true adventures in money hacking

Saturday, October 17, 2009

Bonds

How they work
When you buy bonds, you are lending money to a federal or state agency, municipality, or other issuer, such as a corporation. A bond is like an IOU. The issuer promises to pay a stated rate of annual interest, called the coupon rate during the life of the bond and repay the entire face value when the bond comes due or reaches maturity. The interest a bond pays is based primarily on the credit quality of the issuer and current interest rates. When bonds are purchased, they may be held to maturity or traded. In general, bonds are lower risk investments that have lower returns than stocks.

A bond may be sold at face value, which is the amount returned to the investor at maturity, (also called par) or at a premium (higher price) or discount (lower price). For example, when prevailing interest rates are lower than the bond's stated rate, the selling price of the bond rises above its face value and can be sold at a premium. Conversely, when prevailing interest rates are higher than the bond's stated rate, the selling price of the bond is discounted below face value.

Yield-to-maturity is the effective yield of the bond from the current date until the bond reaches maturity and depends on the total interest payments remaining, and the difference between today’s market value (current price) and par value. Yield-to-call is the same calculation based on the total coupon interest payments remaining between now and the first call date (rather than the maturity date) as well as the difference between today’s market value (price) and the call price.

Risk
Bonds are fixed income products, meaning that the amount you will receive is set when you buy it. In this way, bonds are low-risk investments. The bond market as a whole has historically been less volatile than the stock market, as well. Corporate bonds are usually riskier than government, Treasury, or municipal bonds because there is the potential for the corporation to go under and not be able to afford to pay its bonds when they reach maturity. All bonds carry some risk, however, including inflation risk and interest rate risk (because bond prices generally decline when interest rates rise and vice versa.) These two types of risk are related in that inflation leads to higher interest rates. Bonds with the lowest coupons are at the highest risk when interest rates rise.

Short-term bonds (those with maturities of three years or less) usually have lower yields than longer-term bonds, especially those with maturities of ten or more years. This is because the longer a bond is held, the more subject the holder is to inflation and interest rate risk.

Inflation-indexed securities like Treasury Inflation Protection Securities (TIPS) are designed to get rid of inflation risk.

Ratings
Firms like Moodys Investor Service and Standard & Poor's rate bonds. With corporate bonds, the company's bond rating is based on its financial picture. The rating for municipal bonds is based on the creditworthiness of the governmental or other public entity that issues it. Issuers with the greatest likelihood of paying back the money have the highest ratings, and their bonds will pay an investor a lower interest rate. Remember, in general, the lower the risk, the lower the expected return.

Callable vs. Noncallable
The idea here is the same as with callable and non-callable CDs.

Types of Bonds
Government Savings bonds (EE/E or I bonds) are U.S. government-issued and backed. There are different types of government savings bonds, each with slightly different features and advantages. Series I bonds are indexed for inflation, meaning that they protect against the deterioration of your investment from inflation—the earnings rate on this type of bond combines a fixed rate of return with the annualized rate of inflation. Savings bonds can be purchased in denominations ranging from $50 to $10,000, and typically earn higher interest than savings accounts and CDs, but often lower than other types of bonds.

Ginnie Mae
The Government National Mortgage Association (GNMA aka Ginnie Mae) is a government agency that buys mortgages from lenders, pools them together, and sells shares of the pool to investors (or to brokers who then sell them to investors). The pools are called Mortgage Backed Securities (MBS) aka "pass-through" securities because the mortgage payments (from the home-owners who hold the mortgages) pass through banks (which take out a processing fee) to the investors who've bought the MBSs.

What makes Ginnie Mae MBSs unique is that since the GNMA is a government agency, they get special treatment such as low interest rates on any money they borrow from the government and tax-exempt status from (most) states and municipalities, and are therefore often able to offer higher yields than other MBSs. Plus, Ginnie Mae MBSs (unlike Freddie Mac's, Fannie Mae's, and other MBSs) are fully backed by the U.S. government, i.e. your money is as safe as houses (pun intended) no matter what happens with the housing market, various financial agencies, etc. This means that Ginnie Maes are just as safe as Treasuries but often pay higher interest.

