Investment Vehicles.

There are basically five main are main elements of risk that have to be considered when making any investment choice in property, bonds (government and corporate) and equities: interest rate, market, liquidity and credit[1] To fully demonstrate this below there is a table that broadly sets out the level of risk for each element and following this will be three sections entitled bonds, property and equities that will explain the choices of low, medium and high.

Bonds

Bondholders are lenders to a government or company that issue the bond. Bondholders are entitled to regular interest payments and when the bond matures, are entitled to the full principle back. They are also entitled to precedence over stockholders in a case of liquidation. If a bond is bought for £12000 at 4% for 20 years, the buyer will receive £480 a year until the end of the 20 year period when they will receive back £12000.

One issue about corporate bonds is the quality of the company you lend your money to is crucial. For this reason companies are indexed and receive a grade as to their quality. Companies which have a AAA rating are considered extremely safe and consequently are in high demand. C rated bonds are considered to be basically rubbish and the rating of a D is indicative of a companies default in payment of interest and or principle.

Treasury bonds are guaranteed by the government and are taken to be risk free as the only chance of them defaulting is if the government collapses. “They are very actively traded and so they do not become mis-valued because of a dearth of accurate price information.” (Lofthouse.1994:185). Bond prices will increase if interest rates are lower and conversely will decrease if interest rates are higher. This is the only real risk in investing in government bonds.

Government bonds are said to be risk free; corporate bonds are entirely dependent on the quality of the issuing company. Bondholders enjoy some security, as even if the company goes bust they are entitled to claim what assets are remaining; equity holders have less security as mentioned above, they only get what is left over after the creditors are paid off.

There will be times when interest rates will be low so bond price will be high; this is why the table has indicated under interest rates a high risk. Of course at other times with rising interest rates there may be a reduced return on your investment “Bonds are good alternatives for conservative investors and for investors who are aggressive and wish to diversify their risk. Unlike equities where price follows an irregular trend, bond prices usually trade around their principal value. The reason bond prices fluctuate at all is because the price of a bond depends on future coupon payments and current interest rates.” (Cheng.2004)

Therefore bonds have an inverse relationship with interest. Harvey et al states, “that a bond that was issued in perpetuity with a 3.5% rate of return would be worth £140 on the stock exchange if today’s interest rates were 2.5%. However the bond would be worth just £25 if the interest rate rose to 14%. This example illustrates how due to the fixed nature of the rate of return, the actual level of income the bond generates is governed by the interest rate. Consequently the market value of the bond, if sold before its redemption rate, will be in line with other returns available in the market place. In addition, speculation over future interest rates is one of the driving forces behind the bond market.

He goes on to argue that bonds are popular with investors when it is thought that interest rates are going to fall as the bond holder will achieve a capital gain as well as an increase in income in real terms. If it is predicted that interest rates are going to rise then bond holders may look to offload held bonds and reinvest in for example recently issued bonds already featuring a higher rate of return.

Equity

Market fluctuations and their varying effect on the equities is needless to say a high risk. The downturn of the market is likely to cause the downturn of an equity. “Aspects of asset marketing are puzzling. The work of Mehra and Precott shows that the magnitude of risk compensation in equity markets is a puzzle; treasury bills offer a return of about 1% while equity market portfolio can offer as much as 7.5%.”  There is a huge difference here on returns you can expect to get. (Bansal.2004:1)

Indeed, this has prompted some authors to argue for a 100% portfolio allocation to equities.  However Byrne et al states. “The fact that plan sponsors do not generally follow this route suggests that there are a number of arguments against such an extreme allocation all of which can be related to risk.” (Byrne et al.2001:133)

If the market takes a downturn then it is likely[3] that the value of your equity will go down as well. There is a far greater liquidity in stock market than in property investment where there is very little. If you want to divest yourself of any stock market investment you have, it is as easy as picking up the phone. Property can take months or even years to offload.

“Although equity holders are taking on greater risk, they can potentially get a greater profit when earnings rise. The value of the company’s stock actually increases with earnings, since the cumulative earnings that a company can expect to receive for the next couple of years is higher. In addition, equity holders may also receive dividends if the company is performing well.” (Cheng.2004)

All companies are unique and therefore there stock will bear a specific risk. At the same time all companies are subject to the same economic cycles and consequently all have a risk in common. When the market falls so do most stocks, however the level that they fall will vary. Additionally even with a downturn in the market there will always be some stocks which will benefit. “One can think of stocks as bearing two kinds of risk: systematic or market risk and unsystematic and unique risk. Each stock will bear both sorts of risk.” (Lofthouse.1994:1)

Property

Where it refers to credit in the table under property, this is really a reference to the strength of the covenant in place and the relative risks associated. The reason it has been given a high rating is because securing a decent tenant who pays a good rent is an extremely important factor related to property investment. The strength of the covenant is related to how well the economy is doing, as a slow economy will make it harder to secure a good tenant. “Generally retail properties are more volatile than offices or industrial, due to factors such as their variation in location and type. Retail properties tend to produce higher growth.” (Enever et al.2002:45)

Even during times of no inflation an investor will require a return for foregoing consumption. At times where inflation exists an investor would hope to be compensated for any erosion of his capital and income. There are also taxation issues that will affect the rate of return that will be different case by case in terms of, types of investment, classes of investor and types of return, eg, capital gains or income.

“Any investment other than government stock carries the risk of default…With property, the risk of default on an investment will depend on the strength of the covenant and, in the case of reversionary property, risk is attached to the projected income flow voids and size. With leasehold properties there are problems of dilapidation claims. Many appraisals of property, especially in the boom years of the 1980s, had built in explicit expectation of rental growth, with the amount depending on the age and type of the property and projected demand. Growth can be built into the capitalisation rate; a lower rate means more risk because of the risk that the growth rate will not be achieved. Risk of not achieving target returns is greater with low yielding property.” (Enever et al.2002:174)

Test to follow next Wednesday….