Let’s talk a few facts from last year:
| ||12 Month High||Close on 12/22/00|
|Dow Jones Industrial Average||11,722.98||10,635.56|
|Nasdaq Composite Index||5,048.62||2,517.02|
We could throw a few more statistics at you, or give you some percentages, but what would be the point? We all know that the year 2000 will not be remembered as a banner year for the stock market.
Here are a few more facts you may be unaware of:
| ||12 Month High||Close on 12/22/00||YTD Change|
|Lehman Brothers Composite Total Return Index of U.S. Treasury Securities||6,913.37||6,913.37||12.97%|
|Merrill Lynch U.S. Corporate Debt Issues - 10+ Years Maturity||835.63||835.63||8.70%|
Again, we could throw a few more statistics at you, but we won’t. We wouldn’t even have given you percentage changes in the bond indexes except that the close on December 22, 2000 represented the highest levels those indexes had reached all year.
So what are we trying to say? Simply put, if you haven't done so already, maybe now it’s time to start looking at bonds funds as investment vehicles instead of just the equity markets.
It’s the economy, stupid!
We can say this because there is one very real event on the horizon that should help fixed income investors in the year 2001 and simply put, it’s the economy.
One of the many factors that are driving stocks down at this time is the economy. After a protracted economic expansion, corporate earnings are slowing. This tends to cause concern at the Federal Reserve Bank. Don’t forget that the Federal Reserve Bank is what controls the “Discount Rate”. If the Fed decreases the discount rate, that decreases the prime interest rate. This in turn, all other things being equal, should drive down bond interest rates and that has the effect of increasing the value of bonds already issued.
Will this happen? There are no guarantees in life, but many market watchers think there is a better than even chance it will happen.
So, what are bonds and where do I get them?
Simply put, bonds are I.O.U.s issued by corporations and governments to raise cash. Generally, bonds are for fixed terms and can carry fixed or variable interest rates.
Among the types of bonds available are U.S. Government obligations, municipal securities, corporate bonds, mortgage and asset backed securities, federal agency bonds and foreign government bonds.
You can purchase bonds through your investment advisor on the over-the-counter (OTC) market or, in some instances, the New York Stock Exchange. Normally, the bonds will carry a markup to compensate your investment advisor for finding the bonds, but this is really no different than what would happen if you bought stocks.
Generally, bonds sold in the OTC market are sold in $5,000 denominations. After the initial offering, bonds sold in the “secondary” market will be quoted at a price as if their normal par were $100. For example, if a bond is selling at a 2% discount, it’s price will be shown as $98.
Another way to acquire an investment in bonds is by purchasing an interest in a bond mutual fund. This is much the same as purchasing shares in a stock mutual fund, except that you will normally receive a monthly income from the investment and its value will fluctuate more closely with interest rates.
If you are investing in money market funds, you may be surprised to know you already invest in a bond fund. In this case, the money market fund invests in short-term, highly liquid securities with the objective of keeping the share value at a constant $1. This gives the appearance that all you are earning is interest, but this is not always the case.
Finally, you can invest in a Unit Investment Trust. These are fixed portfolios of bonds that are professionally managed. At their inception, they purchase a group of bonds and, as time passes, principal and interest are paid based on the cash flows of the bonds. Ultimately, the trusts close out when the last of the bonds mature.
What drives the value of a bond and what should you look for when investing?
There are numerous factors to valuing a bond. However, it is a safe bet that the value of a bond will fluctuate with interest rates. When rates go up, the value of previously issued bonds goes down. When rates drop, the values increase. This assumes that other factors in the mix don't affect the value.
Some of the other key factors to consider are the credit worthiness of the issuer, the length to maturity of the bond, redemption features and average life of an issue in the case of mortgage backed securities.
What should I do?
Each investment vehicle carries its own risks and rewards. Ultimately, your investment decision will be driven by your own personal preferences. If you do decide to invest in bonds, here are a few things to consider.
If you are looking to limit the risk of losing your principal, do not invest in a bond fund. Direct purchases of bonds, purchases of unit investment trusts and money market investments all offer the best possibility of ultimately receiving your entire principal. This is because they all allow you the ability to receive the stated interest rates and the stated principal, if you hold the investments to maturity.
Bond funds will fluctuate with interest rates and, due to their very nature, you will never really see a “principle payoff at maturity” because bonds mature and the proceeds are rolled into new investments continually. Also, dependent on the fund manager's philosophy, individual bonds may always be held to maturity.
The flip side to the coin is that bond funds will allow you to diversify your risks. Although the direct purchase of bonds gives you a greater chance of collecting your principle and interest, what happens if the corporation in which you invest goes bankrupt? Because bond funds invest in a number of different issues, this risk is lessened.
Making investment decisions is never easy. The problem is compounded because you necessarily need to consider your long-term goals in an uncertain market. Whether you should purchase bonds or other fixed income investments is a matter of your investment temperament and your current portfolio. However, now more than ever you should look into fixed income vehicles as a way to protect yourself.
Give us a call so we can discuss your options and what might suit you the best. We are always here and always ready to help you.
Happy New Investment Year!