Cash Vs Bonds

Posted on October 11, 2007 , filed under Stocks | Print This Post

A bond can be considered a loan from an entity willing to pay a certain interest rate until the bond matures. By the nature of a bond, your principal is normally guaranteed so long as the company prevents itself from becoming insolvent.

There are many times when an investor should consider bonds as an alternative to holding cash. A major time to consider a bond investment is when there is significant expectation of an interest rate cut. Falling time deposit rates normally means investors will look for higher yields elsewhere. Many bonds trade similar to stocks and are highly liquid just as stocks. Bonds can trade at Net Asset Value (NAV) or at a discount to NAV. When there is some uncertainty over a rate cut you may be able to buy a conservative bond with a decent yield at NAV or just a slight premium to NAV. Bonds pay a fixed coupon rate (read annual interest rate) until maturity and you are guaranteed to receive your principal back.

Bonds are a great investment when the interest rate spread between fixed deposits and a bonds coupon rate increases. Let’s look at the following example:

Let’s look at a fixed deposit of $1,000,000 growing at an average 4.5% interest rate. We will compound the interest twice a year.

Your final amount in five years will be: $1,249,203.43

Let’s compare this to a bond with a 6% coupon rate. We will also compound the interest twice a year.

Your final amount in five years will be: $1,343,916.38

Your gain over the time deposit would be almost $100,000 or a 1o% increase on your original principal.

When you are faced with a situation with falling fixed deposit rates, every little bit that you can safely increase your yield counts.

There are certain bonds that can be considered safer investments than say a currency exchange, stocks or even real estate. As long as the company remains in business you are certain to receive your interest and principal.

The pinnacle of safe investments are fixed deposits and government treasury bonds. A step above this would be infrastructure bonds. Think of these bonds as being your highway’s, your utilities and your communications. The likelihood of the NYC subway system or Con Edison going out of business is almost unthinkable. If you read through this article you will notice that I stress a conservative approach and consider safety first. With ultra conservative bonds you can only expect to get 1-2% higher than current interest rates. However if interest rates fall you will benefit greatly. As long as the interest rate doesn’t go above your coupon rate, an ultra conservative bond will perform better than a fixed deposit.

The greatest advantage of bonds over fixed time deposits though is the ability to use it as a safe short-term hedge against falling interest rates. Many bonds are highly liquid and can be sold at anytime close to your NAV and at times higher than your NAV giving you a fixed coupon rate and a potential increase in principal if you sell early.

In the worst case scenario you will hold the bond until maturity and simply collect 100% of your original interest back plus whatever your interest rate would be. If you buy at a premium to NAV it cuts into the calculation of your annual interest rate since you only get back NAV at maturity.

If you expect an interest rate cut for example you could buy a infrastructure bond like I suggest above and sell it shortly after a cut takes place. When a rate cut takes place it will drive investors to look for a higher yielding investment which in turn will push up the premium for bonds that pay 1-2% higher rates over fixed time deposits. You get the double benefit of a high yield and NAV appreciation.

In some countries there are monopolistic infrastructure services that are private companies supported by the government. These are the safest short-term investments a person can make looking to maximize yield. Many times you can buy these bonds in your local currency so you don’t face any currency exchange risks. Commission charges are usually negligible.

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