What is a tracker bond?

Image attribution: 401(K) 2012; CC BY-SA 2.0

By Catherine Halsey

A tracker bond is a fixed-term investment in the stock market. Upon acquiring one, most of your money will be put in a deposit-based account, while the remainder will be invested in stocks. A tracker bond is set for a fixed term, usually of at least five years. During this time, no withdrawals can be made from the tracker bond. The buyer is given a certain level of capital guarantee, with the level varying according to the degree of risk they wish to take.

A tracker bond can be treated as a long-term saving option, for only once the bond has matured will the investor be able to access it.

Things to consider

When purchasing a tracker bond, the buyer has a number of options to consider. The term of the investment – be it five, seven or more years – will first be determined. Then there is the level of capital guarantee to set, depending on the buyer’s chosen level of risk. In addition, there is the participation rate, which measures the level of participation the investor will have in the growth of the chosen stocks. Finally, a cap may be placed on gains. Ideally, the investor will want there to be no cap on gains, as this limits the potential profit to be made.

Low risk

Tracker bonds are generally regarded as being low-risk investments. This is because many tracker bonds offer 100 percent capital security. This ensures that even if your stocks perform worse than expected, you will at the very least receive your initial investment back at the end of the full term. However, it is worth bearing in mind that were this to happen, your money would likely be worth less in five years’ time due to inflation.

Conversely however, if your bond performs well, there is the opportunity to make a significant return on your investment. How much you stand to make depends on a number of factors, including the cap (if any) that has been set; this may be set at 50% of your initial investment for example.

To maximise your return, choose a tracker bond that doesn’t offer 100% capital security. Provided you’re confident in the ability of your chosen stocks or financial indices to perform, this a smart way to increase your potential profit.

If you’ve got a sum you’re looking to invest but don’t relish the stock market’s unpredictability, a tracking bond could be the answer. There’s less risk, and if you choose well, you could be enjoying a lump sum in just five years.

About the author: Catherine Halsey writes for a digital marketing agency on a range of subjects. This article links back to http://www.ulsterbank.co.uk/ni/personal/saving/long-term.ashx

Guide to surety bonds

Image attribution: Freedigitalphotos.net; standard royalty free license

Surety bonds are a mechanism that protect individuals and businesses from certain kinds of work or service related performance problems. For example, according to the Small Business Administration (SBA) surety bonds on contracts are like insurance, and guarantee individuals or organizations work will be finished according to predetermined specifications. Moreover, in the case of payment surety bonds, those completing the work are guaranteed payment per the SBA.  

Depending on the service being performed and which party is seeking guarantee, specific kinds of surety bonds are used. According to State Farm Insurance, many kinds of surety bonds exist including permit bonds, contract performance bonds and public official bonds. Each type of bond serves a particular function of surety. To illustrate State Farm also claims license bonds assure clients whose contractors are 'licensed and bonded' that they will receive services such as electrical work within allowable standards. 

Surety bonds are not like Treasury bonds that are purchased in full and pay interest. Neither do they pay for claims like insurance companies do according to JW Surety Bonds. Rather, only a percentage of the surety bond's full surety coverage is paid by the buyer to guarantee service, work or payment. To make a claim against a surety bond, a filing of that claim and subsequent investigation similar to other types of insurance takes place. However, unlike many types of insurance, the buyer of the surety bond and not the seller is responsible for payment or service.

If a business, contractor or official holds a surety bond, it not only gives 'surety' of their services, but can improve their marketability. This is because guaranteed service is more likely to have a higher value to paying clients and assuming competitive pricing and functions of a business, provides a market advantage if competing businesses are not bonded. In some cases, especially in reference to government services, surety bonds are mandated. For example, surety bonds on Medicare equipment supplier services are required by the Department of Health & Human Services.

For buyers of services, it may not be enough if a business simply states it is bonded. The specific type of bond and the buyer's right to make claims against that bond are ideally verified for good measure. To confirm the authenticity of surety bonds the registration of the surety bond issuer can be verified with the U.S. Treasury Department. Following this, and upon successful identification of issuer legitimacy, that issuer or surety company can also be contacted to determine whether or not a specific company or service provider is indeed bonded.

