by Neil Jesani
Following the 10 year US treasury rate by the year:
Year
Rate
01/01/1871
5.32%
01/01/1901
3.10%
01/01/1925
3.86%
01/01/1951
2.57%
01/01/1961
3.84%
01/01/1971
6.24%
01/01/1981
12.57%
01/01/1991
8.09%
01/01/2001
5.16%
01/01/2011
3.39%
01/01/2015
1.88%
Municipal Bonds
This is a bond issued by a local government or territory, or their agencies. The United States has the largest market of such securities in the world. Issuers of municipal bonds can be states, cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) at or below the state level.
Many countries in the world also issue municipal bonds, sometimes called local authority bonds. The main characteristic of this type of bond is that a lower level of government than the national government issues the bond. The U.S. municipal bond market is unique for its size, liquidity, legal and tax structure, and bankruptcy protection afforded by the U.S. Constitution.
In America, interest income received by holders of these bonds does not have to be reported for federal income tax purposes under Section 103 of the Internal Revenue Code. It may also be exempt from state income tax depending on the applicable state income tax laws and the type of municipal bonds. Usually, the market factors in the tax advantages of municipal bonds, and the return will be lower than comparable taxable bonds.
An investor is free to trade many municipal bonds once they are purchased. Professional traders regularly trade and re-trade the same bonds several times a week. Smaller retail investors purchase a large proportion of municipal bonds as compared to other sectors of the U.S. securities markets.
Municipal securities consist of both short-term issues, often called notes since they typically mature in one year or less, and long-term issues. These get the designation of “bonds” since they mature in a year or more. The short-term notes are issued for a variety of reasons. It enables a government to get money now in anticipation of future revenues such as taxes, state or federal aid payments, and future bond issuances. They can cover cash flow issues, meet sudden deficits, and raise immediate capital for projects until long-term financing is finalized.
Bonds usually finance capital infrastructure projects needed over the long term. These projects vary greatly, but can include schools, streets and highways, bridges, hospitals, public housing, sewer, water systems, power utilities, and various public projects.
There are two types of municipal bonds. The general obligation bonds are secured by the full faith and credit of the issuer and usually supported by either the issuer’s unlimited or limited taxing power. In many cases, voters have to approve general obligation bonds. Revenue bonds are backed by revenues from tolls, charges, or rents earned by the facility built with the proceeds of the bond issued. Public projects financed by revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities, hospitals, and subsidized housing. Special authorities created for that particular purpose issue many of these bonds.
Most municipal notes and bonds are issued in minimum denominations of $5,000 or multiples of $5,000. Interest is either a fixed or a variable rate subjected to a cap known as the maximum legal limit. The issuer of a municipal bond receives a cash purchase price at the time of issuance in exchange for a promise to repay the purchasing investors or bondholders (if the purchaser sold the bond) over time. Repayment periods can be as short as a few months (although this is very rare) to 20, 30, or 40 years.
Corporate Bonds
Corporations issue corporate bonds in order to raise capital for a variety of reasons. It can be for ongoing operations or to expand business. The term “bond” usually applies to securities with maturity of at least one year. Corporate debt instruments with maturity shorter than a year are known as commercial paper.
There are two types of corporate bonds. There are High Grade (also called Investment Grade) and High Yield (known as Non-Investment Grade, Speculative Grade, or Junk Bonds). The bond’s credit rating determines their classification. Bonds rated AAA, AA, A, and BBB are High Grade, while bonds rated BB and below are High Yield. There are significant distinctions as different types of investors purchase both type of bonds. For example, many pension funds and insurance companies are prohibited from holding more than a token amount of High Yield bonds (by internal rules or government regulation.) The distinction between High Grade and High Yield is also common to most corporate bond markets.
The interest earned (coupon value) on corporate bonds is usually taxable income for the investor. It is tax deductible for the corporation paying it. Sometimes the coupon can be zero. When this happens, the zero-coupon bond is sold at a discount. For example, let’s look at a $1000 face value bond sold for $800. The investor pays $800, but collects $1000 at maturity.
Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. These are called callable bonds. Other bonds, known as convertible bonds, allow investors to convert the bond into equity, such as a common or preferred stock. They can also be secured or unsecured, senior or subordinated, and issued out of different parts of the company’s capital structure. As you can see, there are many facets to corporate bonds.
Deferred Fixed Annuity - Like a Government Bond
Deferred annuities are classified by the method the insurance company uses to determine how interest is credited to the annuity contract. A fixed annuity is the simplest of deferred annuity, and generally offers the annuity owner a guaranteed interest rate for a certain period of time. Once the initial period ends, a new interest rate is established. The fact that fixed annuities have guaranteed principal and interest make them much like the government bond or a Certificates of Deposit (CD) that banks sell. Usually, a fixed annuity pays higher return than comparable government bonds and CDs with tax-deferred growth of the interest.
