by WWM | Aug 30, 2017 | Fixed Income
Today we will review longer term fixed income securities.
There is some differentiation in the way that people define these assets. Many define a bond as a debt instrument that is secured against specific assets of the issuer. Bonds may also be seen as any debt exceeding 1 year in term to maturity.
No one way is the “right way”. But we will go with my terminology to stay consistent in my posts.
Bonds, Notes, and Debentures
I tend to aggregate bonds, notes, and debentures as just “bonds” for discussion purposes. That is because most of their characteristics are very similar. Plus, when you look at fixed income in the investment world, the short form for these three defaults to bonds. Where there are differences between the three, I shall definitely point them out.
Like short term money market instruments, all bonds are fixed-obligation debt securities.
Investors invest in the debt issue. In return, the issuer agrees to pay a certain amount of interest at pre-determined dates over the term of the debt. At maturity, the issuer agrees to repay the principal amount of the debt to the investors.
Bonds may be issued from many sources. Corporate, as well as issues from the various levels of government.
Term to Maturity
Unlike money market instruments, bonds are longer term obligations. I divide debt maturities into three time horizons:
Money market instruments are short term debt issues that mature in 1 year or less.
Notes are intermediate term debt issues with maturities between 1 and 10 years.
Bonds are long term debt issues with maturities greater than 10 years.
Not hard and fast rules on terms and maturities. But those terms are the most commonly used.
When I refer to short, intermediate, and long term debt issues, the characteristics of the bond change as it moves toward maturity. The name of the bond does not change from bond to note to money market. But, as we will see in our pricing discussion later, the major determinant of price volatility is the remaining term of the bond.
For example, General Motors issues a 30 year bond on January 1, 1991. It will mature and its face value repaid to investors on December 31, 2020. At issue, this would be considered a long term bond of 30 years. However, if it traded in the secondary markets and you purchased it on June 1, 2014, you would actually be acquiring a bond with intermediate term characteristics as the time to maturity was less than 10 years but more than 1. And if you sell the bond on June 1, 2020, it will be considered a short term debt security when pricing the bond, although not a money market instrument.
Types of Issues
Secured Bonds
Bonds that are backed by legal claims on specific assets of the issuer. That is, if the issuer defaults on the bond, investors have a claim against the specified collateral on the issue.
You may see secured bonds referred to as “senior” or “mortgage” bonds.
Senior bonds are often secured, but do not have to be. In the event of a default, a senior bond will have priority over other subordinate debt issues when the company pays out any money. A very useful feature should an issuer in financial distress have more debt outstanding than cash available. As a senior debt holder, you move to the front of the line for repayment. In essence, that is an investor’s security.
Mortgage bonds have mortgages secured (attached) to specific assets. Usually real estate or real property such as operating equipment. In the event of non-payment, these assets may be seized by the bond holders and sold to pay off the issue. Again, this provides security that the face value of the bond can be repaid.
A good example of secured debt is the mortgage on your house or the loan on your car. Until you have fully repaid the debt, the lender has a lien on the home or vehicle. Should you miss your payments, the lender may seize those specific assets detailed in the loan agreement.
The same holds true for secured bonds.
Unsecured Bonds
Also known as debentures, unsecured bonds are not backed by specific assets. Instead, the issue is supported only by the general promise from the issuer to pay interest and principal on the agreed dates.
Debt of this nature is part of the issuer’s general credit obligations. Should the issuer fail, debt holders would be one of many creditors fighting for a piece of the entity’s remaining assets.
Subordinated Bonds
Subordinated bonds, or junior debentures, only hold a claim on assets that is lower in position or seniority to other debt obligations.
Subordinated bonds may or may not be secured against specific assets. If they are secure, then there is already senior debt in place that takes precedence in the event of default.
A common example would be a second or third mortgage on a piece of real estate, such as your home.
If you hold the secondary claim and there is a default, you will wait in line until after the senior debt holders are repaid.
When investing in secured, subordinate bonds, be careful as to the assets you are linked with. An indenture will tell you the key details of a bond issue. The indenture is the legal contract between the issuer and the debt holder which specifies the issuer’s legal requirements.
If there is already enough senior debt to consume the asset’s entire value, then you really have no security at all. This needs to be factored into the pricing of the bond. With no practical security, the bond becomes riskier and investors require additional compensation for that increased risk.
