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Investing in bonds

Published: 
Thursday, July 19, 2018

The following represents a couple general points on how to approach an investment in bonds. These can be transposed to other asset classes and also provide the basic guidance for constructing an investment portfolio. The reference to bonds is due to this being topical at this time.

INVESTMENT LESSON #1

An investment is neither good nor bad

No investment on its own should be viewed as a good or a bad investment.

Yet this is the most frequent question that is asked of a financial professional.

If you take the riskiest investment and put it alongside the safest investment then the portfolio as a whole is going to be less risky than the risky investment alone. Everyone should be able to grasp this.

The US dollar is the reserve currency of the world and bonds issued by the US Government is considered to be one of the safest investments in the world.

If you invest 100 per cent of your money in US government bonds then you would own the safest investment in terms of getting the contractual obligations of the investment satisfied.

You are as certain as can be that your interest payments will be paid on time and at the stipulated amount and that your principal invested would be returned to you under the repayment terms agreed at the time of the investment.

Let’s say that bonds from the Government of Iraq sits at the other end of the scale.

A war-torn country that does not have a stable government and where there are so many other variables to consider.

You will appreciate that investing in Government of Iraq bonds would be a scary thing to do. The risk of not getting your money back is high.

However, as I will explain the Iraq bond can serve a useful purpose in a portfolio if used properly.

Let us for the sake of argument assume that a 10-year bond issued by the US Central Bank (The US Federal Reserve) pays interest at three per cent.

That may be a low rate of return on money invested for 10 years. You are trading off safety (low risk) for a low return (three per cent).

Appreciate that you can’t force the US to pay you more interest, that is determined by the market.

As a segue also appreciate that you can’t force banks to pay you a higher deposit rate.

This is also a function of the market and the levels of liquidity.

It is the monetary and fiscal authorities that are responsible for the level of liquidity in the financial system and bank deposit rates are primarily the result of their cumulative and collective actions over the past two decades.

Returning to the investment lesson. Since you can’t force the safe investment to pay a higher rate then you have to adjust your portfolio in order to achieve a higher return.

This also means taking on higher risk. This is where the Iraq bond, even though it is very risky may have value to you as an investor.

Let’s say that the 10-year Iraq bond pays interest at 15 per cent. That higher rate of interest is a reflection of the level of risk that is associated with investing in Iraq for ten years.

The high rate of return on offer is your compensation and incentive to take up the higher-risk investment.

Understanding Lesson 1 brings with it a realisation that no investment on its own is good or bad.

You need to recognise how that investment fits within your portfolio and whether it has any attributes that can serve your investment needs.

In this example the higher risk bond will provide a potentially higher return and the risk can be made acceptable if it is combined with the safe asset.

INVESTMENT LESSON #2

How much you invest is more important than where you invest

If you accept that you can combine a safe asset with a risky asset to manage the overall risk in your portfolio then the next stage is to determine how much money you should allocate to each investment.

Typically I am faced with the question: I have some money where should I invest it?

We tend to focus on the where rather than the how much. From my experience the reason this is so is because we usually approach things from an “all or nothing” perspective.

To move away from that mindset refer to Lesson 1 above. To reiterate, it is about how assets are combined as opposed to the individual assets in and of themselves.

If you avoid the “all or nothing” trap then you are faced with the “how much is enough” dilemma.

In the US and Iraq bond example, if you put all your money into an Iraq bond you run the risk of not being paid because of all the challenges associated with that country so, in simple terms, you can lose all your money. That’s not a good place to be in.

There is also risk in being fully invested into the US government bond. That risk is the low return due to the fact that it is a safe asset.

The risk here is not the financial safety associated with the asset but the risk is related to your financial safety.

You would invest because you are seeking to defer spending today in order to be able to spend at a future date.

If your investment does not grow at a rate that will allow you to increase your consumption in the future then you would be worse off having invested.

So asset safety also has a risk and that risk is that you may not achieve your financial goals with the safe investment.

The secret therefore is to take a level of risk that you are comfortable with. From Lesson #1 you can fine-tune your comfort levels by determining how much you would like to invest in each asset.

Being 100 per cent in the US bond for 10 years gives you a return of three per cent. Being 100 per cent invested in the Iraq bond for 10 years gives a return of 15 per cent.

If you adjust the percentages so that you own some of both bonds you can generate a return greater than three per cent but less than 15 per cent.

If you invest in both hypothetical bonds at the same time and they have the same maturity then at a ratio of 50 per cent in each bond you get the opportunity for a higher percent return with basically 50 per cent of your funds at risk.

Appreciate that here your worst case scenario is the Iraq bond defaults and you lose 50 per cent of your portfolio.

If you are unwilling to put 50 percent of your money at risk then you simply decrease allocation to the Iraq bond.

The smaller the amount at risk the closer you get to a 3 percent return. The reverse is also true in that the greater the amount at risk the closer you get to a 15 percent return.

If you are prepared to put 10 per cent of your portfolio at risk in the Iraq bond and 90 per cent in the safe US bond then you will get a return above three per cent but only have 10 per cent of your money at risk.

This is where a risky asset in an investment portfolio can be of value.

In summary the issue is not about anyone and anything else other than determining what you want to accomplish and how you plan to get there. No investment on its own is good or bad. How you fit together your investment portfolio makes all the difference.

If you are interested in investing in bonds then be sure to read the prospectus, understand the risk factors and then determine how much risk you are prepared to take to benefit from the returns on offer. There is no one size fits all position so ensure that you discuss the matter with a financial professional.

Ian Narine can be contacted at
[email protected]

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