PREFERRED STOCKS MAY NOT BE BETTER AFTER ALL

Some time back I did a post about preferred stocks where I concentrated on the advantages that they had for conservative investors.

A small  run-through is that;

1- In the unfortunate event of liquidation or in profit sharing preferred stock holders are paid before common stock holders.

2- The cumulative nature that preferred stock dividends have in that unpaid dividends are forwarded to the next financial year. This ultimately means a higher payday because of compounding interest.

3- The non fluctuating dividend payment that is paid to preferred stock holders make it even more attractive mostly to people that live on regular income from their investments and the conservative investor looking for the security of regular checks in the mail.

4- The occasional voting rights that the preferred shareholder has during important times in the company like election of new directors makes this investor feel like he has a part to play in the business.

But be that as it may, aggressive investors tend to shy away from this type of stock, while favoring common stock because of the following reasons;

1- The preferred shareholder is dependent on the desire of the company to pay dividends on its common stocks. Once common stocks are omitted, this shareholder finds himself in a bit of a problem since directors have no obligation to pay him any dividends. Like for instance very successful companies do not pay dividends to their commons shareholders e.g. Microsoft and others, means that a preferred stockholders should not expect much in the way of periodic checks in the mail from such companies.

2- Since we above that the dividends(when paid) are fixed, this means that in highly profitable times this shareholder will not be entitled to more that his fixed share(the given percentage due to him). So he must never get excited when a company declares major profits in a certain year.

3- Preferred stocks lack the legal claim of a bond holder (e.g. in times of liquidation, the preferred shareholder has a higher chance of losing his invested capital than the bondholders-who are creditors of the business) or the common shareholders who are more like partners in a company because of their obvious advantages. This weakness is mainly seen in bad economic times like recessions and depressions when the risk of default comes a knocking.

4- Finally they have better tax advantages for corporations than individual buyers. Corporations  pay taxes on part of the dividends rather than the full amount. Let me illustrate. Supposing by law the corporation is to pay taxes on 20% of the dividends that they get in a year and the corporate tax is 40%. And assuming that the dividend is $200[all these are hypothetical figures]. The corporation will pay corporate tax* taxable income* dividend i.e. 0.2*0.4*200=$16. Whereas the individual preferred stock holder has no tax break and has to pay tax on the share of the dividend received i.e. tax* dividend= $200*0.4=$80. This shows that they are really not that attractive to an aggressive shareholder and there is a disservice to the conservative preferred shareholder.

BTW the hypothetical numbers I have used change with time and country but the same logic is used

If not for the corporations, the only time to but the preferred stock is during periods of economic adversity when they are at a major bargain i.e. they are selling at a price well below par.

So preferred stock may not be better that common stock but it all depends on one’s point of view. Your opinions on this new perspective are welcome.

THE GENIUS OF THE ORACLE OF OMAHA

I am a personal finance blogger and there is no secret that i love Warren Buffett. I have linked to most articles that i have ever read of him, the most recent being “invest like the richest“

I like the investing style that he crusades that is so different that what i hear from most financial pundits. He proposes, among other things, a thorough analysis of the fundamentals of a business before investing in it i.e. invest in a business that you would have no problem owning even in a financial crisis. This seems more sensible advice that those that say buy stocks when prices are going up and sell when the prices are going down.

I am also carefully reading “the intelligent investor” a book that focuses more on the mentality that an investor should have in stock selection and a myriad of other things.

I have just found another article on the second richest man in the world that is basically talking about what a good past 18mths that he has heard and his most recent deals he has made.

Sort of makes you wish you were in his shoes huh?

WHY THEY CALL THEM JUNK BONDS

This is a type of corporate bond that is has a high risk of default and thus offers high yields.

A salient feature of bonds is that their risk of default depends on among other things, the credit worthiness of the issuing company. If the company has low credit worthiness, there is a higher risk that the bonds they have offered have a higher risk of default. This risk is normally felt in economic slowdowns when most of these junk bonds default at around the same time, which has happened quite a few times in the past and will happen in the future taking some junk bond investors with them to their graves.  To counteract this, these bonds give unusually high yields that more often than not cannot be sustained in the long haul.