How To Interpret Bond Yield Curves

Yield curves are the percent return on investment offered by financial instruments such as bonds. Bond yield curves are important indicators of economic activity, risk, monetary policy and market conditions. Consequently, bond yield curves are useful in financial analysis. For example,  bond rating and yield indicate the quality of the bonds, and the angle at which the yield curve slopes indicates how risky longer-term bond issues are perceived to be. Understanding what bond yield curves mean can help investors with assessing risk and in arriving at investment decisions such as which bonds, if any to invest in.

Duration

The length of time until a bond's face amount becomes due to the buyer is called the duration. Generally, with longer durations, the yield of a bond goes up because the opportunity cost and investment risk rises with time. It is for this reason that yield curves tend to curve upward, however the slope of these curves can either be low or high depending on the issuer's credit rating. For example, the U.S Treasury Bond yield curves below are from the Federal Deposit Insurance Corporation (FDIC) and show a higher yield for 30 year bonds than they do for 6 month bonds.  More up to date bond yield curves can be viewed at the U.S. Department of the Treasury.

U.S. Treasury Security Yield Curves

 Source: FDIC US-PD

Classification

The kind of bond also affects the bond yield curve. As evident in the above bond yield curve graphs, conventional bond yield curves are placed higher than the Treasury Inflation Protected Securities or TIPS. This is because investors are willing to pay in the form of lower yield for the inflation protection of security that is not offered by conventional bonds according to the Wall Street Journal. Moreover,  when the demand for TIPS is higher, then the yield will be lower. The reason the yield isn't higher regardless of demand is because the inflation protection is not incorporated into the yield, but rather the principal balance according to Treasury Direct.

Issuer

Bond yield curves also differ by bond issuer. For example, a country with a high credit rating is more likely to have lower bond yields, and a flatter bond yield curve due to the low-risk associated with those bonds. However, if an economy is performing badly, the affect on bond yields tends to be toward higher yields and more vertical curvature. This is evident in recent rises to Italian and Spanish bond yields after being downgraded by Standard and Poor's per Reuters. In other words, with lower-risk bond issues, price rises with demand, but the yield curve then moves down. 

Risk

Market risk also affects bond yields. To illustrate, consider an especially highly rated bond; these are thought to be a financial safe haven or low-risk investments for large institutional investors, sovereign wealth funds and individual investors seeking to lower investment risk via diversification into bonds. If other investments seem too volatile for investors, they may invest a larger amount into bonds because of their safety. The affect of this increased investing on the bond yield curve will be  a downward movement of the whole curve where the longer-term issues still curve up, but at lower yields due to increased demand.

Policy

Bond yield curves can also reflect monetary policy. A good example of this is the Federal Reserve Bank's bond buying programs. Quantitative easing as it is also known adds money to the financial system because the central bank purchases more bonds. This causes the Federal Reserve's assets to increase, and also puts downward pressure on the bond yield curve. Another example of this is the Federal Reserve Banks' 'Maturing Extension Program and Reinvestment Policy' or selling of short-term Treasury Securities and buying of long-term ones. This causes the yield curve to flatten at the back end and become more horizontal which subsequently demonstrates the influence of monetary policy on the bond yield curve.

Key aspects of investment decision making

Investment decisions are made to reach financial planning goals. For example, make $100,000 by age 50. Traditional investment plans often assume an interest rate and consistent periodic contribution. In reality this can be easily disrupted by a lay off, change in market returns, or other unplanned for life disruptions. These models of investing are outdated in some ways; in such case, a new way of thinking about investing is needed. The following are key factors in many investment plans whether they are traditional or not.

Inflation

Inflation is the increase in the cost of goods and services according to the U.S. Bureau of Labor Statistics (BLS). Inflation usually occurs every year and amounts to approximately 2-3 percent. This means a $100 can only buy $97-$98 of goods after one year's time at that rate. In light of that, investments should at a minimum cover the cost of inflation if only to preserve the value of money. Treasury Inflation Protected Securities (TIPS) are a government financial security  that periodically adjust for an inflation adjusted return.  

Time 

Time is another important factor in investing. Time really is valuable, and when diligent savings is added with the discipline to only increase the amount, financial results can be pleasing. Everyone retires or dies, and money is needed in retirement.  To see time in action try a savings calculator like the one at the Financial Regulatory Authority (FINRA) and play around with the numbers. To illustrate, $1,000.00 at 5% compounded annually yields  $7,078.04 inflation adjusted over 10 years with monthly deposits of $50.00 and $19,590.82 in 30 years. 

