Monday, March 1, 2010

More fixings for income!

In the previous posting ‘Fix(ed) Income’ we evaluated bonds, in particular government bonds. I have built the evaluation calculations into a small spreadsheet, a copy of which you can request by e-mail (Godfried.wasser@royallepage.com).


Upon reading the last post you may wonder how it is possible to make 10% or more profit on a bond that yields only 5% until maturity. The critical factor is here is the time to lock in your profit. Here is a screen shot of the little calculator for a 5% Bond with 10 year maturity. Two years into the loan, interest rates dropped from 5 to 2.5% for 8 year bonds. The ‘Little Bond Evaluator’s screen shot shows that the current value of your bond has shot up to $116.67. So over 2 years you collected 5% on $100 = $5 per year. Total interest earned $10. If you sold the bond now, you’d also make $116.67-100=$16.67 in capital gains. Total proceeds: $26.67 over 2 years on $100. That is a total Return on Investment (ROI) of 26.67% or 13.34% per year.

The key question is what you are going to do with your now cashed-in bond money. If you would reinvest in a similar 8 year bond at today’s 2.5% yield, your average ROI would have reduced it to the original 5% coupon rate. On the other hand, if you would reinvest in better-returning-investments during the 8 years following your bond sale you could do a lot better. The Key is whether you can invest in another higher yielding investment.

Let me illustrate this point in a different fashion. Say you invest $100 in a lottery tickets. 2 years later you win the Jack Pot and your ROI on lottery investments was 26.67%. Next you invest the money for another 8 years at 2.5% and in spite of the initial spike in profits, on average that 10 year investment yielded you only 5% for a total value of $160.

If you had found other investments that yielded also 13.34% per year, the total return after 8 years would have been more than tripled to a total value of $376.78. So investing is not only about getting a maximum return during a short time, but about having excellent returns all the time. So, you have to ask yourself what is better, the occasional ’10-bagger’ or a consistent decent return over the long haul. By now you should know the answer to this rhetorical question. Duh!

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