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Mutual Funds

It’s a jungle out there and picking the right stocks with your hard earned money can be a task that rises your stress level, and makes the hours of research unbearable. Not everyone is a stock or investing guru. Yes it can be learned, but there is always a stepping stone, and mutual funds offer that to young, or unseasoned investors looking to wealth build.

mutual fundsWhat are mutual funds?

Mutual funds sound exactly the way they sound. A stock portfolio that is comprised of multiple stocks and bonds, funded by various numbers of investors. Essentially you and these other investors become mutual investors pouring your money into this portfolio and each investor essentially gets a piece of it, in ownership and selling ability for profit. And they don’t cost that much either when it comes to an initial investment. Buying up mutual funds can cost as little as a couple hundred dollars to a few thousand dollars, depending on what kind of portfolio you are looking to invest in. Now you wouldn’t manage your stock portfolio on your own. In most cases there is a fund manager that is placed in charge of the portfolio, and is set in charge of selling or buying new funds. So in essence, an fund manager is a lot like a government elected official that takes on the role of delegate. Someone who is placed in charge of running the show, while those that have placed the manager in charge may go about their daily lives and reap the benefits of the manager’s work. You and the other investors are paying this fund manager to manage your mutual funds based on their experience and knowledge of how investing should be conducted.

Stocks and Bonds

There are many types of mutual funds that you can invest in, the most popular two being stocks and bonds. Traditional stocks and bonds are purchased for the portfolio and then divvied up between the many investors who invest their money into the portfolio. Just as you would buy or invest in a company’s stock on your own, the same would occur with a mutual fund. But the same amount you have to gain on ownership or the sale of a stock, you have just the same amount to lose on it as well. I’ve said it in the past, and remain committed to it still, that investing in bonds is a more safe way to invest your money for a better return. While bonds take time to mature, you are almost guaranteed back you initial investment plus the interest gained over the period of time you own the bond. The same application of these works when buying bonds via a mutual fund, because you are still investing in a bond. As stated before, the cost of the bonds that you would be investing in would be spread out among all the other investors.mutual funds

Taxes

Taxes are applied to all those whom own stocks or bonds within the given mutual fund. So if your fund manager is able to sell stocks while they are much higher than the purchase cost, the mutual fund owners are subjugated to the taxes that are applicable to the stocks that have been sold off. The capital gains tax is required to be paid by each individual investor that made even a little bit of profit on the sales of these stocks. But you are a part owner in all of these stocks, and there is a down side. It is possible that you as a group would have to pay a capital gains tax, even on shares you may still own. Because it is the group that owns the mutual fund that is being taxed as a whole. So imagine the funds manger sells off stock, but you personally decide to hold onto that stock; so you maintain 10% of a stock with 90% of the ownership it sold off. While you personally maintain the last 10%, the government is going to tax you as a member of the group on the sale of the 90%. While the taxes may be a downside for the individual over the group, for the most part the membership of being part of a mutual fund still gives power to the individual investor by allowing for the cost of the investment to be subsidized by many investors.

There are pros and cons to any type of investing. Mutual funds offer another option to investing by allowing for the cost of investments to be subsidized by a group of investors and managed by a fund manager that gives the mutual fund a better shot at making money. Having an investment group to help out with the buying and selling of these stocks and bonds, contributes to taking stress off of the individual investor and gives power to the group.

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Is It Time To Be Short On Treasury Securities?


What are Treasury Bonds

short on treasury securitiesTreasury bonds (t-bonds) are marketable, fixed interest securities issued by the federal government. T-bonds have a maturity of greater than 10 years, and are sold in increments of $1,000. Interest payments are made semi-annually and income is only taxed at the federal level. T-bonds and other treasury securities are considered risk free by investors. So if treasury securities are supposed to be risk free, then how could it possibly be time to be short on treasury securities? Read on…

In this post I will show you how interest rates and inflation can affect the price of treasury securities. While treasury bonds may never default and be free of credit risk, they can end up costing you a fortune if you don’t understand how these securities work. To start off I will explain what each treasury security is. After you understand what the investment is we can then begin to learn how interest rates and inflation rates affect the price of treasury securities, and ultimately how there could be a ton of risk moving forward by owning them.

