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Tips from Pace University’s Lubin School of Business
Worries plague “new” investors. Recently flush with cash from their investments and the long-running bull market, young inexperienced stock market players are besieged with anxieties about the inevitable market crash, the Asian crisis, and the loss of their gains. In order to sleep at night, more and more investors are choosing to invest their money in bonds to circumvent fears of “hitting bottom” in the stock market. When making the decision to invest in stocks or bonds, consider the following information from Professor P.V. Viswanath, Pace University’s Lubin School of Business:
I understand what a stock is, but what is a bond? Are there different types besides the Treasury bond?
- Bonds are securities that represent loans made either to the US Government (Treasury bonds or T-bonds), local or state governments (municipal bonds) or to corporations (corporate bonds). T-bonds are free of default risk, i.e., it is almost certain that the principal lent to the US Government will be repaid, and that the interest payments (coupons) will be made on time. However, if the bonds are not held until maturity, their value can go up or down as interest rates fluctuate. Corporate bonds do have default risk, but the amount of risk depends very much on the characteristics of the issuers.
- If you are investing for just a few years, do you invest in stocks or bonds?
If you are investing for just a few years, bonds provide much more safety. In addition, it is possible to choose bonds of the appropriate maturity, so that interest rate risk is minimized. If you want to minimize down-side risk, then you should invest much more in bonds than in stocks.
3) I am in my thirties, do I invest in stocks or bonds? Why?
The average return on bonds, particularly T-bonds is very low, compared to that on US equities. Long-term T-bonds have yielded an average of 5.35% from 1926 to 1993, while the average return on the Standard and Poor’s Composite Index over the same period was 12.31%. Inflation over the same period was 3.23% on average. This means that long-term bonds barely provided a 2% return over inflation, while equities provided about 9% over inflation. Although the year to year variation in returns is much higher for bonds than for stocks, the variation in returns over 20-year periods is actually smaller for stocks than for bonds. Hence, anybody investing for the long-run should probably invest a sizeable portion of their wealth in stocks, provided that the portfolio is well diversified.
- Are bonds subject to the same market fluctuations as stocks? Stocks are subject to two kinds of market fluctuations: one, fluctuations in earnings, and two, fluctuations in interest rates, i.e. fluctuations in the value of money. Bonds, on the other hand (at least, T-bonds), are subject only to fluctuations in interest rates. However, there are empirical relationships between the level of business activity and interest rates, which vary over the business cycle. Hence, T-bonds will also be indirectly affected by fluctuations in corporate earnings, through their effect on interest rates.
- What are “emerging-market bonds”? Emerging Market bonds are bonds issued by governments in countries that do not have fully industrialized and developed economies, or economies that are somewhat more risky. These countries frequently have high substantial political, as well as exchange rate risk. Due to the adventurous nature of these securities, returns can sometimes be handsome, making them attractive to investors willing to tolerate risk. However, the downside danger can be substantial. Examples are bonds issued by the governments of Mexico, Russia, Brazil, China, Hong Kong and India.
- What are some “tips” you can give to first time investors in bonds? Investing in T-bonds is pretty easy, since these bonds mainly differ by maturity. Investing in corporate bonds is much more difficult, since it is necessary to look at the financial statements of the companies issuing the bonds, as well as specific characteristics of the bonds: are they callable, are they convertible, are they secured, are they senior or subordinated, etc. However, in either case, it is advisable to look for mutual funds with objectives and maturities that match your needs. If you are thinking of investing in tax-free bonds, compare their return with the after-tax return on regular taxable bonds. If you are in a high tax bracket, they may be worthwhile for you.
- Who should consider investing in bonds? Bonds should form a part of almost everybody’s portfolio. However, two categories of investors would be particularly interested in bonds: those who don’t like risk, and those who are investing for a specific point in time in the not-too-distant future and cannot bear downside risk (e.g. somebody saving to buy a house in two years).
- What are some websites that provide background information on bonds?
A simple introduction to bond pricing can be found at http://library.pace.edu/~viswanat/class/301/notes/bonds.html
Information on Bond Portfolio Management can be found at http://library.pace.edu/~viswanat/class/652/notes/fixportf.html
Other sources are: