Should you invest in long-term interest paying bonds?
Albert Einstein is reputed to have said that one of the greatest discoveries of all time is “compounding,” this is what allows investments to grow exponentially over time
If you are setting aside money today to fund a long-term (at least 10 years into the future) financial goal, a long-term bond may not be an ideal vehicle. Some issues worth considering are as follows.
A bond is a contract between a borrower (bond issuer) and a lender (the investor); as a contract, there are three key provisions that will not change over the life of the contract; the par value (or the initial amount invested at primary offering), the coupon (stated interest rate) and the maturity date.
Bonds are great cash flow vehicles as it pays out the coupon regularly, whether quarterly or on a semi-annual
basis as stipulated in the contract. As such, this would be an ideal vehicle for retirees or for people generally living off interest income. But for investors hoping to grow their money over time, this could be a bad choice.
Investments can be categorised into the lending type of investment and the owning type.
The lending type of investments are vehicles that pays a fixed regular interest and has fixed maturity dates, interest bearing instruments like deposits and bonds falls under this category and the main source of returns is the interest.
Owning types of investments are vehicles that do not have a regular interest payouts, the source of returns would be value appreciation. Common types of investments in the owning category are investments in real estate or common stocks.
Albert Einstein is reputed to have said that one of the greatest discoveries of all time is “compounding,” this is what allows investments to grow exponentially over time. The basic principle of compounding for the lending type of investments is that interest earned in a period that is left in the vehicle would now form part of the initial investment and would earn interest for the next period, allowing this to happen repeatedly over time would have a “growth effect” on the investment. Long-term bonds that pays out regular interest has “zero” growth potential, and if the effects of inflation are imputed, there would be a real loss, to illustrate:
The maturity value of a P100,000 investment in a 25-year, 6.25-percent bond is P100,000, at 3.0-percent average annual inflation, its adjusted value on the 25th year would be P46,697, a loss of 53 percent!
Credit risk—This is the possibility that the bond issuer may not be able to pay back the investment at maturity, the credit risk of the issuer may be spot free today, but given the long time period to maturity, it may change depending on evolving business and economic conditions.
Interest rate risk—the current low interest rate environment is beneficial to borrowers (bond issuers) to lock in funding cost at a very low level, it may not be beneficial to lenders (investors) over the long term, because when interest rates starts going up in the future, investors would be locked-in at the current low rates.
Another negative effect of a probable interest rate increase in the future is the valuation of the bonds. The contractual promise of the issuer to return 100 percent of the investment happens on maturity date (on the 25th year) not anytime before, investors that may need to “pre-terminate” would have to sell their bonds at market rates, and market rates is determined by prevailing interest rates, if rates are up the time an investor decides to sell, there is a very real possibility of capital loss, no matter who is the issuer. In a low interest rate environment, given the choice between a lending or owning type of investment to fund a long-term financial goal, an owning type may turn out to be a more appropriate choice.
Companies issuing bonds normally do so to expand their capacity or efficiency, borrowing at low interest may result in the reduction of their overall operating expenses, this in turn, may lead to higher profit margins, and for stock market investors looking at the profitability numbers of a company as the basis for stock selection, fresh buying may lead the stock price of these companies to higher levels.
****
Alijeffty Gonzales is a Registered Financial Planner of RFP Philippines. He is a sales and distribution development professional who has over twenty years of demonstrated competence in the identification, development and management of distribution channels for financial products and services.
Source: http://www.businessmirror.com.ph/index.php/en/business/banking-finance/31598-should-you-invest-in-long-term-interest-paying-bonds
Comments
5,348 total views, 1 views today
Social