The same logic applies to junior debentures. But here, there is no security. The debt holder is simply one of many creditors trying to get their money back if a default occurs. Standing in the back of the line waiting for more senior debt holders to be repaid is a risky proposition.
Unless the potential returns are high enough to justify the risk (in your eyes) or the issuer is one with an impeccable credit rating (e.g., US Government), I would suggest that you avoid debentures as a direct investment option.
Relevance for Investing
Ceteris paribus, it should be obvious that investors prefer secured bonds over unsecured and senior over junior issues.
Security
Whether you are investing in public debt issues or loaning money to your brother-in-law, always attempt to get as much security as possible in return. The more security you can get, the safer your investment.
That said, you need to also consider the liquidity and potential for decrease in market value of the collateral. If it is not liquid, or if the collateral can only be sold at distressed levels (a.k.a. fire sale prices), the security you possess might not cover all the debt owed.
For example, you are considering investing in a new debt issue by Sadco. They plan to expand operations in Dictatorland; a country with rumours the government may nationalize foreign company assets. This concerns you, so you only wish to invest in a secured bond issue. As the pledged assets are worth three times the bond value, you decide to invest.
Good strategy.
Unfortunately you did not read the indenture or prospectus and notice that the pledged assets were the company’s operating facilities in Dictatorland. In short order, the facilities are seized and Sadco files for bankruptcy. Good thing you had a secured bond. Now if only you can get the President-for-Life to agree to release the assets to you.
The same securitization issue applies to (say) operating equipment in a factory. New, the equipment may be worth $100 million and amply cover as security for a 20 year, $50 million bond offering. But, like your car, computer, motorboat, etc., over time general wear and tear erodes market value. If the issuing company experiences financial difficulty 10 years out, do you think the equipment will be worth its value brand new?
Any security or pledged assets attached to a debt offering should be worth more than the offering through its term to maturity. If not, is it really protection for your investment? Nope.
Just because a bond is “secured”, does not mean it practically is. Worth remembering.
Risk-Return Principle
If you cannot get proper security, then you need to receive a higher return for the additional risk you face on the debt.
This is a basic risk-return principle. The higher the risk, the greater the return required.
In this post, the greater return will likely come from higher interest payments or deeper discounts on pricing. You can see the level of security offered by a bond issuer plays an important role in the pricing and yield to maturity of any debt issue.
But more attractive returns may also involve sweeteners, such as equity conversion privileges or warrants. Anything that may make the offering more enticing to potential investors as compared to other issuers’ debt.
Before investing, ensure you know which of the above categories your investment resides within. Then compare that issue with other similar offerings to ensure that you receive the appropriate expected return for the assessed level of risk.
Debt with relatively less security will provide higher returns than debt with good security.
For most investors, it may not be prudent to directly invest in individual debentures or junior debt issues. However, you can use diversification techniques to reduce the portfolio risk and still enjoy the higher returns. This may mean investing in multiple offerings to spread out the investment risk. Or to invest in higher risk bonds through mutual or exchange traded funds, so as to spread the risk even more than you could do on your own with limited resources.
When we review portfolio construction we shall look at diversification tactics in some detail.
As for assessing the investment risk, we have reviewed some issuer specific, non-systematic risk factors here and here. We will also look at a few additional bond considerations shortly.
Next up though, a look at some common bond issues you will see in the marketplace.
by WWM | Aug 23, 2017 | Cash Equivalents, Fixed Income
We began our review of the fixed income asset class with some key terms.
As for the asset class, it is common to group fixed income debt into three categories: money market, bonds, and debentures. Today we will look at money market instruments.
Money Market Instruments
I consider almost all money market instruments to be Cash Equivalents within one’s investment portfolio. But as they are technically debt, and are influenced by many of the same variables as other debt issues, I will cover them here.
Money market instruments are part of the short term debt market used primarily by governments and large capitalized corporations with very strong credit ratings. By short term, less than one year until maturity.
Most money market instruments are issued at a discount and mature at face value. No actual interest is paid by the issuer. Rather the difference between the purchase price and the value at maturity is considered the interest.
In every jurisdiction I can think of, the amount earned between the purchase price and face value is treated as interest income, not a capital gain, for tax purposes.
