By Mildred Moss, ContributorMANY INVESTORS are daunted by the decisions they have to make about investing in bonds.
Some of the decisions they have to make include whether to buy government securities or corporate bonds; local or foreign; short or long; now or later.
However, an investment in bonds is no different from any other investment you make, in so far as your choice is dependent on your specific investment goals, risk preferences and other individual circumstances. So, let's look at the conventional wisdom for investing in bonds and trends in respect of investor preferences. You may find similarities with your own profile that may assist you in selecting the bond that's right for you. Why should you invest in bonds?
Every investor should have a diverse portfolio of bonds, stocks and cash of varying proportions. A diversified portfolio protects investors to the extent that the negative returns in one sector or asset class may be offset by the rising values of another asset class. For example, in the US market interest rates have fallen to their lowest levels in over 40 years - resulting in higher bond prices and thereby improving the overall position of investors who have been haemorrhaging from their investment in stocks. More mature and/or retired folks typically have a higher percentage of bonds in their portfolio than younger investors. This is so because these individuals tend to rely more heavily on their investments as the primary source of income. Their preferences are governed by the need for regular income and minimal risk to principal. Bonds typically have predictable cash flows - every six months - and repayment of principal, on maturity. In this way, an investor may structure his bond portfolio so that interest payments provide a reliable stream of income for living expenses. Can you wait until the bond matures to get your money back?
SHORT-TERM
If you have made up your mind to lock away your funds for the short-term (up to 2 years), mid-term (3 to 9 years) or long-term (10 years and above), you may select bonds with maturities that coincide with the time that you will need those funds. Investors with long range plans - for college education or retirement - may want to consider "laddering" bonds. This is a practice that involves buying several bonds with different maturity dates. For example, if you are planning for your child's college education in, say, 10 years, you might purchase four zero coupon bonds that mature in each of the years the child is expected to attend college. In so doing, the proceeds from the maturing securities would coincide with payments for each year in which tuition falls due.
LONG-TERM
If you do not have all the capital to invest at once, you might want to consider a long-term investment account (LIA) as part of your long term planning. The LIA allows for a maximum investment of US$20,000 or the equivalent of J$1,0000,000. You may accumulate this amount each year for a total of five years at a compounded tax-free rate of up to 10 per cent. In the ensuing years 6 to 10, the payments of principal and interest each year will allow you to take advantage of higher interest rates or meet your financial obligations as they fall due.
As a rule, longer-term bonds pay higher yields as they are more vulnerable to inflation and interest rate movements. That said, your decision boils down to a balance between how much income you need and how much risk you can handle.
HOW MUCH RISK ARE YOU
WILLING TO TAKE?
With all investments, there is a degree of risk that you might lose some or all of your investment. In assessing your tolerance for risk you need to ask yourself: How much am I prepared to lose? If you decided to purchase a 10 year sovereign bond, would you buy one that is a very secure US Treasury Bond (AAA rated) that yields 4.3 per cent; a Jamaica (Ba3/B+) bond that yields 9.04 per cent and with gives you a 50:50 chance of getting your money back; or one where there is only a slim chance of getting your money back - Brazil (B2/B+) - which offers a yield of 23 per cent? This example makes clear the relationship between risk and reward.
NEGATIVELY CORRELATED
We recommend a combination of high-grade-low-yielding and low-grade-high-yielding bonds. The proportions will depend on the level of risk you are willing to take. As a hedging strategy, it is important that you select bonds that are negatively correlated - that is, bonds that react differently to global market conditions. Should you decide to sell a bond before it matures you will receive the prevailing market price that may be more or less than the price you paid for the bond. You may speculate that interest rates will fall and, if you are right, you can make money if you buy bonds now and sell them later. However, if rates move in the opposite direction, you may lose all or part of your investment. With a new GOJ eurobond issue on the horizon, you may notice a softening in bond prices as bondholders take profits to position themselves in the new bonds or buy back the existing bonds at lower prices - thereby minimising their downside risk. In the current environment, the Government may be forced to offer higher yields on the new issue to attract investors. What this means is that if you wanted to sell your existing bonds, you would have to discount the price to attract buyers and be prepared to lose some of the value in the open market.
Mildred Moss is the Chief Operating Officer at Sterling Asset Management Ltd.
