Article 1: The case for minimizing risk in your bond holdings by William Bernstein
There is always a trade-off between risk and return. Investors are rational and risk-averse hence, they require additional returns when the risk involved in any investment is high. In this article, William Bernstein explains how investors can reduce the risk in their investments in bonds without necessarily interfering with the expected returns on the bonds. One of the risks affecting bondholders is the interest risk. Changes in interest rates affect the return on bonds. When interest rates rise, bondholders lose since the prices of bonds fall. This is because the bond will be paying a lower coupon interest compared to other market securities. When the Federal Reserve had its policy meeting in September 2015, it did not raise the interest rates which would have resulted in losses for bondholders (Bernstein).
Bernstein argues that investors have misplaced obsession with the Fed and concentrate on the interest rate risk alone. He points out that investors ignore an important risk in bonds, the default risk. Default risk is the risk of loss resulting from the inability of the bond issuer to honor its obligations. In the long-term, markets reward investors that take credit risk. However, the return is not as big as investors think. From 1926 to 2015, the average return on long-term corporate bonds was 6.00% while that on US government bonds was 5.62%. The margin is thin and is not commensurate with the short-term losses associated with corporate bonds. Investors face default risk in corporate bonds as was seen during the financial crisis of 2008/209 (Bernstein). Investors of long-term corporate bonds lost 15.8% in the first ten months of 2008. During the same period, investors in long-term government bonds gained 0.3%.
He explains that the 2008/2009 financial crisis showed that the financial risk is not just about the probability of sustaining losses but also the possibility that the losses arise when investors and issuers of securities least expect them to occur (Bernstein). He argues that in a portfolio, bonds should provide safety and that the risk should be for the equity securities. His advice on reducing bond risk is that investors should avoid credit risk in fixed-income portfolios. He also advises investors to avoid bond funds and limit their fixed-income portfolios to government bonds. About mitigating interest risk, Bernstein advises investors to select a range of securities with staggered maturities. For instance, an investor can take securities with three, four and five year’s maturity. As the securities mature, the investors can reinvest the proceeds (Bernstein). This mitigates the impact of interest rate risk. Therefore, it is possible for investors to reduce the risk in bonds without necessarily reducing the return on their portfolios.
Article 2: The High Consequences of Interest rates by Joe Light
Interest rate levels affect several macroeconomic variables included return on investment, savings, consumption and inflation, among other variables. The worst affected are the investors of fixed-income securities such as bonds. At the start of the year 2016, the Federal Reserve increased its benchmark rate from near zero for the first time since the financial crisis (Light). Light describes that a month after the Fed raised its benchmark rate, rates across all markets are falling, and investors are bracing themselves to a fact that the era of low interest rates is set to continue for a while. In the second week of February, there was a 1.7% fall in the yield on ten-year US Treasury note (Light). This fall was significant since the yield is a benchmark for corporate lending, mortgage rates, and all other rates in the financial markets.
Article 3: Understanding the time value of money by Kurt Heisinger
In understanding the time value of money, it obvious that a dollar that is received today will be worth more than a dollar received in the future. That is the dollar that is received currently and invested immediately will start earning interests than the dollar received and invested some time in the future. Therefore, time value of money implies that one cannot make a comparison on the amounts from two different periods without the adjustments for the difference values. Consequently, when one wants to grasp firmly on the personal finance, it is essential to understand the time value of money.
According to this article, the time value of money is powerful. For instance, if one is to invest $ 1,000 at an interest rate of 8 % for more than four hundred years, the investor will get about $ 23 quadrillion (Heisinger). Therefore, the time value of money is powerful because it is widespread. In comparing the money from different periods, for example, when purchasing a bond today and start receiving interests in the future, then borrowing cash to purchase a house today and making payment in the next thirty years will enable one to determine how much to save every year to achieve such goals. That is there is little in finance that does not have some thread of the time value of money woven through it.
Importance of interest rate
It is not just time that makes invested money to grow, but it is also more about interest rates. According to most investors, the higher the interest rate, the more earnings will be received. This is why some investors are willing to buy risky bonds that pay more interests than the safe bonds that are issued by the government that pay low interest rates. However, some people do not understand the difference that the interest rate is making.
Without the understanding of the concepts of investments such as the time value of money, then the main target of such an investor is poor advice. Similarly, such investors will also be on the disadvantage part because they might not be able to take the advantage of good investment deals and even the understanding the basic principles of finance especially those that apply to the interest rates.
Conclusion
Every decision in finance involves the compounding techniques and time value of money. That is putting cash aside at the present to achieve some future goals. That is the basis of the time value of money is the concept of the compound interest, and the interest paid on the interests. Therefore, with the time value of money, one can determine the growth in investment over time particularly by the application of the following formula:
FVn PV (1+i) n
It is also important to understand the part of interest rate while determining the growth of investment. Both time and the interest rate will determine how much an investor will need to save to achieve investment goals. Therefore, the rule of 72 (72/yearly compound growth rate) may be applicable while determining the time it will take to double the invested cash.
Works cited
Bernstein, William. "The Case for Minimizing Risk in Your Bond Holdings". WSJ. N.p.,
Light, Dan. "The High Consequences of Low Interest Rates". WSJ. N.p., 2016. Web. 7 May
2016.
Heisinger, Kurt. "Essentials of Managerial Accounting". Understanding the time value of money Chapter 3, Wall Street Journal (2009): n. pag. Print.
2016. Web. 7 May 2016.