To copy-paste Wikipedia, since the term junk bond is synonymous with risk, the types of risks involved are interest rate risk and credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Interest rate risk refers to the risk of the market value of a bond changing in value due to changes in the structure or level of interest rates or credit spreads or risk premiums. The credit risk of a high yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency including Fitch, Moody’s, or Standard & Poors.

The yields are like 3 to 9 percentage points higher than government bond issues

As there is a high risk of an investor losing his invested capital, there is also a chance of him getting spectacular returns if he managed the risk involved well and he did his research well on the bond and the issuer. But in this, there is a lot of speculation. But still many investors take on the risk with the hope of higher returns but try to lessen this risk by a somewhat broad diversification in these corporate junk bonds and limit these high risk investments to a small part of their portfolio.

In light of the above, the other two names of junk bonds are high yield bonds and speculative bonds or non investment grade bonds.

These bonds have a low credit rating mainly because the issuing company is not financially stable e.g. like a young company with no other ways of getting much required funding or any other financially troubled institution that has very little in the way of raising funds for operations [bond offering is one of the last money raising options that most corporations have because the banks may not be willing to loan them the large amounts needed]-

Here is a long linked article about the history of junk bonds and the strange case of billionaire Michael Milken, the Junk Bond King.

That is basically the Junk bonds for you, any questions and/or comments are welcome

INVEST LIKE THE RICHEST

We all know who Warren Buffett is-also called the Oracle of Omaha. In the financial world he is looked up to and emulated by all the investors who want large numbers of Zeros in their bank accounts.

Anyways, a few days ago, i was reading through yahoo and i found an article that was reviewing a new book about him called the Warren Buffett portfolio. It basically talks about the psychological mindset that he and other accomplished investors have developed that have worked to their benefit. It is not a book about hot stock tips that will make you rich overnight but a mindset that will surely help you all your investing life.

Here the linked review in the Warren Buffett portfolio. Please read through

I haven’t read it partly because i haven’t got a chance to but judging from the review, it is more or less like ” the intelligent investor- Benjamin Graham”(which i am currently reading). Incidentally it was endorsed by Warren Buffett as the greatest book on investing ever written.

So i guess this young investor is on the right path

THE CONSPIRACY OF THE RICH; A BLOGGER’S PERSONAL REVIEW

For those who don’t know, Robert Kiyosaki (of Rich Dad Poor Dad) has written and published another book that is called the conspiracy of the rich. It is available for sale at amazon.com and it is on the New York Times best seller list. Before it was published, I had the chance to read it for free as he was giving it away chapter by chapter as an online interactive book. (How’s that for a money hack?)

(By the way this is no affiliate program, just a personal opinion of a personal finance book).

In not so many words, the book covers the recession, some of the history of the world vis-à-vis money and true to himself, how to beat the game and become very rich. This last thing he does by giving tips for investing in the stock market, real estate, gold and other things.

I found it very interesting and educative. To say the truth, it is how I came to understand what the recession was all about. My head was just reeling around as I listened to the news but after reading the book, I understood what was happening, to some extent anyways.

Basically, the book is in two parts with the first part having five chapters and the second having seven chapters.

In the first part, he goes into a brief history about money and how it is connected with the recession. But the pith of the book is dedicated to “the new rules of money” that this recession has heralded. This is what I am going to concentrate on.

OLD RULE- save money, NEW RULE- spend money. This change has been brought about by compounding inflation and thus one must increase his/her financial education to spend (read invest) in ways that will make you richer.

OLD RULE- diversify your investment portfolio, NEW RULE- focus and specialize. This change is put forth partly by a statement that Warren Buffett said- “wide diversification is for investors who don’t know what they are doing”. Instead one should learn a few types of investment very well and invest in them. This is in accordance his argument that savers are losers.

NEW RULE- money is knowledge. Here he says that you do not need money to make money, you just need to know the right things. The example given is the ability of making money by selling stock that you don’t own i.e. shorting stock and pocketing the difference (details are in the book).

NEW RULE: learn how to use debt. Here he says that there is a way to use debt to get rich-the good debt like a loan for an investment and avoid bad debts like using credit cards to buy televisions. I found this as another sensational way of saying that one should be frugal and a good money manager.

NEW RULE: learn how to control cash flow. According to him, this is done by being very informed by the global flow of money, jobs and people so as to make wise investment decisions based on this information. (This seems to make sense to me).

NEW RULE; prepare for bad times and you will only know good times. Robert says that everybody should act as if the worst is not over and constantly live as if the sky is falling. In preparing for the worst, a person will see better times. For instance, if one prepares for an inflationary depression that never happens, it means that later on your money will have a greater value, means that you will be richer.

NEW RULE- the need for speed. I know it sounds like the racing computer game but what he is really talking about is looking for ways to do more business in a shorter time to a larger audience, as in using the internet to transact business. This is aimed to make more money than the banks are printing (this is also covered in depth in the book).

NEW RULE- learn the language of money. Robert says this is to be done by getting to know the financial terms and investments available and being able to understand financial speak on tv and websites and in the papers etc. it  is much easier to grow wealth if you know what you are doing instead of gambling away hard earned cash in hot tips.

NEW RULE- focus less on buying and more on selling. In other words, he is advising people to look for their entrepreneurship spirit to get financial independence and control the amount of cash that you spend. This means that more money will be coming in than going out to enrich others and thus you grow richer.

NEW RULE- life is a team sport. Choose your team carefully. He proposes this according to the advice in his other book, rich dad’s guide to investing, mostly the BI triangle. He says that the worst is not over and everybody should start preparing his/ her financial team together. He neglects to show people exactly how to do this but he gives the example of his own financial team. While I am not so sure about how to go about this, it seems like logical advice to have a team in your investing endeavors.

NEW RULE- Since money is becoming worth-less and less, learn to print your own. I know this sounds like the felony of counterfeiting but there is a point that he seems to put across in this second last chapter. In stocks he says to use options, in gold and silver, he says to build and gold and silver mines and sell the shares in the stock market(again, he does not go into detail on exactly how to do this).

Basically these are the new rules of money that the recession has brought forth. While this is the most prominent part of the book there is also a lot of information like capitalism and socialism, things about the Federal Reserve, economic depressions, interesting timelines, “frugality being the new cool” and a large wealth of information but I chose to get into the rules of money as this is what really fascinated me. There are also issues he calls financial fairytales. These are common misconceptions that the average investor has been living with. The setting of the book is(was?) in the global recession and so there is a lot of reference to what was going on at the time the book was being written like the Bernard maddoff ponzi scheme, the bailouts, the presidential election etc. there also quite a lot of reference to his other books like rich dad poor dad and rich dad’s guide to investing.

I found this book somewhat useful to read as there are a lot of things that I learnt about finances. Has anyone read this book? What do you think of it??

WHAT YOU NEED TO KNOW ABOUT GOVERNMENT BONDS

Just like corporate bonds are IOUs by the companies issuing the bonds, government bonds are IOUs to the general public to borrow money that will be returned at a predetermined time at face value with interest payment periodically up to maturity.

Governments issue these bonds when they have more money needs than can be satisfied by tax revenue. Another reason is to regulate the amount of money circulating in the economy. If there is too much money (which can cause inflation), the government issues bonds that it will buy back (redeem) at a given future date and this reduces the money supply. It does the exact opposite when there is too little cash in the economy i.e. redeems the already issued bonds.

They also have other names in other parts of the world. In the UK they are called gilts or gilt edged securities and in the US they are called treasuries. Also bonds issued by governments in foreign countries are referred to as sovereign bonds.

To some extent these government bonds reflect what will happen to interest rates in the future. If interest rates are expected to rise, investors will sell to keep any capital gains and prices will fall. This is because as interest rates rise their prices fall. On the other hand, if the interest rates are expected to fall investors buy for the higher yields that the bonds have as at that time and for the future capital gains, means that their prices rise. It goes without saying that anything that affects interest rates, inflation, economic growth and expectations about both also affects these bonds.

As am sure you have come to learn that more often than not returns in investments like bonds and mutual funds are directly related to risk i.e.  the lower the risk the lower the returns and vice versa, this means that governments bonds are good for the conservative risk averse investor that does not want to risk hard earned money and doesn’t necessarily require high yields. An investor like this would be interested in risk government bonds because of the higher safety in that at maturity, the government can raise taxes to get enough cash to redeem them and thus a lower risk of default.

