Miguel, a recent college graduate who heard that you know something about invest
ID: 2799833 • Letter: M
Question
Miguel, a recent college graduate who heard that you know something about investing, wants to ask about investing in bonds. Miguel indicated that, according to his friends, the stock market was too volatile and bonds were a safer place to invest. Miguel admitted that he really didn’t know much about either stocks or bonds but that he hoped to start saving so that he could purchase a house in the next 5 years. Miguel also mentioned that he had heard about preferred stock and real estate as alternatives to bonds. His roommate recommended that he buy a preferred stock that pays a $4.50 annual dividend or purchase farmland outside his hometown. Answer the following questions in a way that will help Miguel learn investment concepts.
If Miguel thinks that interest rates are going to increase, what type and maturity of bond should he purchase? What type and maturity should he avoid? Why?
Develop a checklist of rules that Miguel should use when purchasing a bond.
If Miguel really wants to purchase real estate to meet his objective, is a direct or indirect real estate investment more appropriate for him? Explain your answer in terms of liquidity, diversification, and safety.
Explanation / Answer
Answer:
1) a) if Miguel thinks that interest rates going to increase, the type of maturity and bond, she should purchase the bonds with the long-term maturity and type of bonds is zero coupon bonds. These bonds issued at discount and redeemed at par. so to maximised gain from this type of bonds, it's wise to invest in zero coupon bonds for the long term since with the long-term the inflation has a negative impact on the interest rate which will able to give better returns.
b) The short-term maturity bonds with the convertible bonds feature should be avoided by Miguel since in the short term the value of the bonds will see erosion in its value due to high inflation which is resulting in high-interest rate. This will result in lowering the investment value and decline in the value of bonds.
2.The checklist for buying a bond is as follows:
a) The tenure for which you are buying a bond: The tenure of bonds for which you would like to buy a bond is very important. It helps in determining the value of bonds over a period of time, which is directly correlated to the inflation rate of any economy. The interest rate is a function of inflation rate which determines the value of bonds in any duration.
b)Income purpose: The bonds can give you regular income with the coupon payment or interest payment on a regular basis or lump sum payment over a period of time through zero coupon payment. if the investor needs a regular income over a period of time, it's better to invest in coupon payment bond as compared to zero coupon bonds.
c)Taxable bonds income: The investor needs to know whether you should invest in bonds its income is taxable in the hands of the investor or it should not be taxable. for instance, while you buy a corporate bond the interest income is taxable in the hands of investor. while govt bonds or treasury bonds income is not taxable if you pay taxes in that country.
d)Liquidity constraints: Liquidity of the bonds determine in how many years, a bond is converted into cash so that investor can utilised the money as and when desired.If an investor needs high liquidity then shorter duration bonds are better with high-risk low income.
e)Bonds backed up: It means from which source the bond derives its value, it can be infrastructure bonds which may give value based on the execution of infrastructure projects. The longer it may take for the project to be executed the higher the risk in the bond income.
3)Real estate investment: Miguel wants to invest in real estate, I think indirect real estate investment is more appropriate for him being a beginner in the investment world. The real estate investment in a direct way requires huge money and comparatively high risk which I think it's not required at this stage. As far as an indirect real estate investment the risk component is low as compared to the direct real estate investment.
Following are the reason :
a) Liquidity: It much better liquidity in the indirect real estate such as REITs which are listed on stock exchange and can get any time buyer and seller for their products to convert their investment into income. while in case of direct real investment there is a number of procedures needs to be followed while selling or buying a property in a physical form which can be a costly affair for the beginners like Miguel.
b)Diversification: since when we invest in indirect real estate we can diversify our portfolio as per the requirement of our return and risk objective. for instance with REITs we can invest in various property at various locations so that risk can be minimized and return can be maximized. while in case of physical assets or direct investment in real estate the diversification seems impossible.
c)Safety: Safety of the principal amount is really important in case of investment. while direct investment has high potential to give higher returns so to the involvement of high risk as well.so for beginners like Miguel, it's better to go for indirect real estate investment since it doesn't involve high risk to the safety of principal amount is there.