Bonds vs Stocks
While bonds and stocks are both securities, the main difference between the two is that a stockholder has an ownership stake in a company, whereas bondholders have a creditor stake in the company (in other words, they are lenders.) Being a creditor, bondholders have priority over stockholders. This means they will be repaid in advance of the stockholders, but will rank behind secured creditors if the company files for bankruptcy. Bonds also have a defined maturity term when they have to be redeemed, while stocks can usually be owned indefinitely.
Institutions such as central banks, sovereign wealth funds, pension funds, insurance companies, hedge funds, and banks buy and trade corporate bonds. Insurance companies and pension funds have liabilities that include fixed amounts payable on predetermined dates. They buy bonds to match their liabilities, as their policies, and sometimes the law dictates what they are allowed to purchase. Individuals who want to own bonds do so through bond funds. In the United States, households still hold nearly 10% of all outstanding bonds.
The volatility of bonds is lower than that of stocks. For this reason, bonds are considered a safer investment than stocks. Bonds are not subject to the day-to-day volatility of stocks. Their interest payments are sometimes higher than the general level of dividend payments of equities. Bonds are often liquid and it is easy for an institution to sell a large quantity of them without having too much effect on the price. That is not true of the equities market where buying and selling has a direct consequence on its price. For many investors, the general certainty of a fixed interest payment twice a year, and a fixed lump sum at maturity is attractive.
Corporate bonds are not
completely risk-free. Fixed-rate bonds are subject to interest rate risk. This means that a bond’s market price will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting an investor’s ability to get a higher interest rate on their money elsewhere.
Bonds are also subject to various other risks, such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk. These are all terms to become familiar with if you are going to invest heavily in the bond market. Some of these will only affect certain classes of investors.
Mutual funds that hold corporate bonds are affected by the price changes in bonds. If the value of the bonds in their trading portfolio falls, the value of the portfolio also falls. This can hurt professional investors such as banks, insurance companies, pension funds and asset managers.
Bond prices can change if the credit rating of the issuer is upgraded or downgraded. An unanticipated downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond’s interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds and holders of individual bonds who may have to sell them.
A company’s bondholders could lose some or all of their money if the company goes bankrupt. As already discussed, the laws of many countries (including the United States) allow bondholders to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders, and trade creditors may take precedence. There is no guarantee of how much money will remain to repay bondholders.
As an example, WorldCom, a giant telecommunications company, went bankrupt in 2004. The company’s bondholders received 35.7 cents on the dollar. This was certainly not close to the entire value, but it was more than the stockholders received.
Summary
Bonds are an investment that have more stability than stocks. As a “fixed-income” security, the rate of return is fixed, and there are no mysteries about what an investor will receive by purchasing bonds. However, as this chapter briefly showed, there are still many variables to take into account when investing in bonds or bond funds.
With bonds, as with all investments, do your homework well on the subject and do not be afraid to seek advice and help from an expert. You need to have the best information possible when deciding if you want to invest in government, municipal, or corporate bonds – or some combination of all three. The broad view of bonds is that they are a good investment and should be part of your portfolio in some fashion. Each investor is different in deciding which ones will work best for them.
CHAPTER 8
The Complex World of Commodities
“Commodities tend to zig when the equity markets zag.”
Jim Rogers
C
ommodity is a term used for an economic good or service that is interchangeable with other commodities of the same type. This means that the quality of a given commodity may differ slightly, but it is essentially uniform across producers. Commodities are the raw resources that go into other products. Examples include wheat, iron, pork, gold, oil and oranges. If you saw the comedy classic movie “Trading Places” with Eddie Murphy, you understand a little bit about the dynamics of the commodities world.
The demand and price for a commodity is very close to being the same across all markets. That is because oil is oil, no matter where the well is. While there are different grades of oil, the same grades are almost identical wherever they come out of the ground. This differs from something manufactured, like a laptop. A product like this differs from one company to another and has so many different design possibilities that they all vary in price. The demand for one type of laptop may be greater than another.
A commodity good has its price determined as a function of its market as a whole. Well-established physical commodities have actively traded markets. As a rule of thumb, soft commodities are agricultural goods such as wheat, coffee, cocoa and sugar. Hard commodities are extracted through mining like copper and silver. In addition, there are also energy commodities, which include electricity, gas, coal and oil. Electricity is a little different from the others since it has the characteristic that it is usually not economical to store, so it is consumed as soon as it is produced.