Other than a steady fixed income in the form of interest paid either annually or semi annually, the low risk of invested capital invested if bonds are held to maturity, a fixed date of maturity, they have a provide a more diversification to a portfolio mostly dedicated to more risky investments(everyone needs safety once in a while)

The best time to but the government bonds is when they are first issued because buying them from the secondary market since expecting to profit from them here has a number of variables like the time to maturity, market interest rates, credit worthiness of the issue (the risk of default) and the liquidity of the bond(some bonds are virtually impossible to sell at certain times). Also if an investor pays less than the face value of the bond(at a discount), he stands to profit when the bond matures to its face value. If he buys at face value or at a premium(above), there is a higher likelihood for a loss when the bond matures.

Another good thing is that you do not have to wait until maturity to sell the bonds. You can sell them in the secondary market and profit if the interest rates have gone down since you bought the bonds and lose if the rates have gone up. There is a lot more on this in a small fascinating government bond post that I have just found. Please read through it because their explanations contain figures and ease understanding.

That is an overview of the government bonds. I will take you deeper into them in future so sit tight.

SENIOR & SUBORDINATED CORPORATE DEBT EXPLAINED

Yesterday’s post was about corporate debt of which there are two types secured & unsecured debt and senior & subordinated debt. We will look at the latter in this post

Senior debt is a secured debt in that it is the primary debt that is paid off in the unfortunate event of an issuer’s bankruptcy. Most high grade debt securities are senior debt and also loans from financial institutions. Since they are secured, this means that secured investors receive lower yield that their unsecured counterparts.

In the words of Wikipedia, senior debt is a class of corporate debt that has priority with respect to interest and principal over all the other classes and equity that an issuer has.

In most cases the law states that taxes and certain payments to employees be paid before creditors have their share of a dying company.

The opposite of senior debt is junior debt also called subordinated debt.   It is a corporate debt that is serviced after senior debt(secured debt) in the event of liquidation. It goes without saying that a subordinated debt holder is exposed to more risk that in the senior debt holder because he will be paid by the portions left over in the loan repayments. This could be a portion of his initial capital.

A little about subordinated debt is that a company issues it as a last resort in that it has already used its assets to back up senior debt but the money obtained is not enough and so they issue this corporate debt. It is more expensive to them in that they have to pay higher interest rates to the investor because he bears most of the risk in case the company goes bankrupt.

Also not all companies can issue subordinated debt. Only those with good reputations and high credit worthiness find this debt somewhat success as no investor want to loan out cash to a company with a reputation of defaulting.

But for the risk tolerant investor, even though there is a large possibility in losing invested capital in the case of bankruptcy, there is also the chance of a higher pay off if all goes well. But this is pure speculation as there is no way of knowing a company’s future. But still an investor will insist on details of a company’s financial records and past performance.

Finally this linked Wikipedia article has quite a lot to say about subordinated debt

That is senior and subordinated debt for you. If you have any questions or additions, the comment box is all yours.

AN OVERVIEW OF SECURED & UNSECURED CORPORATE BONDS

Yesterday, I did a post on corporate bonds and Wikipedia stated that there were two types of these bonds;

-secured and unsecured bonds

-senior and subordinated bonds

I will run through secured and unsecured bonds and the next post will deal with senior and subordinated bonds

Secured corporate debts are bonds that are backed up by the issuer’s (company giving out the bonds) physical assets. This means that if the company is not able to pay back the debts to investors, these assets are liquidated to pay them.

These assets are stocks and bond holdings, furnishings and/or real estate. Because of this backing, they are normally better investments that their unsecured counterparts.

According to wisegeek, secured bonds are not 100% safe investments but the risk is substantially reduced with the asset backing. For instance, let’s say that a secured bond is backed by a mortgage. This means that in the event of liquidation, the mortgage will be transferred to the new owner (the investor). But there is no guarantee that the mortgage itself will not default (there has been a lot of this in recent times) or if the underlying real estate will still be worth the value of the mortgage. But this is better than no backing at all. Wouldn’t you agree??