However, if the money market instrument is traded in the secondary market prior to maturity, a portion of the return may possibly be treated as a capital gain or even capital loss.
Government Treasury Bills
For short term borrowings up to 1 year in duration, governments issue treasury bills (T-bills).
No interest is paid on T-bills. They are issued at a discount to face value equal to the required interest rate. Upon maturity, the face value is paid to the investor and the difference between the discount and par value is treated as interest income.
Longer term bonds that do not pay interest, but are issued at deep discounts, are known as zero coupon bonds.
T-bills are guaranteed by the issuing government of a country. Because of the ongoing solvency of most countries, the shorter term T-bills are considered the safest of all investments. As such, the interest rate on T-bills is normally viewed as the risk-free rate of return.
Note that the fortunes of countries rise and fall. At any given time, a specific country’s T-bills may not be risk-free. For example, US T-bills are considered totally safe as I write this post. However, countries like Belarus, Greece, and Venezuela may not be seen as 100% secure right now.
Like any debt instrument, the interest rate offered by the issuer will depend on its credit rating. The worse the credit rating, the greater the interest rate that needs to be paid.
Corporate Money Market Instruments
Often corporations require short term funding to pay for current liabilities or finance short term assets such as trade receivables or inventory.
On average, corporations are riskier than governments. That should be intuitive. Though this can obviously differ on a case by case basis. For example, Apple may have a market capitalization that would equate it in the top tier of most national governments. Or the current credit rating of Venezuela is lower than many companies.
But being generally riskier than governments, you should expect to see corporate money market instruments paying higher interest rates than similar short term government debt.
When corporations issue debt for periods up to one year, they have a variety of options. Three typical ones, include:
Commercial Paper
Unsecured debt issued by a company. Because the debt is not secured against any corporate assets, only companies with very strong credit ratings issue commercial paper.
Depending on the credit-worthiness of the issuer, these notes may be more or less risky. Interest rates offered on commercial paper will fluctuate between corporations based on their relative risk.
Acceptance Paper
Also know as Finance Paper or Asset-Backed Commercial Paper.
Secured debt that is issued by a finance or acceptance company. The issue is secured by specified assets such as receivables or inventory.
Assuming that the security is adequate to cover the issue, secured debt is normally less risky than unsecured debt.
For example, Debtcorp issues two classes of paper. One secured against its trade receivables and inventory. The other unsecured. The non-secured debt will require a higher interest rate to be offered to reflect the higher risk of the paper.
Banker’s Acceptances (BAs)
Debt issued by a non-financial corporation but where a bank guarantees its repayment.
Of the three corporate options, the least risky for investors. This is because there are two layers of protection with the involvement of the bank guarantee.
Because it is the least risky, all other things equal, BAs will offer the lowest returns.
Investing in Money Market Instruments
Most individual investors never directly invest in money market instruments. That is because the required minimum purchases are too high for many investors.
However, individual investors do purchase these instruments indirectly through money market funds (MMF). As you develop your investment portfolio, I would expect you to have a portion of your assets in MMF. Likely for your emergency funds, cash set aside awaiting investment opportunities, cash available for near term financial obligations, and so on.
While each investor is unique, normally investing in MMF is preferable to holding your cash in savings or chequing accounts. That is because MMF offer higher returns than bank accounts, tend to be low risk, and are highly liquid.
Depending on the financial institution, they usually offer better returns and greater liquidity than term deposits and Guaranteed Investment Certificates.
I think the key takeaway with money market instruments, and any other fixed income offering, is the risk-return relationship. The more risky the debt instrument, the more incentive must be offered to entice investors. For short term money market instruments, this will be in higher interest rates offered for riskier debt.
But for longer term debt, it may be in securitization of the debt or priority of repayment. Or it may be in other sweeteners like conversion privileges into common shares. We will review various sweeteners in the near future.
The higher the risk of a debt offering, the less desirable it is for investors, and the greater interest and/or sweeteners required to attract investors.
You can also look at this from basic demand driven economics that applies to any asset (eg., your vehicle, house, art, gold). You decide to sell your home. If there is substantial demand for your house in the local market (hot market, great house, attractive area, little else for sale, etc.), you can ask more money. If you are selling your home in a down market with few potential buyers, you may need to list for less.