You can invest in commodities just as you do stocks and bonds. Like those other investments, commodities have their own markets. Investors access about 50 major commodity markets worldwide. Futures contracts are the oldest way of investing in commodities. You are purchasing a certain item like lemons or iron at a certain price. It depends on the market for that item on whether the price goes up or down.
Commodities are the oldest form of marketing in civilization. Historians believe that commodity-based money and commodity markets originated in Sumer between 4500 BC and 4000 BC. Sumerians first used clay tokens sealed in a clay vessel, then clay writing tablets to represent the amount for example, the number of sheep to be delivered. These promises of time and date of delivery resemble futures contracts. Early civilizations used pigs, rare seashells, or other items as commodity money. Since that time, traders have sought ways to simplify and standardize trade contracts.
Two early commodities that still demand attention today are gold and silver. In the beginning, people valued them for their beauty and intrinsic worth and their association with royalty. Soon early civilizations used them for the trading and exchanging of goods or as payment for labor. Specific measurements of gold and silver became money. The scarcity, unique density, and the way they could be easily melted, shaped, and measured made gold and silver natural trading assets.
The first stock exchange was actually a commodities market. The Amsterdam Stock Exchange, founded in 1602, began as a market for the exchange of commodities. Early trading on the Amsterdam Stock Exchange often involved the use of very sophisticated contracts, including short sales, forward contracts, and options. In 1864, the Chicago Board of Trade (CBOT) became the main marketplace for selling wheat, corn, cattle, and pigs in the United States. It has since taken on other commodities like rice, mill feeds, butter, eggs, Irish potatoes and soybeans.
Successful commodities markets require broad consensus on product variations to make each commodity acceptable for trading, such as the purity of gold in bullion. This allows someone in the United States to know that the gold bought from Germany, for example, is the expected quality being sold. In its basic form, when you buy a commodity, it is something that you can reach out and touch if you so desire.
Like stocks and bonds, commodities can also be part of a fund. You can buy a share of a fund, and its performance depends on how the commodities within the fund perform. Like every investment we have talked about, doing your homework or picking the brain of an expert in commodities is necessary to put yourself in the best position to have a successful investment.
To further get an idea of how commodities work, let’s look at three commodities that receive a lot of publicity and are actively traded on the market.
Gold
Of all the precious metals in which to invest, gold is the most popular. Investors generally buy gold as a way of diversifying risk. Like any other market, gold is subject to speculation and volatility. Historically, gold has been an effective safe haven as an investment and a way to hedge against the failure of other investments.
Supply and demand drive the price for gold, as well as the demand created by speculation. Unlike most commodities, the act of saving gold plays a larger role in affecting its price than its consumption. Most of the gold ever mined still exists in accessible form. It tends to be in the form of bullion or jewelry, and thus has the potential to come back onto the gold market for the right price. T
here is a huge amount of gold stored and recycled above ground compared to annual mining of the commodity. The price of gold is mainly affected by changes in demand rather than changes in annual production. According to the World Gold Council, annual mine production of gold over the last few years has been close to 2,500 tons. About 2,000 tons goes into jewelry or industrial/dental production, and around 500 tons goes to retail investors and into traded gold funds.
The traditional way of investing in gold is buying gold bullion bars. In some countries, like Canada, Austria and Switzerland, you can easily buy or sell these at major banks. Alternatively, there are bullion dealers that provide the same service. Bars are available in various sizes and generally carry lower price premiums than gold bullion coins. However, larger bars carry an increased risk of forgery due to their less stringent appearance requirements. Efforts to combat gold bar counterfeiting include kinebars, which employ a unique holographic technology.
Gold coins are another common way of owning gold. Bullion coins are priced according to their weight, plus a small premium based on supply and demand. The price of gold coins that were used as money is dictated by supply and demand based on rarity and condition.
If you do not want to worry about physically handling and storing actual gold bars or coins, gold certificates allow gold investors to avoid the transfer and storage of physical gold. There are other risks and costs associated with certificates such as commissions, storage fees, and various types of credit risk.
The first paper banknotes were gold certificates. They were first issued in the 17th century when goldsmiths in England and the Netherlands used them for customers who kept deposits of gold bullion in their vaults. Two hundred years later, the United States issued gold certificates that could be exchanged for gold. The US government first authorized the use of the gold certificates in 1863. On April 5, 1933, the US Government restricted private gold ownership in the United States and therefore, the gold certificates stopped circulating as money (this restriction was reversed on January 1, 1975.) Nowadays, gold certificates are still issued by gold pool programs in Australia and the United States, as well as by banks in Germany, Switzerland and Vietnam.
