Frequently Asked Questions

Fixed Income investing
 
 

What are fixed income investments?
There are many ways through which anyone who wants to, can create wealth for himself/herself and their progeny. As alluded to in Ques. # ____ some of these include real estate development and the creation of intellectual property (inventions, songs, plays, books) for which one should apply for a patent (to retain the monetary value of their creation). Another method of wealth creation is investing in what the trade calls Fixed Income Securities. These are investments where people lend their money to companies and governments, each of which pledges to pay a fixed rate of interest per annum for as long as they retain the use of the money loaned to them. (If the interest rate is fixed, why didn’t they call it “fixed interest” instead? It’s probably ‘six of one and half dozen of the other’! A fixed interest rate on the same principal will generate a fixed income. Bonds (Q # 30) and debentures are popular forms of fixed income instruments.


What is a Debenture? (vs. Bond @ Q 26 on Outline List)
Like a bond, the classical definition of a debenture is that it is a debt instrument, which is absolutely true to the seasoned investor! More generally though, whereas the repayment promise of a bond is quarantined by some specific asset, that of a debenture is generally backed only by the good credit and reputation of the borrower. In order to facilitate both lenders and borrowers, many big money managers create what are called Money Market Fund (MMF) Q. #_31) and invite the general public to invest in these funds. The fund managers then lend the money (savings) in these Funds to any reputable company or government who wants to borrow it. A bond is the instrument through which Fund Managers lend the money in their Funds to governments. When they lend it to a reputable company, they call it a debenture. Both bonds and debentures, somewhat like motor cars, come in various models, each with specific provisions that may appeal to different lenders/investors. A key characteristic of bonds and debentures is the fact that, like the share of a company, they can be bought and sold between investors on the secondary market. See at Yield-Q # 54. There have been some famous Bonds in the past and, over the decade of Finance Minister Omar Davies’ stratospheric interest rates (1994 – 2003), many millionaires have been created in Jamaica without lifting a finger to do any productive work or create any new asset for the country.


What of public bonds! Are there any o/s ones?
The 30 year Bond which is helping to finance the Jamaican toll roads is one of many outstanding bonds. The 10 year period of 1994 – 2003 was replete with some of the most outstanding Bonds (borrows) that anyone might ever witness anywhere on the financial landscape. Many millionaires have been ‘created’ among the people who took advantage of some very high interest rates and lent their money to the government. There is no assurance that these ‘halcyon days’ will come back again! In fact, most people who are supposed to understand has ascribed many serious economic consequences to these high rates and wish that they never again happen to this or any other economy in the CSME. To get a perspective of the period, think 52.49% if your mind can accommodate it! That is where Treasury Bills (T. Bills) See Q # 74) went in Jan 1994. Granted, T. Bill rates are for ‘short’ periods but, think ‘Rule of 72’ also (Q # 80) Many of the bonds during this period were of a type called variable rate (VR) i.e. the interest rate was not fixed for the entire tenure, but varied on the basis of other criteria. However, maybe most were of the fixed rate (FR) type. A fairly recent one was FR Investment Debenture 36.25% 2004 (Series Z), issued in April 2003 to mature (i.e. pay back the money) in Nov 2004. The period from April 2003 to November 2004 is 19 months. This 19 month period s called the tenure of the bond/loan. The focus in this bond is the very high interest rate and what this means for people who lend their money to any government that pays rates like these. At another level, the bond that is helping to finance our toll roads go up to 30 years! This means, that a lender who invested in this bond will keep getting quarterly or half yearly cheques for 30years, assuming he/she does not ‘take back’ the amount that was lent by selling his/her bond. Some 10 year bonds were issued in 2004 but at a considerably lower interest rates. One of these is FR Investment Bond, 17 %, 2014, Series “B”. Interest on this bond will be paid until year 2014.. An important point that should not be overlooked is that, if interest income from this 36.25% bond is put in the same or another bond paying the same (or a higher) rate, each lenders money will double in about two years flat according to the prediction of the Rule of 72 (Q # 80) That is, J$50,000 will become J$100,000, J$100,000 will become J$200,000 and J$1.0M will become J$2.0M without anyone lifting a stray. It doesn’t come any better than this except when the interest rate is higher!

Are there any illustrations of outstanding private bonds/debentures?
One of the most outstanding Bonds in the last 30 years could be the Daily
Gleaner’s First Mortgage Convertible Debenture Stock 1981-1992. Don’t be thrown by the fancy name! It is still a “borrows”. It is probably fair to say that it had it’s genesis (even partial) in the peculiar realities of the decade of the 70s. Part of this reality is that during Michael Manley’s first try at managing our government, many Jamaicans fled the country and most of those remaining were either broke, bankrupt or in disbelief. The Gleaner Company was, like many other companies, starving for cash (another fancy term meaning broke or near broke) and “went to the market” in search of funds. In plain language, it asked whoever could afford it to give it a “borrows” of J$4M and was very successful i.e. it got the amount asked for. The name of the instrument through which the loan was orchestrated was First Mortgage Convertible Debenture Stock 1981-1992. This loan (called a Convertible Debenture had a number of features including the one implied in its name i.e. debenture holders had the option to convert part of their loan into shares of the Gleaner company under specified conditions. One of these was that the conversion rate was 50 cents per stock unit. Another is that there would be a three year moratorium on interest payment and that, while retaining the right to pay off before time (which it did) the terms of the debenture (loan) was for it to be repaid over the twelve year period of 1981-1992. The conversion formula was up to 25% of loan repayment so that, for a loan of J$10,000, J$2,500 could be converted into 5,000 Gleaner shares. If we assume that all of this conversion was made by 1986 (the loan was paid before time) to how many, (A), would those 2,500 units have grown (throw bonus compounding) to end Dec 2004? And, (B) (discounting the lower purchasing power of money) what has been the price of the J$0.50 share over the same period? In respect of (A) the Gleaner’s shareholding has gone up by a factor 206 (5.8M-1,211M). Hence the 5,000 units are now 1,032,602 and, at a price of J$2.61/share at Dec. 31, 2004, a total market value of J$2,7M. In respect of (B), the price range of the stock has been 1986 (J$5.35) 1990 (J$5.70); !995 (J$2.38) 2000 (J$1.78) 2004 (J$2.61) If this Gleaner Debenture looks like it was a good investment, that is because it was! How many Gleaner readers, in Jamaica and abroad, were participants in this debenture and made something off a product on which they spend much of their money everyday?! (Sat 26/3/05)

What is a central bank?
The finances of a county are managed pretty much as a housewife manages her house money. Both ensure that there is enough to do the most important things. This might mean saving up to acquire something versus taking it on credit and, when something has to be taken on credit, that the repayment schedule is adhered to to avoid interest penalties Maybe the biggest differences are in the amount of money being handled and, as a consequence, the strategies which are used to do this. In most or all developed countries, this management of the country’s money is done by an independent body of people, appointed by their governments, because they know something about banking. In England, it is the Bank of England. In the USA it is the Federal Reserve. Usually, these ‘banks’ are called central banks because, they don’t do commercial banking. Instead, they manage the banking industry in their respective country. Politicians do not dictate to these central banks in developed countries. Unfortunately, in the opinion of many, all or most dependent countries with struggling economies and rampant poverty are in that position because their politicians give instruction to their central banks and most times dictate the strategies that suit their political agenda versus those that serve the best interest of their countries. Two of the main function of a central bank are protect the value of its currency while also ensuring its adequacy…neither too much nor too little. Major under or over supply can create many serious economic and eventually social problems.

What are Treasury Bills (T-Bill)?
Central banks have a range of tools, or instruments, that they use to regulate money supply. Treasury Bills, usually called T. Bills, are one of these many strategies. In specific terms, it is what the trade calls a negotiable debt instrument. In effect, it is a loan to governments for periods of less than one year. It is called negotiable because the person who is making the loan i.e. buying the treasury, can negotiate the rate of interest that he gets on the ‘loan’. Central Banks usually use the 6 month ‘Treasury’ to send a massage about interest rate to commercial banks and the general public. As a result, when a government “issues’ what is called a Variable Bond, (see Q # 30) the reference to interest rate is normally to this 6 month Treasury.

What is a Local Registered Stock? (LRS)?
A Local Registered Stock or LRS is another of the instruments that central banks use to regulate money supply and interest rate in the economy. They are usually bonds (see Q # 30) of not too long tenure, maybe five (5) years or so. One major difference with T. Bills is that the interest rate on T. Bills can be said to be negotiable whereas, with LRSs, the central bank sets the rate and the customer (citizen you and I) either ‘take it or leave it’ ie buy it or not buy it through whatever intermediary we use (a MMF or a broker.

What are 'repos'?
The term ‘repo’ stands for Re-purchase Agreement. To get the essence, think of it as a ‘buy back’ agreement! It is another of the many tools or instruments that central banks use to regulate the amount of money in circulation in a country. Private financial institutions also use it as one of the tools by which they raise money for their own operations and, in the case of banks, to lend to their customers. The way it works is that the bank (central or commercial) is said to ‘sell’ citizen A a repo for, say $100 for three month and, simultaneously, give him an ‘agreement’ to ‘buy’ it back from him at the end of that time for $110. In effect, the difference of $10 will be citizen A’s profit for giving the bank the use of his $100 for three months. This profit confirms that citizen A actually lent the bank his money despite the confusing language about him ‘buying’ the ‘repo. To clarify, think of bank B as the initiator of the process ie the seller who buys back the ‘repo’ and everything will fall into place.

