Assignment 1
Dedicated Fixed-income portfolios
1. What are the fixed income investments we should consider? Why?
A. Cash
Among all assets cash is the most liquid, that is, there would be no required intermediary to convert the cash, as it is considered legal tender. Moreover, cash is easily accessible and disposable. However, cash has its downside. Too much cash or that is saving too much is costly. There exists an opportunity cost. With current low level interest rates, cash that is kept at the bank will depreciate in value due to inflation. Inflation rates are higher than interest rates, thus the purchasing power of cash diminishes when kept in the vault or in the bank for some time.
B. CD
CDs or certificates of deposits are considered risk free. Although there exists no asset that is in the truest sense completely devoid of risk, CDs are not affected by unsystemic risk. The only risk it carries is the credit risk of the issuing bank . Usually, it is also insured by the bank that issues it. Another advantage of CDs is that these securities produce periodic interest income which is significantly higher than that of bank deposits. These are short term bank deposits which are required to remain untouched or that the depositor is prohibited from withdrawing it without penalty for a certain period of time. The only risk however is if the issuing bank becomes insolvent.
C. Treasury bills or bonds
Treasury bills and bonds are securities that pay out fixed coupon payments through a certain period of time, called the tenor of the bill. The interest rates on Tbills are higher than the bank deposits and CD’s, but may still well be below inflation. Jut like certificates of deposits, these are essentially risk free. Treasury bills are issued by sovereigns and are banked on the creditworthiness of the issuing country. Since the central banks of States are allowed to print money, Treasury bills carry very little risk of default. The only issue with Treasury bills however is that, when mark to market valuation is used, it is highly dependent on its sovereign issuer’s financial capability. For instance, when Greece ran fiscal deficits, its Treasury bills decreased in value. Moreover, when it became bankrupt, its treasury bills became worthless. Thus, investors of Greek Treasury bills had to write off their holdings, as no entity was willing to purchase it.
D. Municipal Bonds
Municipal bonds or munis are issued by cities and states the proceeds of which are used in local projects. The construction of schools, buildings and bridges for instance are taken from municipal bond sales. Although it is backed by the issuing governmental entity, it has a higher risk as compared to Tbills. Municipal bonds are rated depending on the financial standing of the issuing government corporation. These securities pay higher interest rates too versus sovereigns, to compensate for the higher risk.
E. Corporate Bonds
Among all types of bonds issued, corporate bonds carry the highest risk but also provide the highest returns. These securities are issued by companies which are usually publicly listed. The downside however is that, although their financials seem robust, the income to be paid on the corporate issued bonds will come from the cash generated by future projects. Essentially, in purchasing corporate bonds, the holder is optimistic that the issuing corporation would have positive cashflow in the near horizon.
G. Mutual Funds
Mutual funds are funds composed of different assets, the whole of which is professionally managed. Thus, a fund manager for instance would hold 1 billion worth of funds consisting of bonds, cash and stocks. However, it will sell the ownership of each unit of the fund to the public. A mutual fund subscriber would thus have a right to the proceeds of the fund multiplied by his share. This set up allows the investor to participate in assets which often require very high minimum denominations when bought individually. It also has a subscription fee paid to the fund manager. One downside of mutual funds though is that its performance is highly dependent on the talent of the fund manager in identifying the right asset allocation ratio.
G. Stocks
Among all the assets, stocks or equities have the highest risk reward ratio. Stocks allow an investor a portion to the proceeds of a company, depending on its growth and performance. Thus, since it essentially vests a portion of the company to the stockholder, it also puts the risk of the company’s insolvency on the same investor. When a firm records profits, all the other expenses have to be paid first, and the remaining would either be paid out as dividends or ploughed back into the company for growth projects. Meanwhile, the market, sensing that the company is indeed growing, it may valuate the stock higher, giving the holder means to profit, should he opt to sell in at market prices. However, during insolvency and bankruptcy, stockholders get nothing after all assets have been paid to creditors.
2. How would we invest our funds into long term CD’s? How would we fare in terms of returns and cash flows?
Current certificate of deposits return about 1.1% for 1 12 month term. This means that the investor would be required to put in his money in the bank for that particular period and he is unable to liquidate it for that time being. Although safe and reliable, CD’s are quite tied up investments, that is the holder should ensure that he has no immediate need for the cash, or that cash amount can indeed be put aside or locked in. Assuming that the couple would invest the whole of $300,000 into CD’s, they would be getting an increment of $3,300 on the first twelve months. Since CD’s can be rolled over, and without taking any interest income for example, they would be earning a total of $373,374.25 for the whole 20 year period.
3. What about immediate annuities? We understand there are lifetime annuities and specified period annuities. We are both 65 years old.