Interest 

Interest is also very valuable and can turn small amounts into big amounts over time. When investing small amounts with a disrupted schedule look for the highest fixed interest rate available. For example, assuming a beginning savings of $8,000.00, low income, and monthly investments of just $50 a month at just 2% one can accumulate $39,205.94 over 30 years with annual compounding i.e. interest added yearly. At 5% the amount rises to $77,354.89 and at 7% the value is $125,930.53.  An international bond fund with fixed returns and low management fees is one place to look. An example of a bond fund is the Total Return Bond Fund (TGLMX) listed by US News Money.

Risk

Bond funds are also low-risk if they are high quality bonds. For those individuals with a higher risk tolerance, yields can be higher, but losses can also occur wiping out previous year's gains. Be careful to properly consider risk level in terms of time as risk can sometimes even out over time while providing a higher return. The investment risk pyramid below describes the types of risk and possible returns. Also, be sure to consider schemes and scams described by the Securities and Exchange Commission (SEC).  

Image source: New York State Office of the Attorney General

Contributions

In a volatile working environment and unsteady economic conditions it is a good idea to assume no consistent investment contributions, nor a steady return on investment. Using this method, one's investment plan is not caught off guard when a disruption such as unforeseen expenses, or changes in cash flow do occur. Keep in mind starting off with a high savings balance is a good way to leverage and begin earning more by saving. For example, 2% on $1000 is $20 but 2% on $100 is $2.  A key is to be consistent and keep the amount manageable, a low risk investment won't be exciting to watch but sticking with it can make all the difference.

Instrument

Financial instruments can make or break an investment. High risk investments such as leveraged stock options can destroy savings and kill years of investment savings; be careful. In reality, investors might not have enough to diverse risk across multiple investments. In such case safer long-term, medium-volatility utility stocks with high income dividends might be an option. The Motley Fool provides some examples of dividend paying utility stocks with yields above 6%.   Be forewarned though, even utility stocks can move with the market. The Empire District Electric Company Stock (EDE) listed by the Motley Fool declined over 50% from its 2007 high and still hasn't returned to that price. 

State Credit Ratings and Bonds

When buying bonds from state governments it is a good idea to check out the state credit rating. There are also multiple types of bonds which can have their own credit ratings. For example, California's State credit ratings are divided among five categories of debt according to the California State Treasurer. Of those five are 'general obligation', 'Lease revenue bonds', 'general obligation commercial paper, revenue anticipation notes and economic recovery bonds. 

Some interesting link about state credit ratings:

9 States with best credit ratings:                                      http://tinyurl.com/3gf8ze8
Credit rating by state per California State Treasurer:      http://tinyurl.com/3vatw5c
U.S. States credit score card:                                           http://tinyurl.com/6jd3bsa 

State ratings in 2008:                                                       http://tinyurl.com/m3qzf6 

Tax and expenditure limitations on state credit ratings:  http://tinyurl.com/64ryk3t

State's credit ratings on bonds can change from year to year so having access to up to date information is useful. Standard and Poor's and Moody's have current state credit information but each require registration. Moody's registration and some of its credit data is free; Standard and Poor's offers a free trial upon approved review.

How Net Present Value is calculated

The Net Present Value (NPV) calculation makes use of an important time variable to tell you 1) the value of an investment at present time given future cash flows and 2) if the investment is worthwhile. Net Present Value is important in valuation of projects and investments because the combination of estimated value based on cost, yields and cash flow can sometimes paint an inaccurate financial mirage without quantification of the variables.

Another reason why Net Present Value calculations are useful is because they can help determine if an investment or project is more profitable than it actually is in less uncertain terms. With numerical figures entered into a proven formula, the only factors that may be questionable are the future cash flows and cost of capital. Moreover, if these can be reliably estimated, the resulting NPV stands a greater chance of accurately predicting present value. 

When NPV calculations are used 

If you buy a bond and know the periodic interest rate, and will receive the face value of the bond at a specific point in time like 10 years, then fair valuation would price the bond at the present value of all future payments. Present value adds up all the interest payments, and the difference between the initial purchase price of the bond and the future reimbursement to arrive at a present value. In another circumstance maybe a bond is bought from someone else several years after it was originally issued and you want to know the price. Net Present Value would factor in additional costs if the bond investment were considered as a project.