What are reverse repos?
A ‘reverse repo’ is the flip side or reverse of a ‘repo’ as illustrated Q # 76) Many times, this reverse repo is used by central banks to sets the tone for interest rate

What is meant by the term ‘cash reserve ratio’ in banking?
The cash reserve ratio (CRR) is another of the tools that central banks use to regulate and monitor the financial sector. It is the amount of a commercial bank’s deposits that the central bank can dictate that they (commercial banks) put into it’s vaults (central bank’s) for ‘safekeeping’. What this does is effectively take that amount of currency out of circulation. One of the many complaints about this CRR by the commercial banks is that central banks usually do not pay any interest whatever on this deposit (which is said to be sterilized) and hence they are thus forced to charge higher interest rates to their clients to make up for the shortfall of interest income foregone from the sterilization. This is because, after ‘paying over’ their required cash reserve ratio, they have a smaller amount of deposits from which to lend to their customers. In the decade of the melt down of the Jamaican financial sector (the 1990s) the CRR went as far as about 25 cents in each dollar of a bank’s deposit

What are zero coupon bonds?
When a Bond is “issued” (i.e. somebody borrows money), it usually carries a
fixed rate of interest per annum which it will pay to the lender, usually called a bondholder. This rate of interest is called its coupon rate and will be paid at the stated periods (quarterly, half yearly e.g.) for the full tenure (time the money is borrowed) of the loan. At each payment period, the bondholder would surrender a coupon for his interest payment. It is this guaranteed coupon, especially when it is high, that makes Bonds so attractive, especially to retired people who depend on it to help with their living expense (versus re-investing it to make the principal grow). In recent times however, some Bonds have been designed with no coupons for periodic interest payments. In these cases, the arrangement with bondholders is that they will wait and get their full interest along with their principal at the end of the full loan period. Because they have no coupons, they are called ‘zero coupon’ bonds.

What is the ‘rule of 72’ and what is its significance? (Ques # 40 & 71)
The Rule of ’72 is a formula for predicting the amount of time it takes the money in an investment to double in value under specified conditions. It says that “money will double in value in a time equivalent to 72 divided by the rate of interest at which the investment is made!” The specified condition (condition precedent) is that the yield (interest) from the investment be re-invested (versus being consumed as is the case most times) into the same or another investment earning the same rate of interest. For example, a J$100,000 Bond (or other investment) earning at the rate of 20% per annum would double to J$200,000 in 72/20=3 years and nine months (3.75)!! Every investor should test this rule! Every individual, parent and grandparent in the Caribbean Diaspora should use this rule to build wealth for him/herself, their children and grand children

Can this ‘rule of 72’be illustrated?
Yes! One expects that almost any of the MMF in the Caribbean could be used to illustrate this ‘rule’ The MMF s in the region are.
a) Jamaica: Barita Unit Trust Ltd; Capital & Credit Asset Managers Ltd;
DB&G Unit Trust Ltd; Pan Caribbean Asset Management Ltd.
b) T&T
c) Barbados
d) Eastern Caribbean
See yield table on next page and the extent to which these funds have performed. It is said that ‘a rising tide floats all ships’ and, in the environment of very high interest rate in which these Funds operated up to now, it would be nigh impossible for them not to do well. Even so, high marks are in order for the Investment Managers. Also, whereas the yields do not speak directly to the ‘Rule of 72’ it must be noted that these Funds are designed to do what one might call automatic interest re-investment (see Q # 51) because, the net earnings of these Funds come back into the pool . This is one reason for the growth in the value of units.

The four Money Market Funds in Jamaica have had returns as follows;
Name Starting Date Unit Value @ start Unit Value 31/12/04 % Appreciation Ave Annual % growth
Barita Unit Trust 3/96 1.00 4.98 398 45.49
C&C Asset Mgt.     6.50    
DB&G Unit Trust 3/94 1.00 11.90 1090 101.4
Pan Caribb Asset 8/94 1.00 8.98 798 76.18

There is much practical significance in these average annual growth rates as follows:
a) it took Barita 72/45.5 = 1yr & 7mths to double each dollar invested in that Fund
b) it took Pan Caribb 72/76.18 =11mths to double each dollar invested in that Fund
c) it DB&G 72/101.4=9mths to double each dollar invested in that Fund


What is a convertible bond?
At Ques. # 72, it was stated that the Gleaner floated a very successful Bond for J$4M in 1978 to finance its operations. This bond was called the “First Mortgage Convertible Debenture Stock 1981-1992” The term “First Mortgage” has a very special meaning but we will only focus at this time on the “convertible feature” of this Bond. Three of the principal ways of capitalizing an enterprise (i.e. putting money into it), are capital infusion from owner/directors, infusion from the capital /equities market (ie invite people to buy shares using the appropriate procedure or, “loan financing” i.e. borrowing the money from the bank, family, good friends or the same capital market. When this money is borrowed from the market, many borrowers try to find ways to ‘sweeten the pot’ i.e., make the instrument very attractive to investors. Where the money is to be invested in a listed company, one way to do this ‘sweetening’ is to offer them (investors) the option of converting all or part of their loan into the capital of the company. Where a lender surmises that it will be in his interest to do this because the loan recipient is doing well, he may wish to exercise this option. The Gleaner offered this option, hence the ‘convertible’ in the name of the bond. One suspects that many of the bondholders would have elected this option. As illustrated at Q # 72 they would have been very richly rewarded by dividend (Q # 46) and capital gains (Q # 48) over the years since.
 

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