The same logic applies for all types of debt and equity issues. The more attractive an asset is to the investor, the less a company must do to raise capital. The less attractive the asset, the more a company must pay to attract capital. We will see this over and over and over again as we explore different investments.
Next we will review bonds and debentures.
by WWM | Aug 16, 2017 | Fixed Income
We will start our review of fixed income securities today.
As there are some good things to know, we shall break it down into a few posts.
First, I want to quickly review a few key terms that relate to fixed income. If you can understand a little of the terminology, it will make the whole area easier to follow.
We will refer to the following example as we go through the terms.
On January 1, 2017, you purchase a new issue of $10,000 par value 5 year Canada Government bonds for $10,250. The bond has a coupon of 8% and a current yield of 7.8%.
Fixed Income Securities
In general, assets in this class provide a known stream of fixed income over the life of the investment. Hence the term.
At the end of the asset’s life, the original capital is repaid in full to the investor by the issuer borrowing the funds.
If you hold the security until maturity, there is relative certainty as to your income stream, both the amount and the timing, and in the repayment of your invested capital.
We will consider the “relative” aspect in due course.
In our example, the fixed stream of income is $400 of semi-annual interest payments for the 5 year life of the bond. At the end of 5 years, you also receive the face value of $10,000. Unless the government defaults on its debt, there is a high certainty as to the timing of the payments and the amounts you will receive.
I would include all debt instruments and most preferred shares in the fixed income asset class.
That said, for every rule there are exceptions.
Some debt issues and many preferred shares may not have expiration dates. Other issues may have variable rate coupons, or interest rates that change based on specific events.
Some debt may have the interest coupons stripped from the instrument. You may purchase the debt paying no periodic interest (zero coupon bonds) or you may invest in the coupon stream with no principal repayment (interest only strips).
Also, one can engage in swaps or asset re-engineering to completely alter the characteristics of certain investments. For example, investors may use futures contracts to increase or decrease the maturities of Treasury bills. Or one can utilize an equity swap to take an underlying fixed income portfolio and create a synthetic equity portfolio without selling the bonds or purchasing shares. But these areas are outside the scope of our discussion.
So while the above definition works in most instances, be aware that there are exceptions.
Principal
The “face value” of the security that must be repaid to the investor at maturity. Principal may also be referred to as the “stated value” or “par value”.
All four terms are interchangeable.
In pricing analysis, the principal is typically viewed in multiples of $100.
In our example, the $10,000 is the principal amount. The par is $100 for pricing.
This differs from what you actually paid for the security. The amount you paid, $10,250, is your “purchase price” or “adjusted cost base”. In pricing terms, you paid $102.50 for the bonds.
In this case, you paid $250 more than the face value of the bond. If you pay more than the par value, the extra amount is known as the “premium”. Had you paid less than the face value for the bonds, the difference would be the “discount”.
Note that with debt instruments, you often purchase accrued interest. For the moment we shall ignore this consideration.
Term to Maturity
This is simply the time remaining before the debt instrument matures and it is retired.
At maturity, interest payments end and the face value of the debt is repaid to the investor. There is no longer any obligation by the issuer to the debt holder.
Investors are not concerned with the original maturity date, only the term that remains.
For example, on January 1, 2017, you plan to invest in a 30 year US government bond that matures on December 31, 2018. The fact that the bond had an original maturity of 30 years is irrelevant. You should only be concerned with the cash flow over the remaining 2 years.
Also, the 30 year bond will exhibit the investment characteristics of a 2 year bond. That is very important.
Coupon Rate
A security’s periodic fixed income payment is called its “coupon” or “interest” component.
It is what is actually paid out in interest income each year and is compared relative to the face value of the debt. Not to what you actually paid for the asset.
In our example, the coupon rate is 8%. For every $100 of face value debt, a semi-annual interest payment of $4 will be made by the government. As you purchased a face value of $10,000, your annual interest income is $800.
As a formula, simply divide the interest payment received by the face value of the debt. If you own debt with a par value of $300,000 and receive an annual interest receipt of $18,000, your coupon rate is 6%.
For most debt instruments, interest payments are made semi-annually on the anniversary date of the issue. In some cases though, interest payments may be made more or less frequently. And in some instances, such as with zero coupon bonds or most money market instruments, actual interest is never paid.
