Personal financial planning 101
The Sterling Report
"TWAS the night before Christmas, when all through the house, not a creature was stirring, not even a mouse."
I am sure most of my readers must be thinking at this point "Which rock are you under, it is summer, not Christmas!" Here is my retort: "Planning is what's on my mind." If you have been good all year, Santa could be good to you this Christmas. That means it could be a good time to start sowing those fiscal seeds.
For some time now the market has been relatively quiet. There have been a few positives in the domestic market, like the previously couched, now blatant, encouraging support from the IMF. This has had the effect of increasing liquidity in the domestic market as some amount of confidence has returned, in a somewhat limited way to the local market, but certainly to the international market. The latest issue of US$800 million Government of Jamaica debt at 7.625 per cent is testimony of this, especially when one considers that the issue was over-subscribed by over US$300 million.
Emerging market bonds have recently been seeing increased global interest as large international investors make a play on the risk/return strategy by looking to these markets for higher returns than they are likely to get on higher quality securities.
However, recent developments have caused analysts to take a second look at the market situation in attempting to assess its future direction. In a recent speech, Janet Yellen, head of the US Fed Reserve Bank declared that the market can look for increased interest rates in the coming year (in the US).
Many analysts have said that they are no longer able to use these pronouncements to determine how the market will react. This is because all the general rules of thumb have been dashed by the experiences of the past few years.
Investment planning strategies for the coming year
How will an increase in interest rates affect investors? Different investors invest for different reasons. Let us look at an investor whose primary objective is income; for example, someone who requires regular quarterly interest payments in order to take care of everyday living expenses. First, the investor will determine an amount that he can live off for a specific period; let's say this is US$6,000 per quarter. Suppose the investor has a principal amount of US$300,000 to invest for this purpose, then instead of withdrawing the US$6,000 from his principal, the investor would buy a bond which will allow him to achieve interest quarterly of US$6,000. In this investment climate where interest rates are relatively low, the investor would have to look for a bond paying an interest rate of about 8 per cent per annum. This would mean that the investor may have to look at taking some significant risks as not very many investment grade bonds now pay interest of 8 per cent per annum. That said, this investor would not be looking at selling his bond anytime in the near future, unless he is getting a bond which will give him a higher quarterly return. As such, a higher interest rate in the near future which will have the effect of lowering bond prices will not have any significant effect on this investor, unless it is envisaged that the lower prices are a signal of a default. Based
on Janet Yellen's pronouncements, we can rule out such a signal. This means that the investor will continue to achieve his objectives of earning US$6,000 each quarter to pay his bills.
It appears that one way for investors to survive in a climate of increasing interest rates is to take advantage of bond prices if and when they decline, as may occur in the coming year, by purchasing more of these bonds at the lower prices. The concept is generally known as "averaging down", and can significantly improve one's wealth if successfully done. This occurs when an investor knows he has bought a good instrument but for various reasons, including the increase in interest rates, the price falls, but is expected to recover when the investment climate changes/improves.
It must be noted, though, that the current state of the global economic climate can still present opportunities for capital appreciation on investments, particularly bonds, as the global economies show signs of improvement. This is part of the conundrum former FED Chairman Ben Bernanke referred to, since the experiences of the past few years have shot all predictability out of the water, and investment analysts have to now re-think their models when trying to assess the direction of the markets.
Pamela Lewis is Vice President, Investments and Client Services at Sterling Asset Management Ltd. Contact: email@example.com or visit our website at www.sterling.com.jm.