Reasons for Investment in Bonds - Case Study Example

A Research on Assets There are many financial instruments with distinguished characteristics. The capital market instruments have maturities of more than one year. Financial market instruments having maturities of intermediate term (1-10 years) and long term (more than 10 years) are included in the capital market instruments. Certificates of deposit: Banks also raise short-term funds by issuing certificates of deposit (CDs). Most CDs are short-term deposits with maturities. At one time, certificates of deposit were nonnegotiable, meaning that the original purchaser could not sell them without incurring interest penalties. Since 1961, however, banks have issued negotiable CDs. They now are traded actively in a secondary money market. Corporations can raise funds by issuing stock or selling bonds. Business equities are shares of ownership, such as stock that corporations issue. Owners of equities are residual claimants on the income and the net worth of a corporation. The equity holders of a company are paid after all the debts of a company is paid. The significant characteristic of equities is the variation of returns with the profitability of the company. An investor can become the owner of a corporation by purchasing the equity. The edge of bonds on equity is that if the company goes bankrupt the bond holder will be paid before shareholder on the other hand the profitability of the company doesnt benefit much to the bond holder as a bond holder will only get principal plus interest. Hence the ownership of bonds involves low risk as compare to the ownership of stocks, but this comes at the cost of a lower return. Corporate bonds: Corporations can raise funds by issuing corporate bonds. A Corporate Bond is a long term instrument yielding interest twice each year until the date of maturity. Convertible bonds can be converted into equity shares before the maturity. The corporations offer the convertibility feature with the bonds in order to attract investors. Another feature which increases the attractiveness of bonds is their degree of liquidity which they provide the investors as compare to the equities. The higher liquidity of bonds is due to their trading in the secondary markets. In order to encourage the secondary market trading the Corporations must maintain higher credit ratings. Reasons for investment in Bonds: Bonds reduce the short term volatility of the stock market. The perception that the stocks yield higher returns as compare to bonds is true for the period of 10 years or more. Bonds are suitable for the investors who cannot bear the volatile nature of the stock markets. Bonds are suitable for the investors who don’t want to put their principal amount at stake. Fixed income securities are also suitable option for the investors who need the income for a specific purpose in the relatively near future. The above mentioned generalizations dont represent all the investors. The investors should maintain diversified portfolio according to their requirements. It is also recommended that the combination of asset classes keep on changing. US Treasury Notes and Bonds: US treasury issues long-term debt instruments. The Treasury notes have the maturity ranging from 1 to 10 years. The bonds issued by the treasury have the maturity of more than 10 years. These instruments are traded in the secondary markets due to the low risk involved. They are considered as the most liquid instruments in the capital market. Municipal Bonds: The securities issued by the state or local Government on long term basis are known as Municipal bonds. The interest payments paid at these bonds are free of federal income tax that’s why the interest paid at these bonds are less than the interest paid on corporate bonds. Characteristics of bonds: The trading of bonds can be undertaken both at the organized exchanges and over-the-counter markets. The trading procedure followed at the organized exchanges and over the counter markets is same although the significance of both has been changed with the passing time. Issuance: Corporate debt issues are underwritten by securities dealers, and are typically issued in multiples of $1,000 and/or $5,000. There are five main classifications of issuers representing various sectors that issue corporate bonds: 1. public utilities 2. transportation companies 3. industrial corporations 4. financial services companies 5. conglomerates Features and Benefits: Credit Quality - - Corporate bonds are evaluated and assigned a rating based on credit history and ability to repay obligations. The higher the rating, the safer the investment. Yields - Corporate bonds usually offer higher yields than comparable-maturity government bonds or CDs. This high-yield potential is generally accompanied by higher risks Tax Consequences - Corporate bonds are fully taxable debt obligations. Investors should always consult a tax professional regarding their individual tax situation Liquidity/Marketability - If you must sell a bond before maturity, in most instances you can do so easily and quickly because of the size and liquidity of the market Diversity - Corporate bonds provide the opportunity to choose from a variety of sectors, structures and credit-quality characteristics to meet your investment objectives. Risks: Interest-Rate Risk – Interest rate risk is often misunderstood by the investors as there is inverse relation ship between bonds and interest rates. The value of bonds rises with the decrease in the interest rate. Credit Risk – It is important for an investor to evaluate the companys ability to pay its principal and interest on debt according to the prescribed schedule. Different organizations, such as Standard & Poor’s, Moody’s Investors Service and Fitch provide credit quality Ratings. According to the ratings provided by these organizations, bonds can be divided in to investment grade, speculative investments and junk bonds. Junk bonds are issued by new companies, or the companies operating in highly volatile and competitive markets. In order to attract the investors the companies offer high interest rates on these bonds. The interest rates offered are higher than the investment-grade bonds in order to compensate for the extra risk. Event Risk: The main goal of a corporation is to maximize the shareholder value by adopting different strategies. This includes leveraged buyouts, restructurings, mergers and recapitalizations. The resulting increase in the debt burden due to these strategies result in shape of decrease in the bond values. Corporations have invented measures for bond holders protection but still there are many loop holes which need to be addressed. The event risk can affect the value of all the bonds. It is important for an investor to get information regarding the degree of vulnerability to risk of a company reported by the rating agencies before buying the bonds (Bonds.com). Stocks and certificates of deposits are being traded in the stock market; there are various types of them. Like stocks can be classified