Overview of a Fixed-Income Security (Bonds)

Who are the issuers of fixed-income security or bonds?

• Supranational organizations
• Sovereign (national) governments
• Non-sovereign (local) governments
• Quasi-government entities

Credit worthiness of Bonds

Bond issuers can also be classified based on their credit worthiness as judged by credit rating agencies.

Bonds can broadly be categorized as

• investment-grade bonds or
• non-investment grade (or high yield or speculative) bonds.

Maturity of Bonds

Fixed-income securities which, at the time of issuance, are expected to mature in one year or less are known as money market securities.

Fixed-income securities which, at the time of issuance, are expected to mature in more than one year are referred to as capital market securities.

Fixed-income securities which have no stated maturity are known as perpetual bonds.

Par Value

The par value (also known as face value, nominal value, redemption value and maturity value ) of a bond refers to the principal amount that the issuer promises to repay bondholders on the maturity date.

Bond prices are usually quoted as a percentage of the par value.

• When a bond's price is above 100% of par, it is said to be trading at a premium
• When a bond's price is at 100% of par, it is said to be trading at par.
• When a bond's price is below 100% of par, it is said to be trading at a discount.

Coupon Rate and Frequency

The coupon rate (also known as the nominal rate) of a bond refers to the annual interest rate that the issuer promises to pay bondholders until the bond matures.

The amount of interest paid each year by the issuer is known as the coupon, and is calculated by multiplying the coupon rate by the bond's par value.

Zero-coupon (or pure discount) bonds are issued at a discount to par value and redeemed at par (the issuer pays the entire par amount to investors at the maturity date).  The difference between the (discounted) purchase price and the par value is effectively the interest on the loan.

Currency Denomination

Dual currency bonds make coupon payments in one currency and the principal payment at maturity in another currency.

Currency option bonds give bondholders a choice regarding which of the two currencies they would like to receive interest and principal payments in.

Yield Measures

The current yield or running yield equals the bond's annual coupon amount divided by its current price (not par value), expressed as a percentage.

The yield to maturity (YTM) is also known as the yield to redemption or the redemption yield.  It is calculated as the discount rate that equates the present value of a bond's expected future cash flows until maturity to its current price.

Given a set of expected future cash flows, the lower  the YTM or discount rate, the higher the bond's current price.

Given a set of expected future cash flows, the higher the YTM or discount rate, the lower the bond's current price.

Cash and related currency assets: Their beta may be zero, but their risk is huge.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.”  In truth they are among the most dangerous of assets.

• Their beta may be zero, but their risk is huge. 
• Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. 
• This ugly result, moreover, will forever recur. 
• Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire.

• It takes no less than $7 today to buy what $1 did at that time.
• Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. 
• Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory.

• But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. 
• This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and 
• the invisible inflation tax would have devoured the remaining 4.3 points.
• It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. 
• “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments – and indeed, rates in the early 1980s did that job nicely. 

• Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. 
• Right now bonds should come with a warning label.

Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety.

• At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be.  
• Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. 
• Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain – either

• because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or
• because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. 

Though we’ve exploited both opportunities in the past – and may do so again – we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”


http://www.berkshirehathaway.com/letters/2011ltr.pdf

Reviewing the basics of interest-bearing investments

To have a good understanding of interest-bearing investments, learn and know the followings.

The risks of interest-bearing investments, for example:

• inflation,
• interest rate cycles and
• dubious borrowers with poor credit ratings.

The advantages of investing in this asset class, particularly

• the interest income on which you can rely.

Some of the main interest-bearing investments in the market.  These include: 

• cash,
• money market funds,
• bonds,
• participation mortgage bonds and
• voluntary purchased term annuities.

You have to know about two new market places other than the stock market: 

• the money market, where short-term interest-bearing secuities are traded, and
• the bond market, where longer-term interest-bearing securites such as bonds are traded.

Money market funds have become very popular alternative to bank deposit

A money market fund is a type of unit trust that invests in interest-bearing instruments issued by banks, government and companies when they want to borrow money.

These short-term instruments are

• traded on the money market, and
• have a maturity of less than 12 months.

Money market funds have major advantages in comparison with other cash investments.  For example:

• You gain access to money market instruments even though you invest only a small amount.
• The interest rate is higher than for a bank deposit, as you are part of a group that can bargain for the best wholesale rates.
• You can withdraw your money at any time, like a call deposit at a bank.
• Interest rate risk is largely eliminated because money market funds are allowed to invest only in instruments with an average term of not more than 90 days.

Units in a money market fund have a fixed value of $1, and the only changing aspect is the interest income an investor earns on that unit.

This income is capitalised, or reinvested, which means the investor earns interest on interest.

Money market funds are ideal

• for pensioners who must live on their interest income or
• for the creation of an emergency fund from which you can withdraw money at any time. 

