Saturday, April 11, 2015

bonds let us to lock in a profit today to be realized in N years

After my lecturer touched on this point, I did some research.

For equities, say IBM, if we buy it at $100 and hope to cash out about
5 years from now, we are never confident. At that time, price could
drop below $100 and we may have to wait indefinitely to recover our
capital. That's the nature of equity investment. Barring another
financial crisis (which i consider unlikely in the next 20 years),
price should recover but I might have bought at the peak, as I did
many times in my experience.

For a bond with a coupon rate 7.5% per year, maturing in 5 years, the
current price could be about $100, which translates to a yield around
7.5%, probably a high yield bond issued by some lesser-known entity
XYZ. If all the coupons are paid out only on maturity without
compounding, then the yield turns to be around 6.5%, as illustrated in
the attached spreadsheet.

The special thing about bond (relative to stocks) is, we kind of lock
in an annualized return of 6.5% at the time we buy it, barring credit
events.

As the attached spreadsheet illustrates, today we pay about $100 to
own the bond, and in 60 months we are sure to receive exactly $137.5
i.e. $7.5 x 5 years coupon payment. This terminal value is not subject
to any market movement. The only uncertainty is credit default. Most
bonds we deal with, even the high yield bonds, are very unlikely to
default. If you buy a bond fund, then you would invest into hundreds
of bonds, so some defaults may be compensated by other bonds' positive
return.

If you don't want to worry about defaults at all, then get a
investment grade bond, perhaps at a yield of 4%. You still lock in
that annualized 4% if you hold it till maturity.

The spreadsheet shows that even if there's a credit crunch some time
before maturity, the bond's market value (NAV) may drop drastically,
but it is sure to recover. Even if yield goes up in the last year,
barring default, the maturity value is still exactly $137.5. This
guaranteed return is something stocks can't offer.

There are other factors to muddy the water a bit, but the simple fact
is, barring default, we could effectively lock in a profit today, to
be realized on the bond's maturity date.

I guess that's how insurers can guarantee returns over many decades.
They buy very long bonds which offer higher yields.

What do you think?

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