Perhaps you are a project manager and are attempting to illustrate the value of a project to another executive. The Net Present Value calculation will mathematically give you the total value of an investment's returns that are in the future and are based on key variables including 1) the cost of capital, 2) time, and 3) negative and positive cash flow. Two more examples of circumstances in which NPV calculations may be used are below:

• Example 1: Your business purchases tax free bonds with some of its earnings. The bonds pay 5% every 6 months for 10 years at which time the face amount of the bond is either redeemable without penalty or rolled over. You are trying to calculate how much you should pay for the bond not to be overcharged and use a NPV calculation to do so.

• Example 2: Your company is thinking about investing in a project and wants to know if the opportunity cost is lower than the rate of return for the project. You know how much the initial investment is and have a good idea of what your annual returns will be and how much, if any, the financing of the project will cost. The NPV calculation can help you with the decision.

NPV calculations and methods of calculation

Net Present Value can be calculated in a number of ways and a number of different NPV calculations exist for varying circumstances. In other words, due to differences in variables used, Net Present Value calculations can differ. For example, a bonds can provide either fixed or variable rates of return. Both cases require different calculations. Additionally, cash flows can vary from year to year due to changes in project success and/or cost. NPV can be calculated manually, with regular or financial calculators or with financial software. Examples of NPV calculations are below:

• Calculating Net Present Value against costs of capital and opportunity cost for a fixed rate bond 

Variables: Term of the bond 10 years
Fixed rate of return 5% annual
Future Face Value: $ 5000.00
Interest payments: Bi-annual

Step 1: Calculate present value:
$5000.00 x 5%= $250.00 x 10/20=$125.00
$125.00 x 20=$2,500 + $5000.00 =$7,500.00
The bond is worth $7,500 at present with all cash flow included

Step 2: Reduce value by cost of capital
Cost of capital, inflation + opportunity cost
3.35% (est .avrg)+2% (est. return after risk reduction)
=5.35% = $3210.00+$5000.00=$8,210.00

Step 3: Subtract present values for net present value
$8,210-$7,500= -$720.00
NPV= - $720.00

Conclusion: The bond is a bad investment based on cost of capital and opportunity cost discounting.

• Calculating Net Present Value with inconsistent cash flow

Variables: Project down payment $5000.00
Cost of financed capital (Annual project yield -Annual project cost): 12% per year
Time period: 10 years
Cash flows: Between 12-18% ascending return per year

Step 1: Calculate present value of each individual estimated cash flow
Y1: $600.00 Y2: $625.00 Y3: $650.00 Y4: $675.00 Y5: $700.00 Y6: $825.00 Y7: $850.00 Y8: $875.00 Y9: $900.00 Y10: $900

Step 2: Present value for each future year's payment equals percentage yield plus value to which that yield can be added to amount to the future yield. EX: $600 =$535.71 x 12%., $625.00 =$498.246 x 12% for 2 years.

Step 3: For each year add the present value to arrive at Net Present Value. Ex. $535.71 + 498.25= $1033.96 for 2 year Net Present Value.

Source:

Brigham and Houston. 'Fundamentals of Financial Management 9th ed.' Mason, Ohio. South-Western, 2001, Chapters 8 + 11.

The Difference Between Duration and Maturity in Bond

Bonds are specific types of loans to Government(s) be they foreign, federal or municipal, or Corporations. The interest for these loans can either be fixed i.e. unchanging or floating (changing) and is paid on specific time intervals. Bonds can also be convertible to other financial instruments, have the face value paid along with interest or not, and are exchanged in secondary markets such as the Chicago Board of Trade. Two important features of bonds are their maturity dates and duration. This article will discuss the difference between bond maturity and duration.

Bond maturity

Bond maturity is fairly simple to understand in comparison to duration. Since bonds are like loans, at some point the principle of the loan has to be paid back. For example, if a bond had a 30 year life in which "coupons" i.e. the interest rate on the face value of the loan were paid, the face value of that bond could either be paid along with the coupons or bought back early as in the case with "call bonds". However, other bonds do not pay back the face value until the end of the established term of the loan. This end of bond life is known as "maturity" and is the point by which the face value of the bond must be paid back.

