A Young Lawyer's Financial Guide | Part 3: Lower Risk Investments – Cash, Cash Equivalents and Bonds

Kitch's Corner: A Young Lawyer's

Financial Guide for the Future

Part 3: Lower Risk Investments – Cash, Cash Equivalents and Bonds

If you’ve been following this series, then you’ve learned how to design an efficient budget and you’ve also been given the tools to decide the amount of risk that is appropriate for you and your investments. Now, the next step is to identify the sort of investments that will help you achieve your goals.

In these next two episodes, I will give you an overview of the most common investments available in the financial markets. As you’ll notice, I’ve decided to arrange the investments based on where they fall on the Investment Risk Ladder. In this episode, we will start with the lowest risk securities, and we’ll move on to risker assets next month. I’ve also dedicated a substantial portion of this series to providing you with some important information, tips, and things to consider before making any investment decisions.

Where Do I Purchase Securities?

Most investors will use the services of a brokerage firm (referred to as a broker-dealer/BD) to purchase investments.

Firms like Fidelity and Vanguard (“full-service firms”) are good choices for investors that want to do more than just buy and sell securities – these firms offer retirement accounts, mutual funds, and an array of other services and products. Alternatively, firms like Robinhood (“discount firms”) may be more suitable for investors only interested in trading. You may also open a brokerage account through your bank since most large banks will offer brokerage services through a partner brokerage firm.

Before opening any account, be sure to shop around and compare various brokerage firms. These days, there is immense competition amongst brokerage firms to get customers, so most are being pushed to offer more services at lower costs. As always, pay attention to fees. In particular, ask about commission fees (how much they charge to execute an order) and inactivity fees (fees charged on accounts that don’t have much activity) – note that most firms have moved to a “zero-commission” fee model.

1. Cash & Cash Equivalents:

We begin our analysis of the investment risk ladder with cash and cash equivalents which are considered risk averse due to their high liquidity and general safety.

This asset class includes checking and savings accounts, certificates of deposits (CDs), and Money Market Funds. Another feature of this class of investments is that they are easy to understand – you place your money in a deposit account, and you earn interest on the funds.

Before opening an account, make sure that you pay attention to 1) minimum investment amounts, 2) whether the interest rate is fixed or variable, and 3) whether the account provides Federal Deposit Insurance Corporation ("FDIC") insurance. The FDIC is a US agency that provides insurance of up to $250,000 for eligible deposit accounts in the event that the bank fails. (You can search for FDIC insured banks here.)

Investors who wish to deposit more than $250,000 can still be insured under FDIC. The coverage limit only applies to each eligible account and is not capped on a per person basis. In other words, you can open multiple accounts that each have up to $250,000 in coverage. For example, if you wanted to have $500,000 covered by FDIC, then you could split the total in half and: 1) invest in two different banks, 2) invest in two different account types at the same bank (like a CD and savings account), or 3) invest in the same type of account (like a CD) but open one as a personal account and the second as a joint account with a spouse or family member (for purposes of FDIC, these are considered to be two separate accounts). For more information on FDIC insurance, see here.

The greatest drawback of cash accounts is the low interest rate. In most cases, the interest that is earned seldom beats inflation. So, if you invest $10,000 a year in a cash account with a 1% interest rate, and inflation is around 2%, then you actually lose 1% of your investment each year. This drawback is particularly important today, as we are in a record low interest rate environment. Due to their safety and easy access, cash accounts are appropriate for emergency funds, everyday spending, and savings. They can also be used to park proceeds from other investments if you are not sure about the condition of the market.

2. Bonds:

A bond (or “fixed income”) is a debt security that represents a loan made by a lender (i.e., you) to a corporation or government.

In a typical bond arrangement, the issuer will promise to pay back the lender’s initial investment (“principal”) and promises to make scheduled interest (“coupon”) payments. Each bond has its own “maturity” date, which is the date the investor receives her principal back (terms vary but most are between 5-30 years).

A bond can also come with special features. For example, a “convertible” bond means that under certain circumstances, the investor can convert the bond into another security (usually common stock of the issuing company). Bond ownership does not give an investor any voting rights or ownership in a company. Also, while most bonds pay interest, some do not – and these are referred to as zero-coupon bonds (we’ll get into those later). An example of a zero-coupon bond is a U.S. Treasury bill (“T-bills”), which is a short term (less than a year) debt obligation of the U.S. Government.

Why Are Bonds Considered to Be Relatively Safe Investments?

Bonds are generally considered to be safe investments because the issuer makes a promise to repay the lender – in other words, an investor is given a guarantee that they will be paid back. However, a bond is only as safe as the borrower. For this reason, credit rating agencies like Moody’s will provide credit ratings for bond issuers (you can think of these like a credit score). For a complete list of the various credit ratings, see here.