Investors receive a monthly payment either of interest and a portion of principal or of interest only. In the latter case, the principal is paid in a lump sum when the mortgage matures. The minimum investment for Ginnie Maes is $25,000, making them out of reach (or just plain undesirable) for most of us, but that's where mutual funds and the secondary market come in. Like other bonds, Ginnie Maes can be sold by their current owners who are willing to unload them at a lower price because, for instance, their interests are low compared to newer issues or they're close to maturity and there isn't much principal left to be paid.

The risks for Ginnie Maes are minimal but existent. A bunch of the mortgage holders in the pool could decide sell their homes, pay their loans off early, or refinance, causing the investors to be paid back early. This isn't so much a risk as it is slightly unfortunate. You don't lose anything; you just don't get paid as much interest as you would if the mortgages were held to maturity.

Treasury bonds, bills and notes are sold by the U.S. Treasury to pay for an array of government activities and are backed by the federal government (like Ginnie Maes). Treasury bonds are securities with terms of more than 10 years and that pay interest semiannually. Treasury bills are short-term securities with maturities of three months, six months or one year and are sold at a discount from their face value. The difference between the cost and what you receive at their maturity is the interest you earn. Treasury notes are securities with maturities ranging from two to ten years that pay interest every six months. Treasury Inflation Protected Securities (TIPS) are securities that, like Series I government bonds, protect against inflation. With TIPS, interest is paid on the inflation-adjusted principal.

Treasury securities are sold in increments of $1,000, and along with government savings bonds, can be purchased online directly from the U.S. Treasury. There is no state or local income tax on the interest earned from Treasury and savings bonds

Municipal Bonds
Municipal bonds are issued by a state, state agency or authority, or a county, city, town or village. The money invested in the bonds is used by these entities primarily for public projects such as building or repairing schools, roads, highways, bridges, hospitals, and low income housing. This type of bonds is among the safest of investment types and is special because of its tax-exempt status. This feature makes munis especially attractive to investors in the highest tax brackets.

Taxes
The interest munis pay is often lower than that of other bonds, but since other bond interest is taxed, you will not actually receive that much. For a more accurate comparison of actual interest you would receive, use the muni's tax equivalent yield (TEY) for your tax bracket. The TEY will be higher than the stated yield; it's basically the pre-tax yield that a taxed bond would have to pay in order to equal that muni's stated yield. Discount muni bonds may be subject to capital gains tax when sold.

Corporate bonds are basically loans an investor makes to a company in exchange for interest. Buying bonds for a single company is much like owning stocks in a single company; if something happens to that corporation, you can lose some, if not all, of your investment. Bond mutual funds are an alternative that spread the risk among multiple companies. While bond funds can lose money as interest rates increase, they tend to offer greater protection from losses than single bonds or stock funds.

See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds , Oh My!

Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?

Investing main

Friday, October 16, 2009

Investments Primer

An investment is anything you acquire for future income or other financial benefit. Investments increase by generating income (interest or dividends) and/or by growing (appreciating) in value.

It's important that you go into any investment in stocks, bonds, annuities, or mutual funds with a full understanding that you could lose some or all of your money in any one investment.

As you can see in the chart below, different kinds of investments generally provide different rates of return (as well as different risks—highest to lowest in the chart below). Note that average rates of return are not guaranteed; they only show what has happened historically.

Asset Class	Rate of Return*
Stocks of smaller companies	14%-16%
Common stocks	10%-13%
Long term corporate bonds	6.5%-8%
Long term US government bonds	5%-7.5%
Short term US Treasury bills	3.5%-5%

*Average rate of return since 1926, Ibbotson and Associates

When choosing an investment type (stocks, bonds, annuities, funds, etc.), start by figuring out how much risk you want to take. Yes, yes, obviously we all want low risk, but low risk generally means low returns, so in some cases it's worth the added risk to earn the added cash. Here are some questions to ask yourself to determine the amount of risk you should take:

Do you have a specific financial goal? An amount you need to accumulate over a given period? If not, ask yourself how much you'd like (realistically) to have in ten years, twenty years, forty years, etc. If you're hell-bent on becoming a millionaire (and good luck!), you might decide to opt for higher risk, higher return investments. Also, if you're saving for retirement and it's a ways away, you have more freedom to go with higher risk investments because you have longer to recoup your losses if things don't go your way.
When are you going to need money the most? In other words, how long can you leave your savings tied up in investments before you start needing to spend it? Are saving for your first house in a few years or are you planning on leaving your investments grow to support you in your retirement? Generally, the longer time horizon you have, the more risk you can tolerate because investments tend to have more even growth over long period of time.
How financial stable are you? Can you afford to lose some of your investment or will that leave you completely destitute? If you absolutely cannot take the chance of losing any of your money even if it means the chance of gaining more (yes, it's a gamble that way), choose lower risk investments.

Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called diversification, can be neatly summed up as, "Don't put all your eggs in one basket." Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929--or recently) by following a consistent pattern of adding new money to their investments over long periods of time.

Monitoring Your Investments
Some people like to look at the stock quotations every day to see how their investments have done. That's probably too often. You may get too caught up in the ups and downs of the "trading" value of your investment, and sell when its value goes down temporarily--even though the performance of the company is still stellar. Remember, you're in for the long haul. Check monthly or quarterly instead.

Keep in mind, though, that it's not enough to simply check an investment's performance. You should compare that performance against an index of similar investments over the same period of time to see if you are getting the proper returns for the amount of risk that you are assuming. You should also compare the fees and commissions that you're paying to what other investment professionals charge. Look for a low expense ratio (below 1%).

Invest Wisely / Don't be stupid (adapted from SEC's "Invest Wisely")
Never:

Send money to purchase an investment based simply on a telephone sales pitch.
Make a check out to a sales representative personally.
Send checks to an address different from the business address of the brokerage firm or a designated address listed in the prospectus.
Allow your transaction confirmations and account statements to be delivered or mailed to your sales representative as a substitute for receiving them yourself. These documents are your official record of the date, time, amount, and price of each security purchased or sold. When you receive them you should verify that the information in these statements is correct and file them away safely.
Trust anyone who tells you, "Invest quickly or you will miss out on a once in a lifetime opportunity!"or otherwise puts pressure on you to make an investment quickly.

If your sales representative asks you to do any of these things, contact the branch manager or compliance officer of the brokerage firm.

Certain activities may indicate problems in the handling of your account and, possibly, violations of state and federal securities laws, such as:

Recommendations from a sales representative based on "inside" or "confidential information," an "upcoming favorable research report," a "prospective merger or acquisition," or the announcement of a "dynamic new product."
Representations of spectacular or specific profit, such as, "Your money will double in six months." Remember, if it sounds too good to be true, it probably is!
"Guarantees" that you will not lose money on a particular securities transaction, or agreements by a sales representative to share in any losses in your account.
An excessive number of transactions in your account. Such activity generates additional commissions for your sales representative, but may provide no better investment opportunities for you.
A recommendation from your sales representative that you make a dramatic change in your investment strategy, such as moving from low risk investments to speculative securities, or concentrating your investments exclusively in a single product.
Switching your investment in a mutual fund to a different fund with the same or similar investment objectives. Unless there is a legitimate investment purpose, a switch recommended by your sales representative may simply be an attempt to generate additional commissions for the sales representative.
Pressure to trade the account in a manner that is inconsistent with your investment goals and the risk you want or can afford to take.
Assurances from your sales representative that an error in your account is due solely to computer or clerical error. Insist that the branch manager or compliance officer promptly send you a written explanation. Verify that the problem has been corrected on your next account statement.

If You Have a Problem (adapted from SEC's "Invest Wisely")
If you have a problem with your sales representative or your account, promptly talk to the sales representative's manager or the firm's compliance officer. Confirm your complaint to the firm in writing. Keep written records of all conversations. Ask for written explanations.

If the problem is not resolved to your satisfaction, contact the appropriate regulators listed at the end of this document. Investor complaint information assists these regulators in identifying violations of the securities laws and prosecuting violators. However, none of these organizations is authorized to provide legal representation to individual investors or to get your money back for you.

Obtain information on using arbitration to resolve your dispute by contacting FINRA, the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board, or the Chicago Board Options Exchange. Each of these organizations operates a forum to resolve disputes between brokerage firms and their customers. You may also wish to consult an attorney knowledgeable about securities laws. Your local bar association can assist you in locating a securities attorney.

Securities Regulators to Contact:

U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549
Office of Investor Education and Advocacy
Online Complaint Form

North American Securities Administrators Association, Inc.
Suite 710
10 G Street, NE
Washington, DC 20002
(202) 737-0900
Web site