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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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A smart money manager who concludes that the bad news about Ford is overblown will buy that bondThe Misunderstood and Underutilized Securities of the First Dominant Investment System We see very few investors with bond portfolios or bond mutual funds who are properly diversified over the broad spectrum of what our industry defines as fixed income securities. This is particularly unsettling because most bond investors tend to see themselves as conservative, or at least that part of their portfolio allocated to bonds will be thought to be subjected to less risk. Additionally, few 401(k) plans offer employees more than one or two bond funds. Either the vendor or the plan sponsor suffers, like most people, from a dangerous lack of knowledge about the diversity of the bond market. Listed next is a sampling of different fixed-income securities and their performance in 1997 and 1998peak stock market years and 2001, when the bear stock market had set in. The returns vary widely from year to year and across different sectors of the fixed-income markets. The variety of fixed income securities and their rates of return means opportunity for investors to decrease a portfolios risk while improving performance. At least a basic knowledge of some of the major classifications is necessary. U.S. Treasuries (several types are issued by the government) Bills: Usually called T-Bills; mature in 3 months to a year; sold at a discount (the interest accrues during the holding period to the bonds face value) Notes: Pay interest semiannually and are issued in two, five- and ten year maturities Bonds: 30-year maturities, issuance has been discontinued by the U.S. government TIPS: Stands for U.S. Treasury Inflation-Indexed Bonds; provide a hedge against inflation because their interest payments are periodically adjusted against the Consumer Price Index STRIPS: Stands for Separate Trading of Registered Interest and Prin cipal of Securities; like bills they are sold at a discount, and the interest accrues to the face value; many different maturities are available Agencies (issued by government sponsored enterprises [GSEs; examples are Fannie Mae and Freddie Mac] and fully owned U.S. government agencies) Sold in denominations of $1,000 to $100,000 Pay semiannual interest Wide variety of maturities Interest payment may be exempt from state and local taxes Discount notes are also available and work like bills or STRIPS Mortgages (sold from mortgages originated by financial institutions that pool and sell them to mortgage-backed security issuers) Sold in multiples of $1,000 Pass-throughs collect mortgage payments from homeowners and pass it on to bond holder Collateralized mortgage obligations (CMOs) attempt to provide a more predictable payment stream by grouping mortgages into tranches that will meet certain investment objectives Investors will have principle returned along with each interest pay ment instead of receiving it in a lump sum at maturity Corporates (issued by public and private companies; there are more corporate bonds than stocks listed on the New York Stock Exchange) Issued in multiples of $1,000 Pay semiannual interest Wide range of maturities Credit ratings are assigned by Moodys and Standard and Poor s (S&P) as an indication of an issuer s ability to make all interest payments and return the investors principle at maturity. Municipals (issued by states, cities, counties, and towns) General obligation bonds (GOs) are backed by the full taxing authority of the issuer Revenue bonds are backed by the income from the project being fi nanced Credit ratings are the same as for corporates Many municipalities have insured the interest payments of the bonds, getting them an immediate AAA/Aaa rating Municipal bonds are not taxed by the federal government; interest rates are considerably lower than for other types of bonds Convertibles (corporate bonds that can be converted into stock of the issuing company) Usually available in denominations of $1,000 Pay semiannual interest until converted into stock Conversion dates, conversion stock price, and number of common stock shares that investor will receive are predetermined by the issuer and set out in the prospectus Preferred Stock (issued by public corporations; name derives from the fact that in case of bankruptcy, the owners of these securities receive payment preference over common stock holders) Secondary to bond holders Issued at $25 per share Usually callable within 5 to 10 years of issuance Trade on New York Stock Exchange Rated similarly to corporate bonds All types of bonds are available to be purchased individually, through mutual funds, or individual, professionally managed accounts. The $4 trillion corporate bond market can be particularly intriguing. Good corporate bond managers do their own research and do not rely on Moodys or S&P. The market is far too big for these agencies to thoroughly research every corporate bond. Talented bond managers, just like stock managers, have their methods of knowing when a bond is a good value. If the analysis of the bond is accurate, the manager can generate handsome returns. We will use the example of a Ford Motor Company corporate to explain how this can work. Let us say that the bond was issued in 1997 to mature in 10 years. Its interest rate, sometimes called the coupon, is 7.00%. The bonds face value is $10,000. In our example, someone purchased that bond when it was issued in 1997 and paid $10,000, which they will get back if they hold the bond until maturity in 2007. Two things have happened. First, the person who bought the bond needs to sell it now, and second, some bad news on Fords financial condition causes the bond to slump in value from $10,000 to $9,400. A smart money manager who concludes that the bad news about Ford is overblown will buy that bond for $9,400. One year later the bad news on Ford is forgotten, and the bond is trading at $10,000 again. The manager received a 7% interest payment plus a growth in value from $9,400 to $10,000, a 6.38% increase. 