Apr 7, 2008, 10:53 AM
The importance of investors’ awareness of the uncertainty of investments due to risk factors, as well as the fact that actual returns may vary from expected returns unless determined prior to the investments were the main focus of the previous article. It is necessary also, to bring to the attention of readers why it is importance for investors or fund managers to perform detailed analysis, inclusive of risk and returns assessments of securities prior to investing. Similarly, reference must be made to the fact that investors should ascertain their risk preference, that is, whether they are risk adverse, risk neutral or risk seeker (lover) in light of the possible consequences of the risks involved in investment.
Despite the issues of low interest rates and rising inflation which often affect investment returns, it is sometimes possible for investors to achieve adequate returns by reducing their risk through the use of certain investment vehicles and diversification. Individuals who wish to invest could do so by purchasing either directly through governments, corporations, or investment firms.If invested through Investment firms, they are responsible for managing the investments, and the returns are generated through them. Investment firms minimize investment risk because they manage different investor’s funds and are able to use their expertise to invest in spread of holdings thereby diversifying its portfolios.
There are basic types of investments that one could utilize in order to generate a healthy income whilst reducing risk and maintain capital wealth – Fixed interest income (bonds i.e. government and corporate), and Equity (company shares).
Fixed Interest Income - bonds
Bonds are loans given by investors to government and companies (corporate bonds) which in return promise to make regular payments at specific dates. The bond issuer promises to make specified payments to the investor at a specific point in time in return for cash instantly. Bonds are offered in similar arrangements as conventional loans issued by banks and financial institutions to individuals and corporations. They could be issued by governments, local authorities and companies and are made available in different forms – coupon rate and zero coupon bond. The coupon rates of bonds are used to determine the interest payments and annual payments by multiplying the coupon rate by the par value.
In the case of coupon rate bonds, the issuer (government or company) makes interest payments semi annually (every six months) or annually for the duration of the bond. At maturity, which is at the end of the bond duration, the issuer also pays the par value.Coupon rates are set high enough to induce the investor to pay par value for the bonds. Zero coupon bonds could also be issued whereby the issuer only pays the par value and interest payment at maturity date.The investor pays for such bonds at a price far lower than the par value, but because at maturity the face value is considerably higher, the returns will be the difference between the two.
The return or payoff of coupon rate and zero coupons issued by a government or company should be the same. For example, suppose an issuer requires D100 now, it could either offer a bond with a par value of D100, and a coupon rate of 10% or a zero coupon bond offering with a par value of D110. In either case the returns should be the same.
These are forms of loan that investors give to governments and are termed as ‘risk free’ because the chances of default are very low. The returns from governments’ bonds are certain and are deemed secure and could be considered in a diversified portfolio by individual investors and investment firms (fund managers).
The status quo, however, appears to be shifting as the worst financial crisis in modern history has seen governments such as in Greece asking investors to take a “hair cut” on their bond investments. That is, the government was unable to meet the regular interest payments on its bonds and therefore was asking investors to accept lower payments than previously agreed.Although, during financial crisis when markets are volatile, investors tend to view government bonds as the most secure means of investment. Therefore an investor who has a limited disposal income and is risk adverse should therefore consider investing in government bonds which are almost certain to yield a fixed income over a period of time with minimal risk.
These are also loans given to companies in similar ways to governments bonds, but the only difference is that the risk in corporate bonds is higher. One of the main reasons for this is because companies are less stable than governments and are more likely to go bankrupt. However, because corporate bonds are riskier than government bonds they yield higher returns. If investors invest in corporate bonds they could received more than they would with government bonds. Due to the risk attached, companies may sometimes default in payment. For example, if someone invests in a company and subsequent to that the company goes out of business, it is likely that that investor may not receive any returns on the investment or receive a smaller percentage than that which was anticipated.
There are different types of bonds which are issued by corporations - refunding bonds and convertible bonds.
Companies at times issue bonds with conditions attached that will enable them to repurchase the bond at a specific agreed time before maturity -the repurchase price is agreed at time of issue. Refunding bonds are issued when interest rates are high, but companies expect rates to be lower in the future so that they can retire (buyback) the bonds inorder to issue new ones at a lower rate to reduce interest payments. This is arguably more beneficial to a company than an investor. Therefore, refunding bonds are issued at a higher coupon rate and yield to maturity to compensate investors.
In the case of convertible bonds, the conditions attached are more favourable to the investor because they are allowed to be converted (exchange) to shares in the company when share prices rise. For instance, a company may issue bonds at a time when share prices were low, for example D5, with an option to convert into shares at a future date. If after one year, the share prices rise to D7, and the investor converts, he will gain D2 from this option. Due to share price increase as a result of company performance, convertible bonds are issued at a lower coupon rate and yield to maturity than refunding bonds. Therefore, the return on convertible bonds may be more than yield to maturity if when converting the shares prices were significantly higher.
Equities are investment in companies that are listed on a stock exchange this is by purchase its shares. When an investor acquires a share in a company, the value of the share increases or decreases depending on the performance of the company – shares prices fluctuate (changes) due to volatility or risk .Share prices can also be influenced by the market in which the company is listed. If the market views the likely performance of a company to be good then prices will increase and vice versa. This means that the value of the investment will either go up or down due to share price fluctuation.
Though shares are riskier than both government and corporate bonds, they provide the investor with two forms of returns – dividend and capital gain.
When an investors purchases shares in a company the investor becomes a shareholder of the company. The individual is, therefore, entitled to a portion of the profits earned by the company. The portions of profits that are distributed to the shareholders are called dividends.
It must be highlighted that companies may not always pay dividends to their shareholders even if there is the realisation of profits. Managers (directors) may decide to invest in projects that will increase the growth potential of the company. Investors, however, could pay themselves dividend by selling their shares to the company or other investors in the market, yielding capital gain.
Investing in corporate shares gives investors higher returns than in bonds but are more risky because the funds of a corporation (company) are composed of debt and equity known as capital structure. In the event that the company is unable to pay its debts (bank loans, bond holders etc) it could be liquidated by the debt holders to recover their funds. When this happens the shareholders are at a risk of not getting part or all of their returns because the shareholders are considered last during liquidation.
should be aware that the suitability of a particular investment depends on
their risk appetite, that is, the level of risk they are willing to take in
achieving their desired return. There are other investments available to
investors such as derivatives (option, futures, swaps, FOREX etc) which are
more risky and yield higher returns but are only traded in developed financial
markets such as the
It is always important to seek financial advice from qualified personnel within government departments, banks or private firms (reputable) when considering investing.
The information provided in both articles serves only as guidelines.
Coupon rate – is the interest attach to a bond and express as a percentage
Diversified portfolio –spreading investment to various securities to reduce risk
Liquidation –is process of forcing a company to cease trading through the courts due to inability to meet interest payments on debts when due.
Par value/face value – is the maturity value of a bond
Risk free – return can be earned with certainty
Risk adverse –is an individual who prefers a more certain return with little or no risk and only considers higher risk if compensated with excess return (premium).
Risk neutral –is an individual who is indifferent regarding risk and only considers expected return relating to the risk.
Risk seeker (lover) –is an individuals who would take higher risk even with the possibility of lower return but the aim is to achieve a higher return.
Yield to maturity – is the average rate of return that will be earned on a bond if held to maturity date.