You have bought a 1-year CD for $10,000 at 5% interest rate. After one year you collect $10,500 – a gain of $500. What is your real gain? This depends on what $10,000 can buy one year later, compared to what it does now.

Inflation, the rate at which the prices of goods and services grow with time, will reduce the purchasing power of your original $10,000 investment after one year. Changes in the consumer price index, or CPI (computed as the average price of consumer items purchased by a typical urban family of four), is the standard measure of inflation .

At the current annual inflation rate of 2.5%, you will pay $10,250 after a year to maintain the purchasing power of $10,000 today. So, in effect, what you really gain is $250 (=$10,500-$10,250). In other words, your real interest rate, which defines the growth of your purchasing power, is 5 – 2.5 = 2.5%. The original 5% is the nominal interest rate, which determines the growth of your asset.

Suppose the real and nominal interest rates are r and R, and i is the inflation rate. If the invested amount is a, then the nominal increase after one year should equal the real increase multiplied by inflation. That is, a(1 + R) = a(1 + r)(1 + i), which gives r = (R – i)/(1 + i). When i is much smaller than 1 (like in our example, where 0.025 << 1), we have the approximate relationship

r = R – i.

This is a formal way to present our example. So, higher the inflation, less is the real gain from a fixed-income type investment. Interest rates offered by both the money market and bond market securities are only nominal rate, which you should keep in mind while estimating your asset growth.

Go on to what determines the real interest rate.

Like money market, a bond market is a debt instrument issued by both the US government and corporations to borrow fund from public. But there are two differences: a bond market has longer term maturity, and bond returns are not always fixed (and so it is not totally correct to categorize them as fixed-income securities).

Following are the common bond market instruments.

Treasury Notes and Bonds

“T-note” and “T-bond” in short, these are government debt securities (like T-bill in money market) sold in denominations of $1000 or more. Maturity of a T-note is up to 10 years, and T-bonds mature between 10 and 30 years. Interests are paid semi-annually based on the specified annual rate. For example, at 4.5% annual rate, a $1000 T-note will pay you $22.5 every 6 months. Because they are backed by the government, these securities are safe investments.

Municipal Bonds

These are issued by the state and local governments, and the interest earned is exempt from the federal income tax and state tax in the issuing state. This makes them an attractive investment choice for people in high income category (they pay higher tax). But you must pay tax on any capital gain (increase in the bond value) at maturity.

To see the tax advantage of municipal bonds, suppose the interest of a taxable security is i, and your income tax bracket is t. Your after-tax earning is then i(1-t). So, if you pay 35% tax on your income, then 4.5% interest of a T-note (which is taxable) reduces to a little over 2.9% after tax. Compared to this, a municipal bond that pays 3.5% tax-free interest is quite attractive. This is also why someone coming into lot of money suddenly (like winning a lottery) finds investing in municipal bonds a good choice.

Corporate Bonds

Corporate bonds are a mean by which corporations borrow fund directly from investors. As in T-notes and T-bonds, these too pay interest in semi-annual installments and return the principal at maturity. The important difference is that a corporate bond has relatively higher risk of defaulting (in the event of the issuing firm facing bankruptcy).

Callable bonds are those that can be bought back by the issuing firm at a stipulated call price. Convertible bonds allow the bondholder to exchange each bond for a specific number company stocks.

Mortgage-backed securities

These securities, as the name suggests, are built on a pool of mortgage loans that are securitized and sold in secondary markets. Investors earn from the cash inflow as more and more loans are paid off. Because the mortgage lender collects the interest and principal payments from borrowers (home-owners) and pass them to the investors, these securities are also known as pass-throughs.

They are issued by the Government National Mortgage Association (GNMA, or Ginnie Mae), which is owned by the US government, and also by federally sponsored organizations such as the Federal National Mortgage Association (FNMA, or Fannie Mae), the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) and Federal Home Loan Bank (FHLB).

We will discuss “Stock Market” in a later post.

A money market, or “cash”, is a low-risk, short-term, liquid, debt type security. Reading from left to right, the italicized words mean – the risk of losing the principal (money you paid for the security) is low, it matures typically in a year or less, you can sell it quick, and corporations (and the government) issue these securities to borrow funds. Because of the low risk and fixed returns, a money market is an example of a fixed-income security. Following are the three major types of money markets.

Treasury bill

“T-bill” or just “bill” for short, these are securities that the US government sells to borrow fund. They are issued weekly at a minimum denomination of $1000 for 4-week, 13-week and 26-week maturation periods. You can either buy them directly from Treasury, or at a secondary market from a government securities dealer. Because they are backed by the government itself, there is almost no risk.

The way this works is that you buy T-bills at a discount from the face-value, and get back the face-value price at maturity. The discounted amount is your earning over that period (this is different from periodic earnings until maturity). For example, if you pay $9800 for a $10000 T-bill that has a 13-week maturity, you get $10000 back after 13 weeks, and therefore earn a 2.04%(=200×100/9800) interest over this period.

Certificate of Deposit

A certificate of deposit, or “CD”, is a debt instrument issued by banks. Your principal is locked for a fixed time period, which can be a few months to a few years. You get both the accrued interests and your principal back at maturity, and cannot withdraw any money until then. In this sense, a CD is different from a bank savings account (another difference is that the interest paid on a CD is usually higher than what you can get from a savings account). Bank CDs up to $100,000 are insured with FDIC, and so your investment is safe.

Commercial paper

Commercial papers are short-term debt instruments issued by large corporations to finance their businesses. They are not secure unlike bank deposits, and therefore only firms with high credit ratings can find investors without having to offer large discounts. Maturity of a commercial paper ranges up to 270 days (9 months); longer maturities require approval from SEC. Denominations are in multiples of $100,000, which makes these securities inaccessible to small investors (they can invest indirectly via money market mutual funds, which we will discuss in a later post).

Besides these three common types, other money markets are bankers’ acceptance, eurodollar, and repos.

Next we look at a Bond.

Merriam-Webster Online Dictionary defines the word security as “the state of being secure”. Then further down, “an instrument of investment in the form of a document (as a stock certificate or bond) providing evidence of its ownership”. These two definitions are not unrelated. A security is an investment instrument that is supposed to secure your financial future.

There are two broad classes of securities, depending on the nature of returns on their investment and the risk involved.

Fixed-income security

A fixed-income security, from its name, pays a fixed periodic return until maturity, when the principal (the amount originally paid to buy the security) is also returned. Fixed-income securities involve very low risk of devaluation/loss of the invested principal. An example is a Money Market instrument such as a Treasury bill.

Variable-income security

A variable-income security, by contrast, is one whose returns as well as the value of the principal vary based on underlying conditions, such as changes in the short-term interest rates. Because the principal itself can go up and down, investing in variable-income securities usually involves considerable risk. Examples include company stocks.

Why should I invest in high-risk assets?

A sensible question. Why? Because it is a fundamental fact of investing that taking more risk will reward you with higher long-term growth of your invested asset. For example, buying a 5-year CD (Certificate of Deposit) – a fixed-income security – at 5% annual interest will guarantee you a risk-free periodic return plus the principal after 5 years. On the other hand, investing in the S&P stock Index fund – a variable-income security with large short-term fluctuations – involves high risk, but your asset would grow at over 10% during most 5-year intervals.

The key phrase here is “long-term” (italicized above). If you want your money quickly, you are better off with low-risk fixed-income type investing. On the other hand, if you can wait several years (the more the better), investing with variable-income securities will smooth out the short-term fluctuations, and get you much higher returns at the end.

We continue with Money Market in the next post.