Other Treasury Securities

Notes – Treasury Notes are similar to Treasury Bonds. The main difference is they have a maturity between 1 and 10 years. Usually, the interest rate of treasury note is a little bit less than a treasury bond due to a faster maturity.

Bills – Treasury Bills have a maturity of less than 1 year. T-Bills pay less interest than T-Notes and T-Bonds due to a much shorter time until maturity. A shorter maturity time leaves the investor much less susceptible to a price risk of treasury securities. T-Bills are issued through a competitive bidding process. Investors purchase these securities at a discount to par, and instead of getting fixed interest payments investors are returned the par value at the maturity of the bond.

Calculating Interest for a T-Bill

For this example, lets say a T-Bill is priced at $970 with a par value of $1,000 when it matures in 6 months. To calculate the interest rate you take the $1,000 and subtract $970 which equals $30 (1000-970=30). Next, divide $30 by the price of $970 which equals 3.09% (30/970=.0309). If you purchased this security your would earn a 3.09% interest over the 6 month span.

How Interest Rates Are Determined

Treasury securities are considered to be free of default risk. This means the interest rate is simply the rate of return required by the investor to cover inflation plus a small percentage of income required for letting the government borrow your money.

inflation short on treasury securities

How Inflation Affects Interest Rates

Inflation is a Treasury Security’s worst enemy. If inflation rate increases the interest rate will need to increase as well to compensate the investor for the additional cost of living. If you are having trouble understanding this concept think of it this way: You don’t invest to lose money over time to inflation. If the interest rate of a bond did not cover the inflation rate then the investor would be slowly losing money over time instead of increasing their wealth.

Short-term and Long-term Interest Rates

The central bank of the United States sets the interest rate or borrowing rate for the entire county. The Federal Open Market Committee (FOMC) is responsible for setting interest rates. If you have been following the FOMC Minutes you already know that long-term interest rates are at historically low levels. Right now the FED has set the national interest rate at 2.0%.

The FOMC sets interest rates according to its expectations of future inflation. Historically, short-term interest rates, such as LIBOR have been highly correlated with the federal funds rate. The FED sets these rates to promote economic growth while maintaining price stability.

Calculating a Bonds Yield & Price

bond pricing short on treasury securitiesTo understand why inflation and interest rates affect the prices of bonds you first need to understand the concept of yield and price. For the purposes of this article I will use the most popular calculation YTM (Yield To Maturity). Bonds can be priced at a premium, discount or par value. If a bond is priced at a premium then it will sell higher than its par value because the interest rate is more favorable than current market interest rates. A bond that is selling at a discount has an interest rate that is less favorable than current interest rates. Finally, a bond selling at par has interest rates that are equal to current market interest rates.

Calculating a bond’s price is relatively easy. The price of a bond is the present value of its interest payments plus the par value of the bond when it matures. The equation to calculate the price of a bond looks like this:

calculating a bonds price

For more information on how to calculate the price of a bond visit this article on advanced bond pricing by investopedia. For the purposes of this post what you need to understand about yield is that when the interest rate of a bond is higher than current market rates then the price of the bond increases (worth more than par value). When the interest rate of the bond is less than current market rates then the price of the bond goes down (worth less then par value).

Why is it Time to be Short on Treasury Securities?

The long-term and short-term interest rates set by the FED are the key to this discussion. Since we currently have historically low interest rates there’s really no place for interest to go except increase. On several occasions the FOMC has admitted they would like to restore the Federal Funds Rate to its level before the great recession. Many people believe that date is rapidly approaching. After the last few FOMC Minutes it was surprising that they have decided to push of increasing the Federal Interest Rates.

short treasury securities to save moneyThe FOMC will begin to increase the interest rates when it believes the economy is stable and has fully recovered from the great recession. When they increase this rate many long-term Treasury Note and Treasury Bond holders can be in for some big trouble, because hiking the federal interest rates means the FOMC expects there will be higher inflation. For holder of Treasury Notes and Treasury bonds this could create a disaster.

As we learned above when the interest rate of a bond is below the federal interest rates then the price of the bond will fall so that new buyers of the bond can get the same effective interest rate as current market rates. By paying less than $1,000 dollars for the bond they will effectively achieve a higher interest rate because the par value is no longer $1,000 (for this example lets say the new price is $800). If the interest payments or coupons are $15 every six months then that is a 3.0% annual interest rate (30/1000=3.0%). If we change the price to $800 then the new interest rate is 3.75% (30/800=3.75%).