Yield
Yield on a fixed income asset is a different creature from the coupon rate. It may be the same, but often it is different.
The yield represents the annual return to the investor based on his investment cost.
Current Yield (CY)
Whereas the coupon rate compares the interest paid out to the face value of the debt, the CY compares the interest payments to your actual purchase price (adjusted cost base).
In our example, you paid $10,250 for the bonds. But regardless of what you paid for the bonds, you will still receive interest at the coupon rate of 8% based on the face value. So each year you receive $800 in interest.
To calculate the CY, you only need to know the current price of the security and the coupon rate.
Simply divide your annual interest income into the purchase price and you have the CY. And if you know the CY, you can easily calculate either the proper purchase price or coupon rate, assuming you have one or the other.
If you buy a fixed income security at par value, the coupon rate and the CY will be the same.
However, because you paid a premium for your bonds in our example, your CY will be less than your coupon rate. In this case, your CY is only 7.8%.
Note that had you received a discount on your bond purchase, your CY would be higher than the coupon rate. Knowing this rule on the impact of premiums or discounts on your yield versus coupon is very useful for personal calculations.
Also, as interest rates change, that will impact the current price of the fixed income asset. If market interest rates fall, then the current price of your bond should increase, ceteris paribus. Over time, your CY may fluctuate, so you always need to update your calculations based on current prices.
A major weakness in the CY is that it does not factor in potential capital gains or losses into the annual return.
Yield to Maturity
The yield to maturity (YTM) does account for capital gains or losses in its calculation.
To determine the YTM, you need to know the security price, the coupon rate, and the term to maturity. And, if you have any three numbers, you can easily calculate the missing fourth.
While you can calculate YTM by formula, I suggest you use a financial calculator. In our example above, the YTM is 7.7%.
This should make some intuitive sense if you think about it.
In our example the CY is 7.8% and the YTM is slightly less at 7.7%.
The CY only considers the interest stream against the purchase price. The YTM needs to also factor in any capital gains or losses between the purchase price and the face value at maturity.
You paid $10,250 but will only receive back $10,000. Because you paid a premium, you have a capital loss that must be reflected in the YTM. This loss will lower the yield (your overall return) as compared to the CY.
Had you received a discount on the purchase, you would receive a capital gain at maturity. Factoring this gain into your calculations will result in a higher YTM than the CY.
For example, instead of paying $10,250 for the bonds, you only pay $9750. Your CY will increase to 8.2%. However your YTM will rise even higher to 9.0%, reflecting the capital gain at maturity.
Okay, I think that gives you some understanding of the key fixed income terms.
Next we will review the common investments within the fixed income asset class.
by WWM | Aug 9, 2017 | Cash Equivalents
We begin our look at asset classes today. I will not go too deeply into many of the assets themselves. There are plenty of good definitions on the internet. Rather, I want to look at the asset classes from an investing perspective.
How liquid are the assets? What are their risk and return profiles? What other factors impact their performance? How should you consider their suitability in your investment portfolio?
Today we will review Cash and Cash Equivalents (CCE).
Cash is king.
In life, all things material revolve around the almighty dollar. Without cash, you cannot purchase those things you need to survive. So this is an important asset class.
What is CCE?
As an asset class, CCE covers real cash, such as what you have in your savings or chequing accounts, or even hidden under your mattress.
It also includes other assets that possess these characteristics:
1. Extremely liquid,
2. Provide known rates of return, where investment risk is (almost) zero, and
3. Risk of capital loss is negligible.
Examples include: short term government treasury bills; short term government bonds; short term commercial paper, acceptance paper, or banker’s acceptances from highly rated companies; bank term deposits and Guaranteed Investment Certificates (GIC); money market funds.
As an aside, I am a little hesitant to label this category Cash and Cash Equivalents. Some experts include many marketable securities as cash equivalent. This is due to the high level of liquidity for certain fixed income and equities that trade on major exchanges. Also, that most individual investors lack the capacity to influence the asset price through their own holdings so can sell without impacting market value.
Where including fixed income or other assets in CCE breaks down is in the investment risk. Both in the expected returns and in the potential for capital loss. As we will see in due course, other asset classes all have higher risk levels that CCE.
