Tuesday, December 14, 2010

Investment Lesson #2 - Debt Securities

In the first lesson I made it a point to emphasize that debt is bad -- in fact debt is slavery. Now I'm going to turn it all around and tell you that it's good to be on the other side of a debt. In other words, if you owe money, that's bad but if money is owed to you, that's good.

Of course it isn't that simple. There are situations where borrowing money makes sense. Businesses borrow money all the time, so do governments and banks. It would be very difficult to buy a home without taking out a mortgage. There are even situations where you can leverage your investments by using a form of borrowing called margin--but we'll get into that later.

My mom wanted to teach us about saving so she took us to the local savings and loan. I was earning interest on the money I had on deposit there because someone else was borrowing that money and paying interest on it. Basically, that's how banks work. I was aware that the bank was lending out my money at a higher interest rate than they were paying me, but it would have been very difficult for me to find who was borrowing my money so I could deal with them directly. In addition, all the depositors' money was pooled together so it was impossible to determine who's money was going to which borrower.

What would happen, I thought, if a majority of the depositors decided to withdraw their money at the same time? That actually happens, it's called a run on the bank. People are afraid that the bank would make bad loans, fail and they would loose their money. It happened a lot during the Great Depression in the 1930's so the U.S. government created the Federal Deposit Insurance Corporation (FDIC) which protected depositors. When I opened my savings account, it was insured up to a limit of $15,000. Wow, I thought I'd never reach that. Today the FDIC limit is $250,000 per depositor. Federally insured savings accounts are one of the safest investments you can make, they also pay the lowest interest rates.

Up until this point we've been covering savings, though I sometimes refer to a savings account as an investment. There's a fuzzy line between savings and investing. Some people might define savings as money hidden under the mattress, others say that short term investments like 3-month treasury bills and money market mutual funds are savings, not an investment. Still others define all government issues as savings. It doesn't really matter where you draw the line. As far as I'm concerned when you are accumulating money, you are saving. When you put that money to work for you, you're investing.

Collecting interest on a savings account might sound very basic, but is it really? I didn't withdraw the interest that the bank was paying me, it went right back into my account so that the interest would compound. In other words, the bank started paying me interest on the interest that they already paid me. Over the short term it doesn't seem like much, but over a long period of time it can really add up.

  • "Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."
--Albert Einstein

There is dispute whether this is an actual quote by Albert Einstein, it probably isn't--but it's a good quote nonetheless. Einstein was also credited for discovering a simple mathematical formula for compound interest called the Rule of 72 but the formula has been found in the writings of Italian mathematician Luca Pacioli dating back to 1494. The way you use the rule of 72 is like this: 72/(interest rate) = (years required for the investment to double). My passbook savings account was earning 5.5% so using this formula, 72/5.5=13 years to double. If you can find an investment that returns 12% it would take just 6 years to double. I've made trades that doubled in just a few days, but those are very rare. Why is finding the doubling rate important? Exponential growth. You might have heard of the Wheat and Chessboard fable. Basically, if you put one grain of wheat (or rice or sand or whatever) on one square of a chessboard then 2 on the next, 4 on the next and keep doubling it for each square, how many grains would you have when you finished all 64 squares? The answer is such a huge number that it is greater than the amount of all the grain that was harvested in the history of humanity and the pile would be bigger than Mount Everest. That's the power of compound interest.

The rule of 72 breaks down in the real world of investing as does exponential growth. Still, the greater the return and the longer the time, the more likely you'll be able to accumulate a large sum.

Investing in debt securities may seem very simple and safe at first and once you know about the power of compounding interest and exponential growth--heck it's a no-brainer. Just find the investment that gives you the highest interest rate for the longest time and that's it, right? Wrong! First of all, a bond (a long term debt) that pays the highest interest rate relative to other debt securities is usually referred to as a junk bond. What it means is that the interest rate on a junk bond is high because there is a good chance that the entity that issued that bond will likely default on the payment. In addition, interest is taxable as regular income so depending on your tax bracket the amount you will be able to keep from your interest income is a fraction of the actual interest rate. Another thing to consider is that if you want to sell a debt security that you own before its maturity date, it may be worth more or less than face value due to fluctuations in the prevailing interest rates.