Since the FED has openly stated their mission is to increase interest rates once they see that the economy has stabilized we already know their intentions are to raise the rates. With this in mind it may be time to consider being short on treasury securities. if you own Notes or Bonds, but still want to be in a risk free investment you may want to consider T-bills. T-bills have much shorter time to maturity so the an investor in these securities will not be locked into a low interest rate for a long period of time. When investing in treasury securities you never want to be earning less than inflation. If you are in a low interest rate long-term treasury security it might be time to get rid of those so you don’t get stuck with a bad investment or have to sell the bonds at a significantly discounted price.

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The Junk Bond Market Offers High Yield Returns

The Junk Bond Market Basics

Junk Bond Market

Because of their name, “junk bonds” usually catch a bad name and are associated with investment scams or are considered being a waste of time. On the contrary, junk bonds can definitely assist you in diversifying your portfolio with high yield returns. To understand the junk bond market, you must first learn the basics, and what to look out for.

Junk Bond Market Basics

From all technical standpoints, a junk bond is just like a regular bond. Basically, a junk bond is simply an “I Owe You” from a company or organization that agrees to pay you back a certain amount by a certain date with an agreed interest rate that they will pay on the borrowed capital. Breaking down the above statement, here are common terms to be associated with the junk bond market.
Principal: The base amount you are requesting to borrow
Maturity Date: The date that agreed to pay the capital back.
Coupon:The interest rate associated with the borrowed capital

Junk bonds get that label due to the credit quality of their issuers. This is a characterization all bonds are subject to, and they usually fall into one of two different categories.

Investment Grade: Bonds that are issued by low to medium risk lenders. The bond rating on investment grade debt ranges from AAA to BBB. While they may not offer large returns, the risk of the borrower failing to pay the interest payments (or defaulting) is much smaller.
Junk Bonds: Offers high yields to the bondholders because borrowers have no other option. Their credit ratings are not usually appealing which makes it difficult for them to acquire the money they need at an inexpensive cost. Junk bonds usually fall into ratings “BB/Ba” or less.

A bond rating is basically like a scorecard offering the company’s credit ratings. Firms that offer safer investments have high ratings of course while companies with high risk receive low ratings.

Is the Junk Bond Market Worth the Risk?

While junk bonds pay higher yields there is also a high risk that the company in question will default on the bond. There are two categories that junk bonds themselves can be broken down into:

Fallen Angels: The bond originally started out as an investment grade but was reduced to junk bond classification because of the issuing company’s poor credit.
Rising Stars: Logically, it’s the exact opposite of “Fallen Angels” junk bonds. The issuing company’s credit continues to improve which will in the end, rise to investment quality.

The Junk Bond Market is Perfect For…

Before starting to buy all the junk bonds you can possibly find or telling your broker to go on a full search, you need to understand the risk involved. For those of you who dabble in investments and do not have a large amount of capital behind you, junk bonds can be a dangerous venture. When investing in the junk bond market you need to accept the fact that there is a possibility of never seeing your capital again. Additionally you need to make sure you have some advanced analytical skills (or your broker does), especially in specialized credit. Those who have a large amount of money to invest with or are motivated to risk all for high yield returns are usually key junk bond players. Usually, the junk bond market is the playground for institutional investors.

Don’t Write off The Junk Bond Market

Although the junk bond market can be a risky investment area, individual investors using high yield bond funds does make sense. You are diversifying your investments across the board while also taking advantage of the professionals whose job is to basically spend their days researching junk bonds. Before diving in, you need to make sure you have an idea on how long you can commit your cash to a junk bond. There are certain junk bonds that won’t allow you to cash out for a few years. You need to also make sure the rewards justify the amount of risk you are taking. Historically, junk bonds only have a high yield between 4-6% above treasuries. If that yield has fallen below 4% your timing is off and you should avoid the junk bond market. Be sure to always look for the default rate on the particular junk bonds as well. You can use Moody’s website for assistance.

