Archive for February, 2010
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For years, people like my friend Jim and his father sank their money into cash-equivalent investments, also known as liquid assets, because of how easily they could be traded in for cash. (If you need a visual aid, just think of how easily liquids pour from one container to another.) What would you guess they made on these ultrasafe investments that they could so easily jump back out of? You guessed it: not much.
The return you receive on your cash-equivalent investment depends entirely on the existing interest rate. If interest rates are low (a good thing if you’re trying to borrow money), you’re not going to make as much. In any case, you’re not going to see a great return with these investments. They are essentially where you park either money you’re planning to use in the near future, or your emergency reserve. What kinds of investments are appropriate for this emergency reserve category?
If all bonds were created equal, choosing among them would entail little more than comparing yields. But in truth they are far from equal, which is why they are rated on their credit quality by major rating services like Moody’s and Standard & Poor’s.
Bond ratings are based on the likelihood that the bond’s issuer will default, failing to repay its obligation to investors. The highest-quality bonds receive a rating of AAA from Standard & Poor’s (Aaa from Moody’s). At the other end of the spectrum, bonds rated DDD or lower by S&P are already in default. As you might guess, lower-quality bonds generally offer higher returns as an incentive for investors to purchase them in spite of their higher level of risk.
Bonds rated BBB or higher by Standard & Poor’s (Baa or higher by Moody’s) are considered “investment grade”—that is, appropriate for consideration of purchase by prudent investors. Bonds with ratings below this threshold are considered noninvestmentgrade or “junk.” Junk bonds offer higher yields but are considered to be highly speculative investments due to the company’s risk of default.
Actually, this inverse relationship makes perfect sense. When current interest rates go down, bond buyers will pay more for an existing bond that yields 6% than they will for a new bond that yields only 5%. And on the flip side, if interest rates go up, a buyer will pay less for an old bond that is carrying a lower yield than the bonds that are now being released. Here’s an example of how bond prices reflect the going yields. In June 2003 the yield on a five-year Treasury note with a face value of $1,000 was about 2.5%. But if you went out to buy a bond released several years ago yielding about 5%, you’d have to pay $1,100. Because current rates went down, the price of an older bond with a higher yield went up.
This effect is most pronounced for long-term bonds. When interest rates rise, the price of a 5% bond that won’t mature for twenty years (in other words, a bond that will continue to yield 5% every year for twenty years) will fall more than a 5% bond that will mature in five years. And when interest rates fall, the price of a long-term bond will increase more than the price of a short-term bond.