Immediate annuities are contracts which require one single lump-sum payment in the beginning. In exchange, the holder would be receiving a fixed amount of cash almost immediately after the purchase has been made. However, since the amount of the annuity income is fixed, there is no way to back out of the plan should the retiree need a higher amount. Also, should inflation rates accelerate, then the fixed income received would greatly diminish in terms of purchasing power. Also, immediate annuities are hinged on the assumption that the holder, although a retiree, still has a lot of years to live. Thus, should the retiree die immediately, the annuity is likewise immediately terminated, giving the heirs no recourse.
Specified period annuities meanwhile provide income to the retiree for a certain period of time. The term of the annuity is agreed upon in the contract. However, should the annuitant live longer, he would be unable to receive anymore income if the term has already elapsed. Thus, for retirees who expect or have no reason to doubt that they would still have a lot of birthdays to celebrate, this kind of annuity is not advisable.
Lifetime annuities meanwhile like immediate ones are paid as a single lump-sum. As with all annuities, these are tax deferred investments. For retirees who wish to receive a fixed cash flow throughout their living years, this instrument is advisable. Moreover, for the abovementioned couple, it is advised that they take the joint life annuity, as it would be able to provide for the both of them.
4. What about long term Treasury bonds? How would we fare in terms of returns and cash flows?
Long term treasury bonds are highly marketable securities, depending on the sovereign issuer. Assuming that the couple would purchase US Treasury bonds, then as compared to the other names, such is highly liquid. At any time the couple would like to liquidate their security to finance an immediate need, there exists ready buyers for this security.
There exists an assumption that US treasury bonds are basically risk free. It is partly true, but semantics aside, there is not such instrument that carries no risk. The risk of the Treasury bond is that, it is dependent on the creditworthiness of the United States, which in turn is dependent on the state of the economy. Yes, during upcycles, and positive times, Treasury bonds have high mark to market valuations. But, during recession, Treasury bond prices are also depressed. A bond may thus be discounted, meaning, it will sell less than its face value. An investor who holds a bond that he bought at $100 for example may be sold at $90 when the economy is expected to slide.
Moreover, long term Treasury bonds are subject to duration risk. The longer the tenor of the bond, the higher the duration risk. Thus, any changes in the interest rate would affect a longer term bond as compared to a bond with a shorter tenor.
Assuming that they would wholly invest the $300,000 in a bond that pays an interest of 3% semi-annually, then they would be able to obtain $544, 205.25 after 20 years. However, since they would need to have fixed income, they might not be able to reinvest the coupon payments of 3% or 1.5% semi-annually.
5. What about a single, corporate bond issue of the highest quality? How would we fare in terms of returns and cash flows? If we do this, we would like to see if we could have annual cash flows over $15,000 per year. Also could you please prepare the following three different scenarios?
A single corporate bond of the highest quality may pay more than a Treasury bond, but also carries with it lower liquidity. Since corporate bonds are issued by companies whose standing depend on their financial reports, at any time they would report negative returns or lower than expected income, the corporate bond would immediately be valued at a much lower price. Thus with corporate bonds, the mark to market valuation of the paper would fluctuate more. Moreover, for some corporate names, despite being issued by highly reputable companies, some buyers still purchase them at a much lower price due to lower expected future income.
Scenario 1
If they invest $300,000, and given the requirement of wealth preservation, the couple will be receiving a net interest of 5% yearly, equivalent to the needed $150,000 annually.
Scenario 2
If they choose to sell half of their bonds, then they would be selling $150,00 or $7500 yearly.
Scenario 3
Meanwhile, should they decide to sell all bonds, they should be selling $15,000 yearly to reach a total of $300,000 in 20 years.
6. How do each of these investments compare with investing in bond mutual funds? What bond funds would you recommend to us for long term investing?
Investing in mutual funds may offer better asset diversification for the couple. Since mutual bonds contain a mix of stocks, equities, bonds and cash, the risk per asset is different. Also, since it is professionally managed, the couple would have access to the services and acumen of an advisor. However, mutual funds carry with it risk, that is fund value is daily appraised depending on market valuations. Thus, mutual fund investments are good during economic upturns, for each day would bring higher valuations and possible selling opportunities for the couple. However, during unexpected downturns, the liquidity of mutual funds sharply decline. Should they need to encash the fund value, they would have to agree on a discount.
For long term investing however, one is advised to do bond funds which are highly concentrated on fixed income securities, particularly sovereigns. Assuming that the bond fund contains bonds from various countries, the risk of all the countries defaulting is very small.
References
Empowering Women Investors." How Do Annuities Work? Web. 03 Mar. 2016.
"Bond Fund Definition | Investopedia." Investopedia. 2003. Web. 03 Mar. 2016.
"Treasury Bill (T-Bill) Definition | Investopedia." Investopedia. 2003. Web. 03 Mar. 2016.