Bonds that are rated “Investment Grade” offer the most security but lower coupon payments – these include treasury securities (considered the safest investments available), and highly rated companies. Anything below Investment Grade is called a “High-Yield” or “Junk” bond. These lower rated bonds must compensate investors for the additional risk by offering higher coupon payments. Investors in bonds should pay close attention to the issuers credit ratings – a change in credit rating may affect the risk profile of a bond, which in turn may affect its appropriateness in an investor’s portfolio.

Bond Prices and Interest Rates

When a bond is first issued, it is given an artificial value of $1,000 (or sometimes $100) which is known as “face” or “par” value. This value is important because the coupon rate is always a percentage of par. For example, a bond issued at $1,000 par with a 10% coupon provides an annual $100 payment. Par value is also important because at maturity, a bond will always repay an investor at par – in other words, if par is $1,000 and you purchased two bonds, then you will receive $2,000 at maturity (this will make more sense as you read). Once issued, the price of a bond will fluctuate depending on various market forces (in particular, changes to interest rates). A bond that is bought at a price below par is said to be bought at a discount, while a bond that is bought above par is bought at a premium.

Bond prices have an inverse relationship to interest rates, so as interest rates increase, bond prices fall and vice versa. While this might seem illogical, there is an explanation for why this happens. Most bonds have fixed coupon rates. So, if interest rates increase, then newly issued bonds are offering higher coupons. In response, the holders of older bonds (with lower coupons) have to sell them at lower prices to attract buyers. On the other hand, if interest rates fall, then the coupon rates of older bonds are now higher than the rates of newly issued bonds, so the older bonds can be sold at higher prices.

Who Should Invest in Bonds?

Bonds are appropriate for investors seeking both income and growth opportunities – and they can also be utilized by investors with varying levels of risk tolerance. For investors focused on growth investing or trading, and not looking for income, a simple strategy is to buy bonds at a discount or par and sell them at a premium – for this strategy, you are essentially betting that interest rates will be lower in the future.

Additionally, zero-coupon bonds are appropriate for investors that are not interested in income. The way they work is that instead of offering a coupon payment, a zero-coupon bond is issued at a deep discount and redeemed at par. To illustrate, if a company issues a zero-coupon bond, its par value will be $1,000 but they may sell the bond for $800. In this scenario, at maturity the investor will redeem the bond at par and receive $1,000, so their overall return on the bond is $200.

The Importance of Calculating a Bond’s Yield

For income investors, bonds can be very complicated. This is because the vast majority of investors are buying bonds that are sold by other investors, and therefore the prices are rarely at par. This difference in price will affect the overall returns of the bond. For an income investor, determining the total return (“yield”) of your investment in a bond is a critical calculation.

To illustrate, let’s imagine that a company issued a 10-year bond with a 5% coupon payment at $1,000 par, but the bond is now trading at $1,100. Since the bond is no longer trading at par, the coupon rate is no longer an accurate measure of the total return (since it doesn’t factor in the change of price). To determine the return, an investor could calculate the bond’s “current yield” – this calculation represents the return on investment if the bond is purchased and held for a year. To find the current yield of a bond, you divide the bond’s coupon rate by its current market price. In this example, the current yield of the bond is now 4.5% [(5%/1100)*100]. Essentially, that means that the $100 increase in price lead to a .5% decrease in the annual return.

The current yield calculation is just one of many calculations available to determine the yield of a bond. Unfortunately, it does not take into consideration other important factors such as taxes, inflation, or the time value of money – nonetheless, current yield is still a useful calculation. Another important calculation is known as Yield to Maturity, which represents the overall return on investment if an investor plans to keep the bond until it matures. If you are interested in learning more about calculating bond yields, this supplemental article is a good start. Also, be sure to focus on understanding the purpose of the calculations instead of the actual formula for which you can use excel or online yield calculators.

Conclusion

Bonds and cash and cash equivalents play an integral role in an investor’s portfolio. As noted in my previous article, young investors usually do not want to have the majority of their investments in these assets (subject to changes based on circumstances) but it helps to have some exposure. For example, since bonds tend to move in the opposite direction of stocks and riskier assets, they provide important diversification in your portfolio.

You can use sites like Bankrate or Nerdwallet to keep up with cash and cash equivalent accounts (they also have other helpful resources).

For bonds, you should keep up to date with prevailing interest rates (especially the Fed Funds Rate and treasury security rates) and you can also follow bond rating agencies such as Moody’s and Standard and Poor’s (S&P). Note that any interest received from interest bearing cash accounts or bonds (even if the interest is reinvested) is subject to state and federal income taxes – U.S. treasury securities are exempt from State and Local taxes, while certain municipal securities are exempt from State, Local, and Federal taxes. Any bond that is bought and then subsequently sold by an investor will be subject to capital gains taxes at the time of sale.

Tune in next month where I will discuss the remaining asset classes in the investment risk ladder – I’ll also provide more resources and talk briefly about tax considerations.

PracticePro and the writer of this article do not provide tax, investment, or financial services and advice. Always consult with a financial professional or an accountant for the most up-to-date information and tax implications. This article is not investment advice, and it is not intended as investment advice.