Bond duration

Duration is an important financial equation that measures risk of return due to fluctuations in market interest rates. For example, since bonds are loans made from companies or governments to individuals or other companies or governments and new bonds are issued frequently, the benefits of older bonds may rise or decline in relation to new bonds. In other words, if interest rates rise on new bonds, the old bonds won't be as valuable in secondary exchanges because the new bonds are a better deal. The risk of this happening is termed interest rate risk and is measurable by the duration equation.

Duration is a very useful equation to investors because of its ability to quantify interest rate risk. This quantification assists in the investment decision making process and does so by expressing the relation between interest, time, and price variables of the bond. The result becomes an "interest rate sensitivity" i.e. risk level. Logically speaking, duration is a time value that either equals, is lower or greater than the original interest payments. In other words, when interest rates fluctuate old bond prices change, causing the duration value to also change. Since duration is a weighted average function of time, the greater the difference between original duration and new duration, the more risk is present in the bond.

Bond duration equation

The duration equation is a sophisticated combination of variables that each have a unique meaning unto themselves. However, one might consider the most important aspect of the duration equation to be the outcome rather than how it is calculated as it is the outcome that helps indicate investment risk. Nevertheless, understanding the logic and the relationships between the bond variables can help clarify the dynamics and depth of understanding between the variables. This can in turn, give one a greater appreciation for the nature of the bond market, and investments within it. A few key variables in bond duration are the following:

Important variables:

• Present value of payments: Value of interest payments in proportion to face value, bond price in secondary markets. Also known as discount rate.
• Bond price: Current bond price for used bonds
• Interest rate: i.e. coupon rate
• Face value of bond: The future value at maturity
• Future value of bond: The future value if other than face value
• Time i.e. number of interest remaining in the life of the bond

Duration can be calculated by adding the sum of the present value of coupons by the weight of that coupon in proportion to total payments including face value. There are a lot of concepts built into that last sentence. Of particular relevance is weighted average which is present value of coupon rates i.e. (adjusted interest payments based on current bond prices) divided by the latest bond pricing.

Essentially, in this case, weighted average is a concept within a concept that contains another concept i.e. present value which is calculated by inputting remaining payments, new interest rate, payment amounts and future value i.e. final bond payment into a financial calculator, spreadsheet application or by hand. The result becomes a time value that is either lower, higher or the same as the original bond duration i..e time between payments and term of the bond. If the duration is lower the risk is also thought lower and if the duration is higher than original bond duration, the risk is thought higher.

Summary

Calculating duration is a way to double check accuracy in bond pricing as well as determines price risk. For the most part, adjustments in bond prices are efficiently adjusted for in the secondary bond markets through market efficiency. However, some bonds may be at greater risk to opportunity cost i.e. the risk of obtaining higher yields from alternative investments. This being the case the duration equation is a necessary tool to bond traders and investors.

Since the duration equation can be complicated and conceptually advanced, it can be a good idea to break it down in terms of its sub-components and relationships. This can help make the final equation make more sense. Following this underlying understanding, the duration equation can be simplified and expedited through the use of financial calculators and spreadsheets.

Sources:

1. Bodie, Kane and Marcus. 'Investments 5th ed.' Boston. McGraw-Hill Irwin, 2002. p.485-492
2. Brigham and Erhardt 'Financial Management: Theory and Practice 10th ed' Mason, Ohio SouthWestern, 2002 p.352-357
3. http://en.wikipedia.org/wiki/Bond_duration
4. http://www.investopedia.com/university/advancedbond/advancedbond5.asp

Inflation bonds 101

When an investor, financial institution, mutual fund or foreign Government seeks inflation protection, it is a good idea enter into one or more of several financial vehicles designed to protect financial interests and worth. One such financial instrument is the inflation bond.

• What is an Inflation Bond: An inflation bond protects against inflation by offering an interest over and above a periodically adjusted inflation rate.

• Where you can find Inflation Bonds: U.S. Government inflation bonds can be bought directly from the department of the treasury, bureau of public debt. (http://www.publicdebt.treas.gov/) and foreign inflation bonds such as the Canadian Real Return Bond can be purchased through brokerage firms.

• Benefits of Inflation Bonds: Inflation bonds can do more than protect against inflation. Inflation bonds can also help one diversify an investment portfolio against adverse economic and market conditions. Additionally, since interest is not paid until maturity or redemption, inflation bonds can be utilized as an untaxed retirement savings vehicle. When they expire and/or are redeemed the owner may benefit from being in a lower tax bracket than at the time of purchase.