Final Advice to Play the Junk Bond Market

For those of you that will inevitably journey into the junk bond market, there are ways to receive high yield returns without a large amount of risk. How? Here’s our secret:

There are a number of mutual funds and ETFs (Exchange Traded Funds) that invest in the junk bond market and offer attractive dividends that are based on the high yielding junk bonds they hold. By investing in the junk bond market through mutual funds or ETFs (as they invest in numerous junk bonds), you greatly reduce the risk of losing your investment principal. Also, junk bond mutual funds and ETFs are managed by professional money managers that seek out the best junk bonds to invest in and are capable of foreseeing default problems and selling bonds that are in danger of default. Finally, junk bond mutual funds and ETFs offer liquid trading markets that make it easy for investors to buy and sell them, whereas individual junk bonds may be thinly traded and difficult to efficiently buy and sell.

Junk Bond Market Wrap-Up

So there you have it. While there is an high amount of risk in the junk bond market, there is a potential to receive high yields. Our bottom line advice? Forget about investing in individual junk bonds, reduce the amount of risk you are taking by going through the mutual funds and ETFs that are investing in a large group of junk bonds. This way you keep your capital investment principal a little safer than what it would be as you trade individual junk bonds. It’s a great way to diversify your investments, as long as you know what you are doing and what you are getting yourself into. As with any investment, make sure the rewards are worth the risk.

Happy trading, let us know how you fair!

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Bond Basics – A Primer to the Bond Market

by

Railroad BondToday we’re going to revisit the basics of the bond market. Bonds are issued by companies and government entities in order to finance their operations. They are a form of debt, contrasted with stocks which are a form of equity (though some bonds can be converted into equity in a company, these are called convertible bonds). Bonds are generally underwritten and issued on primary markets for companies. For governments they are usually issued at auction to both banks and individuals. Bonds have a par value at issuance and pay an interest rate called a coupon. They can be redeemed at maturity date.

Dynamics of Bonds

There are many factors that influence how much a bond will be worth.  Perhaps the most important factor is the market interest rates. Bonds are usually issued with fixed interest rates so when market interest rates increase, the price of bonds will decrease. The most basic way to measure bond performance is to calculate its yield: Yield = coupon amount / price. So for a $500 par value bond with a maturity date of 10 years and a coupon rate of 5%, its total coupon amount will be $25: 5% yield = $25 coupon value / $500 price. Decrease the price to $400 and the yield increases to 6.25%, increase the bond price to $600 and the yield drops to 4.17%.

Another dynamic to consider when buying bonds is their credit rating. US Government bonds usually carry a lower yield as they carry some of the lowest risk of default and investors are attracted by their security. Bonds with higher yields are often issued by companies and governments with troubled financials in order to attract investors; these bonds are called junk bonds. Credit rating agencies like Standard & Poors and Moody’s allow investors to check the health of bond issuers.

Types of Bonds

As we mentioned before, bonds can be issued by many different entities. US Treasury bonds are issued by the US federal government. This is generally the lowest category of risk and is classified by maturity time:

  • Treasury Bills (T-bill) – Matures in less than a year
  • Treasury Notes – Matures in 1-10 years.
  • Treasury Bonds – Matures in 10 years.

Municipality bonds, or muni bonds are bonds that carry a slightly higher risk but are still unlikely to default, as they are issued by cities and towns: Governments are able to adjust their taxes to pay back bonds. Many muni bonds are also completely tax-free which can be a great incentive for some investors.  Finally corporate bonds are the highest risk category and it’s important to check the credit rating and financials of the company issuing these before considering purchasing.

Zero-coupon bonds should also be of mention.  It’s possible for bonds to be issued without a coupon that is paid annually or semi-annually.  The most well-known kind of zero-coupon bond are Series EE Savings Bonds.  Instead of the Treasury paying coupon rate, these bonds are sold at a 50% discount and accrue interest that can be redeemed along with the par value on or after the maturity date.  There are even some rare bonds on the market which pay a coupon but do not mature.  Finally, it’s possible for the coupons and the par value of bonds to trade separately.

Why Bother With The Bond Market?

The first thing early investors often look to invest in is the stock market, but the bond market is just as important in a balanced portfolio. During a bull market, stocks generally outperform bonds and can deliver staggering returns. However, during a bear market, bonds are often seen as a safe haven to make a predictable return on investment.  Bonds usually perform well when looked at as a long term investment.

