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 | Mar 5, 2017 | Fixed Income
I tweeted today about a Bond 101 Primer courtesy of PIMCO. Well worth a read.
When we reach asset classes in this blog’s investment series, we will go into bonds in detail. A good article, but the PIMCO primer illustrates why I am trying to build up some core investment knowledge before tackling the assets, strategies, and tactics. It is a much better read if you understand diversification, correlations, hedging, and such.
Bonds Get a Lot of Questions
I mention it now as bonds are usually a big question from clients.
Namely, “Why should we invest in an asset class (bonds) that tends to offer weaker expected returns than other classes (e.g. equities)? Shouldn’t we want to put our money in assets with the best expected returns?”
I would not disagree with either question. So why should you invest anything in bonds?
Non-Return Bond Benefits
I like bonds in portfolios for a variety of reasons.
Yes, you can get real returns from bonds, so they are not a waste of capital (though they can be in certain economic conditions). You can also generate substantial capital gains (or losses) from bonds (again, depending on economic conditions). So there are possible returns from capital as well as interest.
But I like bonds in client portfolios for non-return benefits.
Bonds often provide higher stability and certainty of returns than equities. Over time, bonds may earn less than equities, but your risk level should be lower. Preservation of capital may outweigh potential returns for many investors. And, as you approach retirement and plan to live off your savings, having a known income stream is important.
Bonds often are less than perfectly correlated with equities. This enhances portfolio diversification, a desired result.
Bonds may provide hedging opportunities which can be beneficial.
Bonds come in multiple sub-classes in a variety of currencies. Depending on your risk appetite, some bonds may offer potentially lucrative returns versus equities. Tactical bond strategies within the asset class alone can increase returns, reduce portfolio risk, and enhance hedging. You can purchase plain vanilla buy and hold until maturity bonds. Or you can engage in many varied tactics. Bonds offer all things to all investors and can achieve a wide variety of objectives.
I think most investors, even those with extremely long investment time horizons, can benefit with a percentage of bonds in their portfolios. Obviously, the exact proportion fluctuates between individuals, as well as over time for a specific investor, based on unique and ever-changing personal circumstances.
One Other Note
I do suggest taking a look at the PIMCO piece. If you understand all the terminology and concepts, great.
If not, do not worry. The article illustrates what I am attempting to do with my blog posts. Over the next little while, we will lay a solid foundation of investment concepts. Asset correlations, diversification, hedging, etc.
By the time we get into the properties, advantages, and disadvantages of various asset classes, you will easily follow the points. But without the groundwork, probably not as much value diving right into asset class pros and cons.
For example, I tweeted that I tend to favour using bond ladders for the average investor. PIMCO touches on ladders. But when we finish the core concepts and get into fixed income, you will better understand WHY bond ladders may be useful in your portfolio strategies.
To me, it is the understanding why something should be utilized that makes investors successful.
Hopefully, over time, we achieve that together.