An Asset with a Fixed Income
Companies and governments issue bonds as a way to borrow money. Because they are loans, if you buy a bond, you are entitled to receive regular interest payments. At maturity, the organisation that issued the bond will repay the loan. So if you spent €100 on the bond when it was issued, you will get €100 back.
The largest potential pitfall is the risk that the issuer will default. In general, this risk is low, and lowest of all with Government bonds. However, the risk is higher with bonds as there is a greater chance that the company will default and be unable to repay the loan.
The value of Government bonds and corporate bonds will vary during their lifetime. If you sell them you might get back less than you initially invested.
The Relationship to Equities
Equities (stocks & shares) are less predictable than bonds, but over the long term, stocks and shares offer a larger potential for growth. But bonds still play an important role in many portfolios because: the interest payments can offer a source of income bonds can help with portfolio diversification, as bond prices are not affected by the same factors as stock prices they offer risk-averse investors a safer choice.
You can buy bonds directly from the market, where they are traded like shares. If you want to hold particular gilts or purchase bonds issued by a specific company, direct holding lets you buy exactly what you want. The market price of bonds and gilts can fall as well as rise. Depending on the buy and sell price, you may get back less than the initial investment.
If you want to hold a wide range of bonds, a bond fund or ETF gives you the advantages of pooled investing. With one purchase, you gain exposure to a range of bonds that fit into a particular risk profile or interest rate.
Rating agencies grade bonds on a letter scale that indicates credit worthiness and risk. In simplest terms, the lower the letter scale, the lower the quality and the higher risk potential:
AAA or triple A rating — indicates the highest-quality bonds that offer the highest protection for principal and interest payments;
A or single A rating — indicates good to medium-grade bonds;
BBB or triple B rating — indicates medium-grade quality bonds, with adequate protection;
Below triple B is considered speculative, high-risk securities and the category is referred to as junk bonds.
Most bonds carry a rating provided by one of the three independent rating agencies: Standard & Poor’s, Moody’s, and Fitch. From U.S. Treasuries to international corporations, these agencies conduct a thorough financial analysis of the entity that is issuing the bond. Based on each rating agency’s individually set criteria, analysts determine the entity’s ability to pay their bills and remain liquid and assign a credit rating to the bond. The bond rating is an important process because the rating alerts investors to the quality and stability of the bond. That is, the rating greatly influences interest rates, investment appetite, and bond pricing. Furthermore, the independent rating agencies issue ratings based on future expectations and outlook.
Understanding Stocks and Shares
When you buy shares in a company, you actually own a small piece of that company and the value of your investment will fluctuate in line with the share price. The company may pay dividends – which are made to shareholders out of the company’s profits.
It is reckoned shares are fully priced within four seconds of any news relating to the market in general, or the individual equity. Equity exposure is dangerous as the market is closed for two thirds of the day, meaning proper risk management needs to be applied. Predicting the future movement in equity prices is a “crystal ball exercise” since nobody can predict the future.
Risk and Rewards
The gift of the market to investors and traders is risk reward. Shares are considered riskier than cash and bonds, but the potential returns can be higher. Bear in mind that the value of shares can fall as well as rise and you could lose your original investment.
Spreading your investment across different companies, industries and even countries can also help to offset some of the risks associated with only holding shares in one company. Spreading the risk like this is known as diversification.
Manged vs. Passive Funds
A managed fund has its investments chosen by a fund manager. Fund managers use their judgment (and a lot of research) to select the investments that best match the objectives of the fund – and as long as those are of a type that the fund’s rules allow them to invest in, they have a degree of freedom in their choices.
A passive fund, on the other hand, selects its investments entirely automatically, based on predetermined rules. Most passive funds are index trackers, which don’t aim to maximise returns but simply to mirror the performance of their underlying index, such as the FTSE 100 or S&P 500. If the market falls by 30%, a good index tracker will do the same.
Make sure you read the policy document of the fund and know what management charge is being levied.
Funds are a pooled investment – they issue shares to a large number of investors and fund managers use that money to buy shares, bonds and other assets. These are also classified as low, medium and high risk.
There are many types of funds – they may focus on:
Generating income – by investing in companies paying high dividends.
High capital growth – from identifying smaller companies likely to succeed in the future a particular industry or region.
Think of what you hope to achieve with your investment. Calculate what percentage of your wealth you are investing. Make sure you do understand the choices you make.
The key advantages of a fund include:
Diversification – Funds hold a variety of assets, protecting you against major losses should a single investment lose value
Expert opinion – Fund managers are constantly analysing the market and making decisions on behalf of their investors, saving you the trouble of researching assets on your own
Greater reach – Funds give you access to assets that may be hard to invest in on your own, including overseas investments and specialist products like commodities.
The drawbacks include: The value can go down as well as up and you can lose money.
These are medium to long term investments, so may not be suitable for everyone.