Since the fallout from the 2008 financial crisis, the bond markets have been highly active in part due to the fiscal policy adopted by the Federal Reserve.  We’ve reported before that the bond market can also be incredibly risky in this economy. Recent statements by the Federal Reserve chairman have caused the markets to turn and many investors are now exiting on concerns that the Fed will stop quantitative easing and/or raise interest rates.  It’s unlikely that the Fed will be able to keep up its bond purchase programs indefinitely and the bond market could be the next bubble to burst.  Indeed already the US Treasury yields have been on a steady climb.

Where to Purchase Bonds

Most bonds are purchased through a broker. Most brokers require investors to keep a deposit with them in order to purchase bonds on the market.  Be sure if using a broker to background check them at BrokerCheck to be sure of the legitimacy of the broker you’re working with.  The US Treasury also now sells bonds directly through their own Treasury Direct website.  Finally, it’s also possible to trade pools of bonds using various ETF’s to take advantage of leveraging and play on when the yields are going to move.

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Why Emerging Market Bonds Are the Right Risk

Emerging Market Bonds

Emerging Market Bonds: Another Way to Invest in Growth

There is more than one way to invest in emerging markets. Many investors focus on the businesses that operate in developing countries. However, the most profitable emerging economies are sustained by governments that are borrowing in order to build more infrastructure. The emerging market bonds that are generated by these efforts can be very lucrative investments. This is especially true now that many developed countries may be looking at possible bond defaults in the future.

Why Invest in Bonds from Emerging Markets?

Just looking at these markets in general, you can come up with at least three good reasons to invest in their bonds.

• Bonds from emerging markets typically trade with higher yields. This is attractive right now when bond yields are so low in developed nations such as the US. Even though many of these nations have considerably reduced their repayment risks in the eyes of global creditors, by improving their balance sheets, the yields remain high. This juncture in history may be a rare opportunity to secure such high coupon rates while exposing portfolios to comparatively minor risks.

• You can get higher returns out of bonds that are denominated in local currency if those currencies outperform the dollar, even for a short period of time. Currency appreciation generates about 17% of return on these bonds. If inflation of the US dollar continues, you can expect these returns to increase even more.

• While emerging markets generate excitement with the risk and associated potential for earnings, their bonds generally present less risk while still benefiting from heightened interest.

The Best Bonds in Emerging Markets

• iShares MSCI Emerging Markets

• iShares JPMorgan USD Emerging Markets Bond

• PowerShares Emerging Sovereign Debt

These are just three out of several dozen funds concentrated in the emerging markets. The total number of options increases every day.

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Preserve Your Wealth with Inflation Indexed Bonds

Inflation Indexed Bonds

Find a Safe Harbor in Inflation Indexed Bonds

Inflation Indexed Bonds are a way for people to park their assets in troubled times without having to worry about being eaten up by as sudden outbreak of inflationary pressure. Most bonds offer a flat rate of return and then rely on market pricing structures to compensate for inflationary and deflationary pressures through adjustments in the premium over or below the face value of the bond.

The problem with this sort of bond in a highly inflationary time is that the bond might have to sell at a significant discount from its face value if it is a low percentage rate security. An investor who purchased a $10,000 face value bond might have to take hundreds, even thousands, off the price if he were to attempt its sale at a time when inflation was running at a high level.

Indexed securities offer investors a way to make sure that they will not take a bath on their bonds if inflation rises suddenly. There are two ways in which bonds can be indexed.

The Two Types of Inflation Indexed Bonds

• Interest rate adjustable bonds are designed to have the bond pay a higher rate of interest on the principal in the event of rising inflation. Thus, a 5% bond could conceivably become a 6% bond if the bond’s indexing provisions were to come into play.

• Principle adjusting bonds are those, which keep the coupon rate the same but add an inflation-adjusted amount of additional principle to the bond, as circumstances require. In this case, a $10,000 bond might become a $10,500 bond but still pay the same original interest rate.

Most countries offer some sort of inflation-protected bonds to investors. In certain circumstances, there are both high face value bonds for institutional investors and smaller savings bond-type securities for the little guy. The most common inflation indexed bonds are the US Treasury TIPS and the United Kingdom’s Index-linked Gilt.

Both countries also offer small savers the option of purchasing the US Series I Inflation Indexed Savings Bonds and the UK Index Linked Savings Certificates. Most inflation indexed bonds are tied to a widespread national inflation index such as the American CPI.

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