Liquidity
Liquid assets can be quickly converted to cash; at minimal to no financial cost, nor impact on the asset price.
CCE are the most liquid of assets as they are already cash, or one small step from being cash.
Due to the liquidity benefit, you should have your emergency funds primarily in CCE. This should amount to between 3-6 months’ cash requirements. As your wealth increases, you can reduce the amount of liquidity held to some degree.
You should also invest in CCE with assets required for any short term spending requirements. The closer the time to the expenditure, the greater the need to keep the required funds in liquid assets.
For example, you plan to buy a house in 4 years. You can invest in a wide variety of assets, both liquid and illiquid. However, if you need to close the home purchase in only 4 months, you should have all the necessary funds invested in highly liquid investments.
Negligible Investment Risk
CCE are considered investments that have little, if any, investment risk.
That means the difference between the expected and actual rates of return is almost non-existent. There is no real volatility in the performance of this asset.
The Good News – Cash is Relatively Risk-Free
In investing, cash is considered certainty. With every other investment, there is some uncertainty that the amount you expect to receive in the future will be actually what you get.
If you recall our discussions on risk, the greater the uncertainty between what you expect to earn and what you actually earn is the risk (or volatility) of the investment.
With cash, there is no risk in the investment sense. What you have in your jeans is fully certain, assuming there are no holes in your pockets.
You know what you have and you can plan your spending accordingly.
Now there may be some investment risk with CCE, at least the CE portion of the term.
A GIC with a solid, national bank may have less risk than one with a small, regional institution which is having business difficulties. Although both GICs are considered cash equivalents, you need to look at the other risk factors also. We will look at this below.
The Bad News – Cash is Relatively Risk-Free
There is a direct relationship between risk and return.
The lower the risk of an investment, the lower the expected return.
So while CCE are risk-free to a great extent, the returns that you will earn will be low compared to other investments.
While this may protect you during the short term, when investing for long time horizons you should be considering higher risk assets, with better expected returns.
This is why many asset managers recommend only holding about 5-10% of one’s assets in CCE.
This amount typically covers the liquidity needs I mentioned above. It also serves as an investment reserve to allow for new purchases to be made without having to liquidate other non-cash assets.
Known Rates of Return
Time Value of Money
Knowing with certainty your actual return is useful when investing. When looking to the future, you can plan your investments to meet your upcoming cash requirements.
The higher the certainty, the better your planning can be.
You can invest that dollar today and receive more than that dollar tomorrow. Or next week or year. That is the basis for the time value of money principle.
In the case of CCE, your future return is almost certain.
For Example
You require $5150 for your school tuition and books in 6 months time. If you have $5000 now, you could invest in a 6 month Guaranteed Investment Certificate (GIC) from your bank paying 3% over the term. Upon maturity, you would receive your $5000 in capital, plus another $150 in interest income.
You have exactly enough to meet your requirements. Simple.
Now consider an investment in shares of a publicly traded company.
Over the 6 months, many variables could impact the share price. There is a possibility that the shares may be worth substantially more than the required $5150 in 6 months. But there is also a strong probability that the shares will be worth less than that amount. If the latter scenario occurs, you will not have enough money to fund your school needs.
For short term requirements, focus on liquid assets with minimal investment risk.
Beware of Non-Investment Risk Factors
While investment risk is negligible and nominal return is known, other factors can impact your real wealth accumulation.
Inflation
Inflation can erode the future purchasing power of your money by making goods more expensive over time.
In our example, you require $5150 for tuition and books. However, during the 6 months before you pay, inflation rises 4%. This equally affects your school requirements. Now your total costs have risen to $5356.
Had you not considered the potential impact of inflation, you would not have saved enough money for the required costs.
In our example, you would have invested in the GIC and ended up with $5150, but that would be $206 short.
A second takeaway concerning inflation is that it can reduce real wealth. In our example, you invested in a GIC. However, inflation outpaced the interest rate and your real wealth actually fell. As we discussed before, you need to always focus on real returns, not nominal ones.
Currency
If you live in a country whose currency is declining, you may also see an erosion of your cash value on a global scale.
Say you live in the US and want to buy a new BMW. Specifically one that is manufactured only in Germany. The car costs Euro 100,000 and the Euro/USD exchange rate is 1.00. Over the next 6 months you save your money and finally have USD 100,000 in the bank. You head down to the BMW dealer and go to place your order.