into following different categories; Common stocks: these are kind of shares which are last to be paid when the company is wound up. Preference stock: they are the shares in which shareholder are preferred over the ordinary shares at the time of dividend distribution. Cumulative preference stocks. Redeemable stocks. Like wise certificates of deposits has also it various types, certificates of deposits are similar to the savings accounts in that they are insured and thus virtually risk-free, they are "money in bank" They are different to savings account in that way they provide specific fixed term and fixed interest rate. They have to be held till maturity at which the money can be withdrawn along with interest. The different types of them are; Traditional. Bump-up. Liquid. Zero coupon. Callable. Brokerage. High-yield. These stocks are being traded in the stock market; the buying of them requires the following steps to be followed; Sign up with a discount brokerage. Fund the account. Get the online quotes regarding that stocks you are interested in buying. After doing all above recommended steps start youre trading. Restrictions on trading: There could be some restrictions on the trading of stocks and certificates, like the investors can be restricted to sell their shares for a certain period (approximately 2 months), the rationale behind it that it would reduce the potential seller from the market and would encourage the impact of trading on prices. Means of financing: These stocks and shares are also taken as a means of financing like financing a company by selling of them known as Equity financing, they are used as a long term investments. Un-official financing is known as trade financing, usually it provides the working capital to the company. Arbitrage trading: Its simply a trading of securities and stocks when the opportunity exists during the trading day to take the advantage of difference in prices between the markets. Here selling and purchasing are identical but at different markets. Historic factors that affect the stock market: Usually it is observe that market sometimes rises and falls, there are some really historic factors which affect the market trend like inflations, interest rate, earnings per shares, oil/energy prices, social and political issues etc. Some of them are a really affective factor which speeds up the trading or suddenly crashed the market down like wise when earning per share exceeds the long term averages. Stock derivatives: These are the financial instruments which has a value that is dependent on the price of the underlying stock. The main types of stick derivatives are: Future derivatives: It is a contract to buy and sell any specific commodity in future at future market prices. Option Derivatives: It provides a right to the buyer to establish a position previously held by the seller of the option, to sell the assets at a later date and at agreed price. Suitability to Financial Goals: The choice of CDs depends upon the risk tolerance, financial goals and the time constraint faced by the investor. In order to effectively address the inflation risk it is important for an investor to use diversified portfolio options. The principal concern for individuals investing in cash equivalents is inflation risk, which is the risk that inflation will outpace and erode returns over time. It is important for an investor to have up to date knowledge regarding the maturity of a CD. In case the investor doesnt have clear knowledge regarding the maturity of the CD the capital can be tied up for undesired period. It is a safe option to take the maturity date in writing. Effects of current financial crisis: The latest crash of market has its drastic effects on whole Western market, especially US but on the other hand United Arab Emirate economy has its mild effects, the gulf economies are not immune to the global financial crisis. Hamad Bin Amin, the director general of Dubai chamber of commerce and industry said, "Now the GCC economies are also in the middle of this turmoil, GCC government should draw lessons from the experience and developed new strategies to better manage their assets." As compare to US and other western economies, approx. 95% of UAE enterprises are based on small and medium sized family companies, employing mostly family equity with much less dependence on international capital market. Therefore the impacts of current crisis on such family enterprises are assumed to be mild and most of these families are dealing with trading which are not depending on international capital market. UAE financial sector like banks are also less dependent on external financial market. According to the UAE central bank, bank financing from the European commercial paper (ECP) and the medium term notes (MTN) to total bank assets is not more than 9.9% , for the inter bank deposits percentage , it is 12.7% to the total assets and most of these are owned by UAE banks. In the real estate sector of UAE, because of this current financial crisis, the demand seemed to be reduced and a softening of real estate prices is observed. Financial market impacts, 2007 IN 2007, HSBC, the worlds largest (2008) bank, wrote down its holdings of sub-prime -related MBS by $10.5 billion, the first major sub-prime related loss to be reported. During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold. During 2007, the crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value". Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the food price crisis and oil price increases due to a "commodities super-cycle." Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials. Approximately 80% of U.S. mortgages issued in recent years to sub-prime borrowers were adjustable-rate mortgages. When U.S. house prices began to decline in 2006-07, refinancing became more difficult and as adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities backed with sub-prime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and USA government sponsored enterprises, tightening credit around the world. When Lehman Brothers and other important financial institutions of USA failed in September 2008, the crisis hit a key point. During a two day period in September 2008, $150 billion were withdrawn from USA money funds. The average two day outflow had been $5 billion. In effect, the money market was subject to a bank run. The money market had been a key source of credit for banks and non-financial firms (commercial paper). This credit freeze brought the global financial system to the brink of collapse. The response of the USA Federal Reserve was immediate and dramatic. During the last quarter of 2008, the central bank purchased dollars worth billions of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks. REFERENCES: Business link.com Frugal Traders, "Million dollars Journey.com" Robin Greenwood, published online on march 27,2008 ken Little , about.com Impact of crisis on UAE economy, UAE property trends .com Wikipedia, free encyclopedia, March 2009. Certificates of deposits ,bank rate .com Read More