Tips on investing in stock market to enjoy high returns

Last week we covered about some of the ingredients of success in investing in shares (or equity).

We ended the article by this statement: “as much as possible try to put a financial cushion, you will reduce the chances of raising cash by selling stocks/shares when the market is crashing. Of course one way of achieving such an objective is to invest in fixed income instruments such as bonds — given their contractual nature of paying fixed amounts in pre-agreed periods”. So, today’s article we cover investments in bonds.

When you buy a bond, you are basically making a loan to a government (if it is treasury bonds), or a company (if it is corporate bonds), or a municipal (if it is municipal bonds) or some any other entity on that matter.

As it is the financial markets loves to make the idea of investing in such financial instruments as bonds seem complex, but if you look at it — it is pretty simple. Bonds are loans. When you lend money to the central government, it is called Treasury bonds, when you lend money to a city, or a municipal or a local government, it is a municipal bond, when you lend money to a company such as NMB Bank, or Exim Bank or TBL etc, it is a corporate bond.

And when you lend money to a less dependable company and hence a high risk company, it is called a high-yield bond or a junk bond. You see! it is that much simple — do not let anyone tell you how complex the concept of bonds is, simply because it is not.

So, how much can you earn as money lender (or often called a bond holder)? — the answer is, it depends. In normal cases, lending money to the Government you may not earn as much — why? because there is little chance that the government may renege on its debt — why? because it is significant repetitional matter when a government fails to honour its bonds obligation. It basically impact the overall cost of funding in the economy.

I said in normal cases, however, we have observed many a case where loaning money to some governments is a way riskier that loaning money to a corporate entity.

So the interest rates in such governments’ treasury bonds ought to be much higher because of the risk related. Now, it is unfortunate for such a situation to happen, because as I said earlier it impact interest rates (cost of funding) in all other financial instruments in the economy — why? because yields in government bonds are used as benchmarks in arriving at other financial instruments’ interest rates. However, whatever the case — these are matters of trade-offs between risk and reward.

A good analogue of what I am saying here as it relates to risk and return would be that of one government (or entity) asking you to cross a traffic-free rural road somewhere in Butiama on a sunny day, and another government (or entity) is asking you to cross a busy high-way in the city of Dar es Salaam on a rainy stormy night while wearing a blindfold — now that is too dangerous.

That is how one need to consider the issue of risk as it relates to the entity that issues bonds.

What it is however, is that normally the odds that a company will go into bankruptcy and fail to pay its bondholders are higher than the odds that a credible and well governed government will default on its loans.

So the company has to pay a higher rate of return to its bondholders compared to a government. This addition amount of interest rate is called a risk premium. Similarly, a young and small company in a risky business that wants to borrow money by issuing a bond has to pay a higher rate than a blue-chip, good brand and established company. So, whenever contemplating on investing in bonds consider this fact as well.

In other parts of the world rating agencies like Moody’s, Standard & Poor, Fitch, etc provide ratings for companies, and these rate grades are used to benchmark risks and hence interest rates.

The other critical factor for investments in bonds is the duration of the loan.

The Tanzania government will currently pay you about 10 per cent per annum for two 2-year bonds; 12 per cent per annum if you lend the government for 5-year bonds. If you lend that money for seven, 10 and 15 years the government will pay you 14 per cent and 15 per cent respectively.

And of course there is a reason why you receive a higher rate for lending the money over a longer period: it is riskier.

So, why do people want to own bonds? For a start, as we indicated last week and in the opening of this article — they are much safer than stocks.

That’s because the borrower is legally required to repay you, and at the agreed rate and periods. If you hold a bond to maturity, you will receive all your original loan (called principal) bank, plus the interest payments — unless the bond issuer goes bankrupt.

As an asset class, statistics — globally, indicate that bonds deliver positive calendar-year returns approximately 85 per cent of the time. (Continues next week)