My experience with debt securities began when I opened my first Individual Retirement Account, IRA. I was just turning 30 and realizing that I've got to start doing something about retirement. Interest earned in an IRA are sheltered from taxes until you start withdrawing at retirement. I figured that I should play it safe so I invested in short-term debt securities issued by the U.S. government. The simplest way to invest in these treasury notes, bills and bonds (they have different names depending on the length of maturity) was through a mutual fund. An advantage of investing through a mutual fund was that instead of investing the entire $2,000 IRA limit at one time I could invest $166.67 per month--that made it much easier for me to get started. I kept close watch on my IRA and saw it gradually go up in value, never going down. I was definitely playing it safe, too safe. As it turned out, the mutual fund was a "tax advantaged" account meaning that a portion of the interest was exempt of state and local taxes--but the IRA was already exempt from all income taxes so it didn't make sense using this investment in an IRA. If I had invested instead in a taxable bond fund I would have gotten a better return. I eventually changed my investment strategy for my IRA from bonds to stocks but a couple of years ago I went back into bonds for my IRA. Why? Because bonds are a valuable mix in a total investment portfolio and the interest is sheltered from taxes in the retirement account.

One of the biggest risks to debt securities, even a greater possibility than default, is interest rate fluctuation. I read about it and thought I understood it but it didn't sink in until I experienced it. Once my father died my mom started relying on me to help her with her finances. She had some money that she put into a mutual fund in that same savings and loan where I had my first savings account. She wanted something that paid a better than average interest rate but preferred it to be non-taxable, she hated to see her earnings get eaten up by taxes. The manager at the savings and loan suggested a tax-free mutual fund for her. Tax-free mutual funds invest in bonds issued by local and state governments (municipal bonds) for community projects like building bridges, dams and schools. Since it is an investment in the community these municipal bonds are either not taxed at all or are taxed only by state but not federal or federal and not state. Many municipal bonds have very long maturity dates and very low interest rates. My mom was happy getting her meager tax-free interest but what she didn't realize was that her principal, her original investment, was dropping in value faster than the interest that was coming in. The way it works is like this--let's say you buy a $1,000 bond that earns 5% interest and you decide to sell it before the maturity date. At the time you put the bond back on the market the interest rates have gone up to 10%. In order to get that 10% the bond will sell for less than face value. It depends how many years to maturity, dividend date and other factors but basically, your bond has lost value. Of course the reverse is true if interest rates drop. If you intend to hold onto the bond until maturity, it shouldn't really matter to you if the value goes up or down, you will still get the same interest (coupon rate) but since a mutual fund has to report the value of it's portfolio they have to report the current market value. In addition, a mutual fund may need to sell or trade bonds before maturity to meet customer redemption demands. In my mom's case, interest rates were rising and her mutual fund lost value. She had no idea until I pointed it out on her statements. I also discovered that the fund she was invested in had very high fees and were commission based, also known as load funds, so the drop in value was even more severe.

There are a wide variety of bonds, some have interest rates that change during the life of the bond (like the Treasury Inflation-Protected Securities - TIPS) some bonds are callable, meaning that the issuer can pay them off before the maturity date, some don't pay interest at all but are sold at a discount to their face value like series EE Savings Bonds. There are also many rules how they are taxed and reported. I got to play the rich uncle when I sent my nephews Kevin and Brian $100 Savings Bonds for Christmas that only cost me $50--and since it was a gift to a minor nobody had to report taxes on them. There's lots to bonds, the way they are reported in basis points (0.01% = 1 basis point), the way they are listed, some can be converted for company stock, etc. It can get very complicated and as a result bonds are neglected in many portfolios--I didn't invest for bonds for several years.

What I do these days is to put a portion of my investment in a mutual fund that invests in a large number of bonds in order to match an index of the total bond market. I'll get into this more in another lesson on asset allocation.

In the next lesson we'll finally get into stocks--something that I'm sure you'll find much more exciting. However, some people that know the stock market much better than I do put all of their money in bonds. Joe Dominguez, the author of "Your Money Or Your Life" worked in a Wall Street firm but put all of his own money into 30 year treasury bonds. He retired when he was 31 years old. Of course back then the "Long Bonds" as they are known were paying over 13% interest. I'd gladly put all of my money in 30-year treasuries with that sort of return. Today they pay a measly 3.73%. Of course interest rates are at historically low levels, but what happens to today's bonds if, or rather when, interest rates rise?

Next lesson--the stock market.