Money market funds also provide useful parking for investors

• to limit the risk of an investment portfolio in uncertain times or
• to phase in their funds.

When you invest in a money market acount, you should know the difference between the nominal and effective rate. 

• The effective rate is the interest rate you will earn if your money is deposited for the whole year and all the interest is reinvested. 
• The nominal rate is lower because this is the rate you earn every month before any reinvestment of interest is taken into account.

The 'safe' option of cash

Cash has always been seen as a fairly safe investment, and our forefathers were quite happy to put their money under the mattress and leave it there.

Today we realise that you cannot just put your money away and forget about it, because inflation will erode its value.

If you want a stable income, a bank deposit is still a valuable investment option.

However, money market funds have become a very popular alternative.

The calmer waters of interest-bearing investments: their risks and rewards

The interest-bearing investments include:

• cash
• bonds
• the money market securities.

Compared to the roller-coaster ride of equities, interest-bearing investments are like a sea of tranquillity.

The focus of interest-bearing investments is not on the appreciation (increase) of the capital you have invested, but rather on the provision of a steady interest income - often at a fixed rate.

While shares offer you higher returns at a higher risk, interest-bearing investments offer you lower returns at a lower risk, making them a safe haven for many investors.

But this safe asset class is not safe from inflation. 

Interest-bearing investments often do not generate the kind of return that beats inflation, and it is very important to remember that interest income is taxable.  After taking tax into account, the return on interest-bearing investments often struggles to beat the inflation rate.

The reason for this is simple.  Interest-bearing investments are normally money you lend to a bank, government, company or other institution with the undertaking that this exact amount will be paid back after a period of time. 

In return for this, you earn interest.

Since you only get the same amount back after a couple of months or years, that amount is usually worth less as a result of inflation. 

Your only real benefit is the income that you receive.

Interest-bearing investments also hold other risks. 

• This asset class is subject to the ups and downs of the interest rate cycle.  As interest rates increase or decrease, your cash flow can be affected - unless you have a fixed interest rate.
• Furthermore, you should beware of institutions with credit risk.  A high interest rate is not everything:  you must also be sure that your capital will be paid back. 

The so-called junk bond market in America is well known as a market where companies with poor credit ratings offer exceptionally high interest rates.  Sometimes it is better to earn less interest, but know that your money is safe.

Interest-bearing investments do, however, play an important part in an investment portfolio.  Although inflation will still erode the capital value of your investment, these investments do have advantages, including:

• offering you a relatively safe and predictable income.
• offering you less risk and volatility than an investment in equities
• offering diversification in your portfolio in case stock markets collapse
• giving you instant access to cash when you need it.

CDs, Savings and Money Market Accounts

The big attraction of the choices in this group is their safety of principal.  In fact, they are considered so safe that they are generally lumped together as an asset class called "Cash/Cash Equivalents."  For the purpose of this article, let's call them all "cash".

The main attraction of cash is simple - the value of the principal does not fluctuate and may even be guaranteed depending on the amount of the investment.  Put a dollar in, and you'll get a dollar back, plus interest.  In addition, the assets in cash group can generally be "cashed in" at full value on short notice (although CDs may have meaningful early surrender penalties).  No matter what gyrations the stock market or interest rates are going through , the value of these assets stays the same.  Most financial planners will recommend that you have enough money salted away in cash/cash equivalents to cover three to six months' living expenses, plus an amount to cover any known major outlays you'll have to make in the next year or two.  This group of assets can also add stability to your portfolio because their value is stable.  All in all, cash plays a key role in building a portfolio as a sound foundation for funding emergencies or contingent expenses - but not for income!

Major types of Investments

Major types of Investments



Main types

1. Stocks or equities

2. Bonds or fixed income securities

3. Money market investments



Derivatives

1. Options

2. Futures



Unit trusts

1. Money market funds

2. Bond funds

3. Equity funds

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Bonds or fixed income securities

Bonds are loans issued by companies and governments to borrow money, and they have two main characteristics:

1. They have lifespan greater than 12 months at the time of issue.
2. They typically promise to make fixed interest payments according to a given schedule.

Bonds are hence also called fixed income securities.

Bonds have their own unique terms: Suppose you buy bonds with a face value of $10,000. These bonds mature in 2 years and pay 4% interest annually. The 4% interest equates to $400 a year. The face value of the bond, or the principal amount of $10,000 will be returned to you when the bond matures in 2 years.

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Money market securities

Money market securities are similar to bonds except that they are short-term investments. They have two main characteristics:

1. They are loans issued by companies and government to borrow money.
2. They mature in less than a year from the time they are sold, which means that the loan must be repaid within a year.

Some of the most common money market securities include

• Treasury Bills (issued by the government and considered the safest investments around),
• fixed deposits,
• bank savings accounts and
• certificates of deposits.

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