity date of the bond. Tax-free municipal bonds are a low-risk investment because they are coming from the government so it is nearly impossible for the lender to default. Investors are able to predict how much money they will make and plan accordingly. There is a small risk, however, if you sell the bond before its maturity, because the market price could be more or less than the original price due to inflation. An investor in a state that has high income tax would purchase a municipal bond that pays less interest than taxable bonds because investors would keep more of the interest than the interest of taxable bonds after taxes. There are municipal bonds that may offer higher tax equivalency return than other bonds and will make a higher profit if purchased. An effective yield to compare municipal bonds versus taxable investments would be a tax-equivalent yield (CNBC money). Corporate bonds are IOU’s issued by public and private corporations for many different reasons such as expanding the company and purchasing new equipment.

When purchasing a corporate bond, investors lend the principal value to the corporation which promises to pay back the principal price plus the interest that has accumulated at the maturity date. Corporate bonds are considered fixed income, therefore less risky than many other options. Included in corporate bonds are the call and put options. The call option allows the issuer to buy back the bond before the scheduled maturity date and “replace an old bond issue with a lower-interest cost issue if interest rates in the market decline (Fabozzi p.4).” This could be an opportunity for the lender to improve on his investment by giving him cash so he could seek out more profitable opportunities. As for the put option, “if interest rates rise after the issue date, thereby reducing a bond’s price, the investor can force the issuer to redeem the bond at par value (Fabozzi p.5).” As interest rates go up, the value of bonds go down so if the investor waits until the maturity date he will not make as much money. It gives the investor the opportunity to cash in at a higher value. These options are examples of opportunities which help in the control of investments.

 

A convertible bond is a very good investment because it allows people to convert a corporate bond directly into company stock. Corporations issue convertible bonds because they pay lower interest and investors buy convertible bonds because although they have lower yields, they hope to trade it in for the company’s common stock. If the stock increases quickly, they will make a lot more money than with a bond, but if the conversion does not pay, they can hold onto the bond and collect the interest (CNBC money). As stated in The Investor’s Guide to Convertible Bonds, “these hybrid securities offer investors a combination of benefits similar to a balanced portfolio of common stocks and straight corporate bonds (Noddings p. 14).” Unfortunately these bonds can be risky. One risk is that the bond issuer has the right to buy back the bond if the interest rates continue falling and reissue the bond unless the buyer had already converted the bond into company stock. These bonds should be purchased when the interest rates have fallen for a considerable amount of time eliminating the risk of a buyback. Since the objective is to increase assets through interest in poor economic times and investing in stocks in good times, an investor should purchase convertible bonds only after common stock has been evaluated and is expected to rise sharply in value. When purchasing this type of bond, it is very important to research the company’s stock to make sure that the company will be profitable and not fold. The exchange from bonds to stocks should be done when the conversion value of the bond exceeds the bond value (CNBC money). In the last three years, many investors have not been concerned with how much an investment has made, but how much of the investment was saved or if they should sell in order to claim a loss to reduce their taxes.

 

The reason to focus on bonds during a slow economy is to reduce the risk on the investment and to save your existing portfolio from losses. A goal of investors is to keep the profits from the stocks and use that to make more money however low it may be in bonds. Investors want the win-win situation instead of first losing what they had already made in the stock market and then transferring what is left into bonds to start all over again. A diversified portfolio has a mix of investments, weighted and variable. The mixed investment consists of large and mid cap stocks with dividend yield, small cap stocks, bonds, and fixed income (money market). Weighing is done by owning more than 50% of small cap stock during a strong economy or more than 50% of bonds during a poor economy. It is variable because a small cap can be sold as the economy turns poorly and used to purchase bonds and conversely, if the economy is trending forward, bonds can be sold to purchase small stocks. Bonds are a great way to invest money because they have a low risk compared to other investments such as the stock market and mutual funds. When investing in the stock market you never really know for certain if you are going to make any money on your investment or if you will be able to sell in time to break even. When investing in bonds, there is still some uncertainty, but they are much more predictable. The investor has to look at the current yield which is the annual return on the dollar amount paid for the bond as well as the yield to maturity which is the interest received from the time the bond is purchased plus any gain or loss if you purchased the bond below or above its face value. It is also important for investors to remember that the price of a bond “is the present value of its expected cash flows (Fabozzi p. 15).”

The value of the investment is the amount of cash that will be available at its maturity. In a poor economy, bonds enable investors to maintain control over their investments. Therefore, the ability of evaluating bonds as interest rates change gives the investor the opportunity to make an informed decision on how his investment is producing income. Since bonds are low risk in general, the actual risk determines the profit return on the investment. Duration, rate, ability to call, security, etc. are many variables that determine the low risk and almost assure a profit as opposed to the high risk stock which most likely will give investors a loss if they are unable to constantly watch over it. In conclusion, bonds are a safe haven during poor economic times and quickly convertible to other options on the upswing. When the market is trending downward, investors should purchase bonds and when the market bottoms out it would be convenient to change to other options. It is evident that the economy is reversing directions when the ten key indicators discussed above reverse directions and the unemployment rate for example decreases. Although the specific bonds discussed above may not be the best option for everyone due to age, risk, etc., it is almost certain that for the majority of people, the basic idea would be to follow the economic indicators and listen to various economists and invest in bonds during bad economic times while investing in higher risk options during good times. The key for most investors is to remember to keep a diversified portfolio with the option of changing investments as the economy changes.

 

Work Cited

Updegrave, Walter. “The Economy: Ten Indicators.” CNN Money November 22, 2002 <http://money.cnn.com/pf/investing/features/ten_indicators/>

CNBC money. Questions and Answers, November 22, 2002. <http://moneycentral.msn.com/quickref/quickref.asp?Cat=10&SelCat=3

&RefType=0&QAMode=1&QID=1308&Topic=2&Sub=1>

Fabozzi, Frank. Bond Markets, Analysis and Strategies. Third Edition. Prentice Hall, NJ, 1996.

Noddings, Thomas. The Investor’s Guide to Convertible Bonds. Dow Jones Irwin, Illinois, 1982.

Bibliography

Belkaoui, Ahmed. Industrial Bonds and the Rating Process. Quorum Books, Westport, Connecticut, 1983.

Fabozzi, Frank. Bond Markets, Analysis and Strategies. Third Edition. Prentice Hall, NJ, 1996.

Noddings, Thomas. The Investor’s Guide to Convertible Bonds. Dow Jones Irwin, Illinois, 1982.

Updegrave, Walter. “The Economy: Ten Indicators.” CNN Money November 22, 2002 <http://money.cnn.com/pf/investing/features/ten_indicators/>

Veale, Stuart R. Bond Yield Analysis: A Guide to Predicting Bond Returns. Prentice Hall, New York Institute of Finance, 1988.

CNBC money. Questions and Answers, November 22, 2002. <http://moneycentral.msn.com/quickref/quickref.asp?Cat=10&SelCat=3&RefTy

 

 

 

 

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