Unfortunately for you, while the price of the BMW is still Euro 100,000 that crazy US dollar has fallen to 0.80 against the Euro. In US dollars, your BMW now will cost you USD 125,000.
While liquidity and short term investing were not issues, you still suffered a shortfall due to the currency fluctuation.
Business
As I wrote above, GICs are issued by different financial institutions. Some are financially more stable than others. The same holds true for many other financial instruments.
When reviewing investment options, do not assume that a term deposit, commercial paper, or even government treasury bill is entirely risk-free. Always review the issuing entity and determine whether they are stable or not.
Would you consider debt issues of the US and Venezuelan governments to have the same risk?
One way to quickly assess business risk involves the returns being offered.
For example, banks A, B, and C issue 1 year GICs. A and B offer 5% annual interest rates. Bank C offers 7%.
Exactly the same product, so why the difference is rates?
Remember that risk and return are directly correlated. The higher the risk, the higher the return.
If I analyzed bank C, I would expect to see that there is higher risk of non-payment for the interest or original capital as compared with bank A or B. Because of the increased risk, bank C must offer higher rates than A or B to induce investors to take on the higher risk. If C offered only a 5% return, no rational investor would purchased a GIC from them.
Conversely, if C was as secure a bank as A or B, yet offered higher interest rates, no investors would purchase GICs from either A or B. Those banks would need to increase their interest rates to be competitive.
For additional general risks that may impact liquid assets, please review systematic risks.
For key areas of company specific risks, please check out non-systematic risks here and here.
So CCEs may be relatively risk-free from an investment and nominal return perspective. However, you definitely need to be aware of other risks that can affect your cash’s value and purchasing power.
Next we shall look at fixed income as an asset class.
by WWM | Aug 2, 2017 | Investor Profile
Individuals often consider their goals and objectives when investing, but fail to focus on their personal constraints.
However, investor constraints require equal consideration as they play a substantial role in one’s investment strategy.
Constraints are limitations or restrictions that are specific to each person. Some may be common to many people, others may be unique to that one individual. Today we shall look at a few.
Liquidity Requirements
Liquidity is an investment constraint for most individuals.
The need to always have some cash on hand to deal with daily expenditures or planned purchases necessitates that one avoid certain investment options for a portion of one’s assets.
Three common liquidity needs are emergency funds, planned acquisitions, and investment opportunities.
Emergency Funds
Most investors require a portion of their assets in cash to cover required expenditures, such as mortgage and loan payments, rent, food, transportation and other necessary living costs.
Some experts recommend maintaining 2-3 months spending in emergency funds. In uncertain economic times, when there is a higher risk of employment loss, 3-6 months costs in your emergency fund may be more appropriate.
Another reason for the greater number of months is that many readers are young with relatively low salaries and little in the way of investments or wealth. As you increase your salary levels and begin to build up an investment portfolio, then you may consider reducing your emergency funds to around 3 months of required expenditures.
Short Term Planned Acquisitions
Many individuals plan to make major personal expenditures in the near future. This may be a car, home, travel; anything that requires a large payment at a specific date.
Planned acquisitions require individuals to structure their investments so required amounts are available in cash at the due date. This may result in liquidity constraints as you set aside other funds to make the major expenditure.
For example, investments in venture capital typically have a payback period of between 12 and 14 years. Venture capital is usually an illiquid asset. Therefore, it may be difficult to recover your capital quickly should the need arise.
If you want to maintain $10,000 in liquid assets for emergency funds, you should use it to invest in a venture capital project. In this case, the need for ready cash constrains your investment choices to highly liquid and secure investments.
Investment Opportunities
As you get older and accumulate some wealth, I suggest keeping a small portion of your assets in liquid form at all times. This allows you to take advantage of investment opportunities that may suddenly arise.
If you do not have any liquid assets, then you will have to dispose of another asset in order to purchase the new investment. And when you are forced to sell something at a time other than of your own choosing, often you will not get the best price for it.
But by maintaining about 5% of your wealth in liquid assets, you should always be able to take advantage of interesting opportunities. Obviously, that percentage fluctuates based on your total net worth and desired amounts to hold for unexpected opportunities.