• Costs of Inflation Bonds: Government Inflation Bonds come in a number of different denominations and generally the amount one pays for them is the face value of that denomination. Corporate inflation bonds can be purchased either through a broker or directly form a company.

Tips on buying inflation bonds

When buying inflation bonds there are several things worth thinking about as in many forms of investing. Essentially those things revolve around finding the best deal with the least amount of risk. Some of the factors to consider are as follows:

• Bond Grade: Investment grade is an important indicator of the financial credibility of the institution(s) issuing the bond. The closer the rating is to AAA, the more accountable the issuer is.

• Secured Versus Unsecured: Collateralized bonds may not always be what they are cracked up to be. For example, secured AAA bonds backed by mortgage securities can decline in credibility if the housing market experiences a downturn. Unsecured bonds or 'debentures' rely on credit alone making the grade even more important.

• Real Rate of Return: The real rate of return is the actual amount of interest after inflation is deducted. Not all inflation bonds offer the same real rate of return. Shopping around can assist in finding the best rate.

• Rate Adjustments: Government I-bonds typically readjust interest rates every 6 months. It is a good idea to investigate how corporations readjust for inflation before purchasing their bonds.

• Foreign Inflation Hedge: If one lives in a country where inflation is high, investing in U.S. I-Bonds, Treasury Inflation Protected Securities (TIPS) and/or Corporate Inflation bonds may be a wise choice to protect ones income from losing value. Additionally, such investments can earn money in lieu of a less secure foreign savings vehicle.

Inflation Bonds are an attractive choice for both individuals and institutions wishing to protect, secure, diversify and stabilize investment capital and/or investment portfolios. While the returns on these types of bonds are not always as high as some other possible choices of investment, they do provide a consistent source of capital growth. Such capital growth can also be tax deferred in the case of I-Bonds, and interest gained from TIPS is both state and locally tax free.

Why bonds fluctuate in value

Bonds are more than just loans to the Government and corporations they are often transferable securities that are traded through auctions, or through broker assisted deals. A bond can either trade at face value, at a premium, or at a discount or below face value. Bonds typically pay interest rates between 1-7% depending on the type of bond and these bonds can be traded on exchanges at different prices than their face value after original purchase.

Market making, interest rates and bond grading

Since many bonds are transferable, buyers and sellers of the bonds bid and ask for different prices. When a significant of these prices are satisfied, the price of the bonds either moves up or down. The exchange of bonds is managed through a market maker system in which the prices organizations and investors enter are tallied and arranged through a computerized system. If there are more buy requests satisfied these can have the affect of pushing prices upward and vice versa. As market conditions continue to change, the price of the bond is re-negotiated through the exchange system.

Other conditions affecting bond price include either corporate or Governmental adjustments to interest rates. For example, over time, an variable rate inflation bond may change by 1-2% to adjust for inflation. Also, the demand for higher paying yield bonds may be high causing a decrease in the value of bonds with lower interest rates.

Another factor that can influence a bond price is a corporate bond downgrade. If a bond watchdog such as Standard & Poors determines a company's credibility has declined, the bond grade of their bonds usually decline. These price drivers are summarized below:

• Market Making and Market activity: Trading on exchange is managed by a market maker and as prices investors are willing to pay or sell at change so to do bond prices.

• Interest Rate Adjustments: When the Government or corporations adjust their interest rates, changes in the price of pre-existing bonds occur.

• Bond Grade Down or Upgrade: If a Government or Corporation's credibility declines, often the bond quality also declines potentially affecting price.

An example of an interest rate driven bond price change is given as follows to illustrate features of the bond pricing mechanism. During the course of exchange in bond markets the U.S. Treasury or other Foreign Treasury may adjust the treasury yield which directly affects interest rates.

If the new rate is lower than the old rate, old Bonds will increase in value because they have better interest payments. For example, assuming an exact market adjustment to new interest rates, a 30 year Bond with a fixed rate of 4.5% valued at $1000.00 with 25, $45.00 interest payments remaining on Monday, will be valued at $1,164 on Tuesday because new rates are now 3.5%.

What to look for when purchasing bonds

As we have seen, bonds trade after they have been issued and the Treasury changes interest rates. This causes the price of the bonds to fluctuate. When actively traded in markets, prices can change further. Predicting these changes before they occur can mean the difference between predicting a price movement and not predicting a price movement. Some helpful indicators of potential price movement in bonds are as follows:

• Gross Domestic Product (GDP) Trends: If an economy is stumbling or slowing via slowing GDP, bonds may become more attractive to investors seeking more stable returns. This can cause an increase in the demand for bonds and consequently a rise in prices.

