WHEN your friends discuss stocks and bonds, do you stay silent because you have nothing to contribute?
On meeting new investors, I often ask: “Have you heard of stocks and bonds?” They always answer: “Yes!”
When I follow up with: “Do you know the difference between stocks and bonds?”, about 80 per cent of the time they will say: “Not really!”
I then explain that stocks are about ownership while bonds are about “loanership”.
When we buy a stock or a collection of stocks through an equity fund, we gain direct partial ownership of one company through its stocks or indirect partial ownership of many companies through our equity fund.
When we buy a bond directly, which can be expensive for retail investors, or when we buy into a bond fund, we are effectively lending our money to the bond issuer, in the case of a single bond purchase, or to the many different bond issuers represented within a diversified bond fund.
When stock or equity markets are lumped with bond or fixed income markets, we have the capital market, which has two mirror image functions:
1. To raise money. Specifically, the capital market allows companies to raise funds by selling shares in themselves (their stock) or by issuing debt paper as IOU instruments (their bonds). It also allows governments to issue sovereign bonds to raise money, usually for development or debt refinancing.
2. To provide a platform for investors to buy and sell those securities — meaning stocks and bonds — within a liquid marketplace.
The capital market can be profitable but we should learn to save cash first before we invest in stocks and bonds.
Someone who has never ridden the investment rollercoaster can become shell-shocked and paralysed by fear the first few times risky investment portfolios values nosedive in imploding markets.
Seasoned investors know that if investments are well-chosen to begin with, those inevitable drops in value will usually be followed by price recoveries. Still, to better handle the stress of portfolio contractions, having sufficient cash reserves can provide financial strength and emotional stability.
Once sufficient cash is saved, though, venturing away from the safe shores of savings into the deeper, wilder waters of investments can be rewarding.
Nonetheless, you know from watching toddlers that we should walk before we run! That’s where relatively safe bonds or fixed income investments shine.
While they are “relatively” safe, you must remember bonds and bond funds are investment instruments and not savings storehouses. They fluctuate in value because of specific bond issuer (company or government) default risk and because of interest rate movements (bond prices fall when interest rates rise and rise when interest rates fall).
However, over the medium and long-term, bonds are safer than equities and other “risk-on” investment asset classes like investment real estate and alternative investments (alts) such as derivatives, structured products, forex and — my favourite alts sector — commodities.
By safer, I mean bonds are less volatile. But that also means they usually generate lower returns than risk-on investments. Still, since bonds are riskier (more volatile) than cash, they yield higher annualised returns, particularly if you keep your bonds for two to three years.
If you were to buy a bond directly — which is beyond the ability of most normal retail investors because minimum purchase sizes are often RM250,000, RM1 million or RM5 million — your return would be the coupon payment.
If a bond has a so-called face value of RM100, a coupon rate of 4.5 per cent and if it pays its coupon semi-annually, then for every RM100 in bonds you own, you’ll receive RM2.25 every six months or RM4.50 every year. To compound your bond growth, reinvest your coupons into more bonds.
In my opinion, a better, lower risk way to enjoy bond or fixed income exposure is through a bond fund. My clients and I use bond funds for our fixed income asset class exposure within our portfolios.
Since a unit trust structure is utilised, the returns you generate from a bond fund come in two forms: per unit price appreciation and per unit distributions.
Many people incorrectly refer to those distributions as dividends. They aren’t! (I’ll explain what dividends are next week.)
Part of the total return you gain from a bond fund will stem from the bond fund manager’s ability to sometimes lock in capital gains through opportunistic trades and accrue growth from the multiple streams of coupon payments stemming from the numerous bond issues held within your fund.
So unless you’re retired and must spend your bond fund’s distributions, you should reinvest your bond fund distributions so that you can benefit from a growing number of bond fund units.
Since bond funds grant retail investors like us ready access to professional management and instantaneous bond diversification for entry prices as low as RM1,000, I use them extensively in my clients’ and in my own wealth-building exercises.
Perhaps you too should consider doing the same for yourself.
© 2016 Rajen Devadason
Read his free articles at
www.FreeCoolArticles.com. Connect on rajen@rajendevadason.com, www.linkedin.com/in/rajendevadason and Twitter @RajenDevadason