Time Horizon
As we saw in our Life Cycle analysis, investment time horizon can be a plus or a minus to one’s strategy.
As the time horizon until your financial objective decreases, the variety of assets in which to invest also diminishes. Also, the less the time horizon, the less volatility or risk an investor can tolerate in his portfolio.
Tax Issues
After-tax returns are what investors should be most concerned.
You cannot re-invest and earn compound returns on money paid to the government in taxes. Your investment goal should always be to maximize after-tax returns, not gross returns.
Personal Tax Bracket
The tax bracket that the investor is in will impact investment decisions.
If an investor is currently in the highest bracket, she may want to avoid investments that generate taxable income while she is in the top tax bracket. Instead, she may prefer to invest in assets that experience future capital gains. Hopefully, these gains will not crystallize until she has moved into a lower tax bracket.
The same applies to an investor who is in a secondary tax bracket. He may need to be careful about generating too much annual interest or dividend income to avoid being pushed into a higher marginal tax rate.
In both examples, the investors may also be very interested in tax-free investments and/or tax deferred investment accounts. The availability of these investments and accounts varies greatly between tax jurisdictions.
Tax Laws
Tax laws also play a significant role in one’s investment decisions.
In some countries, like Canada, interest income is taxed at a higher rate than certain dividends or capital gains due to tax credits and lower inclusion rates.
If you reside in a country that has different tax rates for different types of investment income, it should affect your investment choices to some extent.
For example, perhaps you live in a jurisdiction where interest income is taxed at a higher rate than dividend income. You have to choose between two investments of equal risk, both offering the same gross return. One pays out interest, the other dividends. You would select the one with the better after-tax return. In this example, the dividend stream.
Many countries offer tax-deferred investment accounts. There are often limitations on annual contributions to the accounts and the possible investments that may be held. Again, this will constrain your investment strategy.
For example, a Canadian Registered Retirement Savings Plan (RRSP) has a 2017 contribution limit of 18% your 2016 earned income, subject to a maximum CAD 26,010. An RRSP will also have restrictions on what investments can be made. A self-directed RRSP provides much more investment latitude than a non-self-directed. But you still cannot hold certain assets such as Bitcoins, uncovered calls, stocks from non-designated exchanges, etc.
Legal and Regulatory
The legal and regulatory environment may also constrain one’s investment decisions.
Typically this is a more important consideration for institutional investors than for individuals. However, there are areas in trusts and foundations where legal issues can be a problem for investment options.
For those of you in public accounting, banking, or law, you may experience issues here.
For example, if you audit a public company, you may be precluded from owning shares in that company. Or if your bank is performing certain work on a company, you may have a blackout period for trading shares in that corporation.
The same may apply in respect of insider trading laws. If you have non-public knowledge, you may run afoul of securities’ laws.
Your sister is president of a publicly traded company and tells you the company is about to be sold for a huge premium. If you go out and buy shares in the company prior to the announcement, you run the risk of being charged with insider trading. You also may run into difficulties if she did not tell you and you coincidentally bought shares a day before the announcement. So whenever there is the potential for issues with an investment, take care.
Unique Circumstances
Finally, many unique circumstances can constrain one’s investment strategy.
Some are self-imposed, others are forced upon the investor.
Certain investors believe in ethical investing. That is, they do not want to invest in companies that they consider unethical. This might include tobacco or alcohol companies.
It may also include companies that operate in certain countries. This was common practice among many investors during Apartheid in South Africa. Today there are countries which by personal choice, or even through laws in some jurisdictions, that prevent individuals from investing in them.
The US currently has legislation that severely restricts trade or investment in Iran. If you try to invest in Iran or Iranian companies, you may be subject to prosecution. Note that this could also be considered a legal constraint.
Other unique circumstances include the ability to purchase certain investments.
For example, a new Initial Public Offering (IPO) may only be available to the best clients of the brokerage house marketing the offering. Or some hedge funds may only be open to investors with extremely high amounts of money. Some mutual funds may no longer accept funds from new investors.
By now you should have some ideas on where you are in life cycle, what some of your investment objectives are, and some of the constraints that you face.
You also may have formed an opinion on your risk tolerance and investor profile.
Next week we will look at asset classes. Probably not too much detail on the actual descriptions, but more how they tie into risk tolerance and one’s investment strategy.