• Inflation Statistics: Inflation values such as the Core price index(CPI) and producer price index (PPI) can mean an impending drop in interest rates. If Bond rates decline, the value of old bonds rise.

• Liquidity Shifts: Big money moves and flows in and out of various markets. By tracking the flow of this money one can also track underlying demands and supply. These changes in supply and demand can affect bond prices.

Comparing bonds Vs stocks as an investment

A big difference between bonds and stocks as investments are that bonds are considered 'bear' investments and stocks are considered 'bullish'. In other words, when the stock market is being flailed and vulnerable to 10-20% swings, more cautious investors may head for the bond market in which returns may be more stable and/or fluctuate less. Some investment advisers believe it is sensible to diversify investments between the two markets via portfolio ratios such as 30:70, or 40:60. In turn, this can be an indicator of a particular firms stance on the market.

Bonds and stocks really are two different breeds of investment. Bonds, especially the Government kind, are less vulnerable to recessions and weak market conditions because their value is tied to their interest rates. The value of stocks however, is generally not coupled to interest rates per se, but rather share price via economic and market conditions. While a change in the Federal reserve funds rate may influence stock prices, these changes in valuation are correlation only and not an absolute relationship as with bonds.

Risks and rewards

There are risks and rewards associated with both bonds and stocks because of principles such as opportunity cost and market timing. Time value of money is also a factor in the pricing of investments because present values of an investment are determined in part by the future flow of income and/or capital gains via stock dividends, bond interest payments, as well as changing industry and/or market conditions.

As these things change, the foreseeable value of investments can rise or decline because of better investments such as higher yielding bonds, a giant new contract for a newly financially streamlined company, or an IPO in a high demand industry. Risks and rewards associated with stocks and bonds are listed below:

• Financial Stability: In the case of bonds, an investor can generally have more peace of mind because even if interest rates do rise causing the price of bonds to lower, the percentage fluctuation in price is likely to not be as great as can occur in the valuation of stocks.

• Earnings Potential: The earnings potential is most often higher in the stock market because stock prices are essentially unlimited in how much they can rise. For example, a stock price can rise as much as 50% over the course of a few months under certain circumstances whereas the chances of this type of percentage rise affecting a bond is significantly lower.

• Opportunity Cost: If one has bought a substantial position in Bonds, such as 80% of one's investment portfolio and a dramatic improvement in economic conditions emerge, the return on stocks could prove fantastic in comparison to bonds making the opportunity cost higher of holding the bonds higher.

• Leveraging: When one has investments in Bonds one may be able to take out loans against those Bonds and in effect leverage a new position into another financial instrument. In other words, a financial institution or private lender may view paper or Government bonds held outside of an exchange as good collateral for a loan which can be used to make further investments. With stocks, such leveraging may not be as likely due to their potential volatility and nature of exchange.

• Timing: Since the primary risks involving bonds is that interest rates on bonds may rise after bonds have been purchased and vice versa, how an investor uses time in each market becomes a potential risk or reward. That is to say, if an investor does not time investments well by entering too early, or exiting too late, that investor faces timing related risks and rewards. 

In the former case, if one buys bonds with an interest rate of 3.5% fixed returns and the rate changes to 4% the value of the 3.5% bond becomes lower, the investor has in essence been affected by timing risk. The same holds true for stocks. For example, if an investor takes a position in a company that is very financially strong, if the timing is wrong, the investor may still lose. This is especially true in companies that benefit from seasonal and cyclical trends.

Deciding what to invest in:

Making the decision to invest in stocks and bonds does not have to be daunting. It is for all intents and purposes impossible to predict all financial conditions, price movements and economic conditions. While forecasting, technical analysis and fundamental analysis of financial information can assist with predicting investment outcomes, eventually an investor either decides to invest, not invest or think some more.

When choosing stocks and/or bonds one may consider the above information in determining how much of each investment would be prudent given current financial trends and data. Conditions in the stock market can affect conditions in the bond market and vice versa. Bonds often serve as a hedge against stocks, and stocks assist in capitalizing on market conditions. By investing in both, one can potentially benefit from the best of both financial markets.