7% plus 6.38% equals a one-year total return of 13.38%. The manager may sell the bond to lock in the profit. This example is simplistic. Millions of dollars of bonds would be bought and sold like this, not $10,000, but the principle is the same. Professional investors do not usually buy bonds to hold them until maturity. Similar opportunities exist in the municipal market as well when talented municipal bond managers do their own research. Here is an example of another way a professional can create value for his or her client. Let us say that the city of Chicago wants to issue a revenue bond to improve its water and sewer systems. The portfolio manager researches the revenue that the system creates as well as demographics and any circumstances that could prevent the city of Chicago from paying interest on the bonds. The portfolio manager concludes that the bonds are very low risk. The probability that interest and principle can be easily paid is very high. The city of Chicago was planning to issue the bonds to yield 3.75%. They had intended to pay an investment banking firm to help them underwrite and sell the bonds. They had intended to pay Moody and S&P to rate the bonds so that they would be more attractive in the marketplace. Both of these things cost a lot of money. Instead, the portfolio manager who had carefully researched the bond issue offered to buy all the bonds if he could get a tax-free interest rate of 4.25%. The city of Chicago agreed because they would have spent the difference between 3.75%, the interest rate they were originally going to pay, and the 4.25% on underwriter and rating agencies. The money managers got to add a highquality security to their clients portfolios at an above-average yield. This is just one example of why every investor needs to have a pipeline to the fixed-income markets through either a skilled fixed-income portfolio manager or an investment advisor with access to a research and trading desk. APPRECIATING THE POTENTIAL OF THE EMERGING MARKETS We hear people misunderstanding the term emerging markets. Some mutual funds are called emerging growth funds, which means that they invest in younger U.S. companies beginning to realize their moneymaking potential. This is not the same as an emerging market mutual fund or stock. The emerging markets represent the countries outside of the United States whose economies and businesses are not as entrenched as are those of the developed countries such as Japan, the United States, or many of the countries of Europe. Some of the countries that are categorized as emerging are: BermudaMalaysiaBrazilMexicoCayman IslandsPeruChilePolandChinaRussiaCzech RepublicSingaporeHong KongSouth AfricaHungarySouth KoreaIndiaTaiwanIndonesiaThailandIsraelTurkey Where we refer to businesses or economies of these countries as being less entrenched, more fluid, and entrepreneurial, others call them underdeveloped countries or third-world countries appellations that sound vaguely, if not blatantly, condescending. This negative spin uses the same backward logic that lumps a visionary company like Exult with fly-by-night.com. Just as Digital Dow2 companies do not have to battle internal bureaucracies or suffer the expenditure of cost and time related to destroying old infrastructures, the emerging economies of the world can more easily incorporate the new business strategies enabled by the tools of the digital age. Chinas productive economy has created an enormous need for office supplies. The country is dotted with plants manufacturing pencils, staples, staplers, and all the other sorts of equipment used to operate any office. What was needed was a way to connect all the manufacturers with wholesalers, retailers, and eventually the buying public. Asia.com was able to fill the gap by creating a comprehensive catalog of office supplies and facilitating the opening up of channels to get the products to a wider market. Stories like these are the stories of emerging markets. It is instructive to note that wireless technology has proliferated in Southeast Asia and Latin America. There are more cell phones in use in these countries than in the United States. These areas never had a network of lines and poles crisscrossing their continents to impede the spread of the new communication systems. Because profit follows productivity, it is instructive to look at the economic growth of emerging-market countries compared to the United States. Average Annual Percentage Increase in Gross Domestic Product, 1990-1999 It is important to view this growth during the global economic slowdown at the start of the twenty-first century. During this period, economic uncertainty was created by the World Trade Center attack and increasing tensions between Israel and the Arab nations. Percent Increase in Gross Domestic Product over Previous Year Period Ending April 2002 (from Economist, May 11, 2002) You can only imagine the resistance we faced from clients when, during the perceived soaring of growth stocks in late 1999 and during 2000, we advised that a small percentage of their portfolios be allocated to emerging markets stocks. By the end of 2000 the emerging markets index had fallen 30.61%. As global economies slowed in 2001, as turmoil set in over fears of terrorists and financial disasters, imagine the reaction of these same clients when we recommended increasing their allocations to emerging markets. The result is that as of June 12, 2002, the emerging markets were the best place to have had money amid the difficult period since December 31, 2001. Source: Lipper Analytical Services. The story reinforces two lessons from earlier chapters: (1) Successful investors must ignore preconceived notions from the old dominant investment system, and (2) investors must work with investment advisors who have access to the laboratories of finance we discussed in Chapter 3. It was from one of these laboratories that we received the information that led us to the decision to invest appropriate clients in the emerging markets. The ability for billions of dollars to be moved instantly from one market to another, without control or regulation, can create enormous volatility in the financial markets of emerging countries. It is appalling that this has not yet been corrected, but avoiding this asset class means missing out on important opportunities. The right financial advisor is your best source of information as to how much money should be allocated to this overlooked and underappreciated set of securities. |
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