Needless to say, unsecured bonds are not at all backed by any physical assets but by the credit worthiness of the company issuing these bonds.

They are also called debentures so let this not confuse you

The fact that this debt carries more risk to the investor means that it becomes more expensive for the issuer which is in terms of higher interest rates to the investor. But this is not to say that if the issuer goes bankrupt the unsecured creditor will not be paid. Far from it. He will be paid but after the secured creditors which means that they may get a smaller portion that the secured investors.

To understand this pay back scheme in the event of a bankruptcy, secured creditors are paid first and then the next group is the unsecured creditors, banks and financial institutions, insurance companies etc(the general creditors companies have). Finally preferred and common shareholders are paid last.

As the unsecured bonds have higher yield, they are more attractive to risk tolerant investors.

That is basically an overview of the secured and unsecured corporate bonds. There are other things that I have left out like the types of unsecured bonds and what not which I will cover later. This was just to familiarize green readers

CORPORATE BONDS & CORPORATE BOND FUNDS EXPLAINED

First we will look at corporate bonds and then their corresponding mutual funds.

I recently covered the bond funds and mentioned the types of bonds.

Basically corporate bonds are debt instruments by which both private and public corporations (referred to as the issuer) use to raise money to expand their businesses by borrowing money from the general public. They have a relatively long maturity period(at least a year). Their corresponding shorter term securities are called commercial paper. The insurance of the corporate bond is the credit worthiness of the company and sometimes the company’s physical assets.

BTW corporate bonds are riskier investments that government bonds since with the latter, the government will just increase taxes and print more money so pay bond holders- something that unfortunately corporations cannot do. Therefore to counteract this higher risk, investors are offered higher interest rates.

In the agreement the principal is to be returned at a predetermined date until which you will be getting interest payments from the issuer. This is one of the major differences between corporate bonds and stocks because even though and investor gets interest payments from the company, he does not have any ownership interest as in the case of a stockholder.

Another interesting feature of corporate bonds is that they have call provisions/call options that allow the investor to redeem get his money back before the maturity date.

In investing in these bonds, the major thing that you should look for is that if the company has enough money to repay and the fixed interest so in a sense you could say that you have become a bank to the corporation

Wikipedia says that there are other types of bonds called convertible bonds that allow investors to convert the bonds into equity

Finally, as they are traded in the markets, their prices fluctuate a lot more or less like stocks.

Of late, corporate bond yields have been very good unlike in the recent years and this is because of this recession, Banks were wary about lending money in volatile times and since the companies needed money the encouraged bond holders with attractive interest rates.

According to thisismoney.com (and coincidentally Benjamin graham- the intelligent investor) the main risk for bond investors is inflation. If central banks see as if the economy is slowing down faster than the rising prices, they tighten monetary policy and this leads to the interest rates of bonds rising and their price falling, making investors wish that they has kept away from them.

In light of the above, the corporate bond fund is a mutual fund that invests in these corporate bonds. They make it easier for a small investor to invest in the somewhat complex bond market. Since the fund manager wants to maximize returns he selects corporate bonds (investors have no control over selection) and sometimes the bonds are not held up to maturity. This therefore means that interest payments fluctuate. Also these funds have low volatility and this yet another reason that they are good for risk aversive individual investors.

The corporate bond funds were hit hard by the recession just like the lower rated bonds.

Finally this linked article that I have found shows that one must never get into an investing craze because of the masses by showing the major losses that investors suffered because of this misjudgment.

That is basically the corporate bond and their corresponding mutual funds. Any additions or corrections or whatever are welcome.

WHAT REALLY CAUSED THIS RECESSION??

To the above question, i have just an inkling but there is an author/writer that has a more detailed and credible argument on this economic catastrophe.

A while back, i did a post on type of economic depressions and for some strange reason the post still gets a lot of traffic. Anyways, i was reading through the forbes website and i found a really fascinating article on the great depression of 1930,

It basically tries to explain the relationship between that depression and capitalism and what has been done to curb a repeat. It is quite the interesting read even though somewhat long.

Over to you. Do you think that there is going to be another great depression in the future?? Speculation on this is allowed. You do not have to be an economics expert to contribute. Personally i think that this excessive money printing by the major economies may cause an inflationary depression. What of you??