Today’s blog is going to be short and ‘sweet’. Over the next couple of weeks I will be turning my attention to some fun activities that include working on my taxes and college financial aid documents. Since the time I have to work on my blog will be limited I have decided to post some brief and to the point blogs on bonds. Today I’ll be talking about interest rate risk and average duration of bond funds.
The key to understanding the interest rate risk associated with bond funds is to be aware of bond funds average duration. If you like mathematics and have an interest in how bond duration is calculated you can check out the following URLs:
- http://en.wikipedia.org/wiki/Bond_duration
- http://www.investopedia.com/university/advancedbond/advancedbond5.asp
If you are interested in minutia, for giggles you can verify that the duration of zero coupon bonds is the same as the maturity of the bond. If the zero coupon bond has a 10 year maturity the duration will be 10 years. The good news is that some of the bond fund companies will give you the average duration for each of their bond funds. For example, the Vanguard and Fidelity bond funds will display the average duration when they are talking about their funds. I could not find any average duration of the Pimco funds on their website (I tried using my browser’s find command and could not find it).
Why are average durations for bond funds important for understanding interest rate risk? Here’s why: if the average duration for the bond fund is 7 years and interest rates go up 2% the value of your investment will decrease 14% (average duration X interest rate change = gain/loss). For example, suppose you have $10,000 invested in a bond fund the average duration of which is 7 years and interest rate goes up 2% you just lost $1400 of your investment. It works the opposite if the interest rate goes down by 2% -you just made $1400. This is the reason why some bond funds earned returns greater than 10% last year.
The first time you look at this, the inverse relationship between interest rates and bond prices seems somewhat illogical but, if you think about it, it does make sense. For example, if a bond is guaranteed by the issuer to pay 3% every year for ten years but the bond is sold in year 2 when the going interest rate is 4.5%, you would not receive the full price for the bond. The bond price would be discounted to make up for the 1.5% difference in the interest rate.
Examples of bond fund durations and interest rate risk:
Bond Fund Average Duration Interest Rate +2% Interest Rate -2%
Vanguard Total Bond
Market Index (VBMFX) 4.4 years -8.8% loss 8.8% gain
Vanguard Long-Term
Investment Grade (VWESX) 7 years -14% loss 14% gain
Fidelity Series Investment
Grade Bond Fund (FSIGX) 4 years -8% loss 8% gain
If you are risk averse or think interest rates are going up you would want to buy bond funds with low average durations (less than 1 year). You’d want to own high average duration bond funds (> 3 years) when you think interest rates are going down. Please do your homework. For any bond funds you own or want to buy you need to understand both the duration average for that fund as well as what you think the future interest rate environment will be.
Next week, I will write about different type of bonds. Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks and Mr. C.
Please add your insight. Let’s have an on-going discussion of financial and investing ideas.
Paul
Saturday, February 27, 2010
Friday, February 19, 2010
Derivatives
Derivatives
Today my topic is investing in derivative Exchange Traded Funds (ETFs) and other information about derivatives. What is a derivative? It is a security, the price of which is related to one or more underlying assets. An example of the underlying assets can be commodities (i.e. Gold, Natural Gas or Oil), currencies (i.e. US or foreign), options, stocks, bonds, stock indexes, etc. It is a contract between two or more parties. Its price fluctuates with the price of the underlying asset and some derivatives can be highly leveraged. The most common types of derivative are future and forward contracts, options, swaps and stock indexes. Underlying other derivatives are such things as weather, amount of rain, number of sunny days, etc. Virtually anything that bears risk in one direction or the other can be a type of derivative.
Why and how are derivatives used for hedging against risk and investing? They can be used to hedge risk, speculate, maximize profit whatever direction the market or assets go and to help manage portfolios. The following is an example of how derivatives can hedge risk for sellers and buyers. A farmer who plants wheat wants to reduce his risk of losing money and the possibility of losing his farm if the price of wheat is low at the end of the growing season. At the beginning of the planting season he sells his future wheat via a derivative contract to a manufacturer that uses wheat as a raw material. The farmer knows what he will be paid at the end of the growing season for a bushel of wheat and the manufacturer knows what the cost of his raw material will be. This reduces the risk of both the farmer and the manufacturer. This is one of the reasons why derivatives have become so popular: they enable risks to be traded efficiently. If you review the 10K reports of major corporations you will see that many of them use derivatives to hedge against risk. For example, corporations that sell goods worldwide will use currencies derivatives to hedge against currencies risk. Natural Gas (NG) drilling corporations sometimes use future contracts to hedge against risk for some of their production. They at times use future contracts to know what price they will get for NG over the next year, thus improving their ability to plan and reducing risk to the corporation.
You can also use derivatives for investing by using ‘exotic’ or ‘simple’ ETFs. Exotic ETFs use, for example, interest rate swaps and forward one month future contracts. A simple ETF might use the Standard and Poor’s (S&P) 500 index. An example of an exotic ETF is the following: in the summer of 2008 you determined that the financial sector was going to have a major drop in stock prices. You could have used an inverse (also known as ‘bear’ or ‘short’) derivative to play this opportunity. Inverse derivative ETFs could have been used for this investment (you could have shorted the financial sector 2 or 3 times). If you think the oil sector is going to increase its profits and that oil corporation share prices will increase you could use an Oil stock index ETF (simple) or leveraged ETF (exotic) to take advantage of the increasing share prices. You can maximize your profit whatever direction the market is going by using derivative ETFs.
If you are going to use exotic ETFs you should have a very good understanding of the underlying assets and the advantages and disadvantages of using these financial products. You may want to ‘Google’ exotic ETFs and read up on their associated pros and cons. For example, the US government looks at the underlying assets to determine tax rates. Some exotic ETFs can be taxed at ordinary gains and not long term gains if the asset is held over one year (you could use these ETFs in your deferred tax account). The Commodity Future Trading Commission is reviewing whether it should put limits on energy future trading ETFs using one month forward contracts. Examples of these ETFs are OIL (tracks Oil) and UNG (tracks Natural Gas).
Derivative ETFs can also help you manage your portfolio to maximize your profit and tax liability. For example you buy a financial corporation stock that pays a high dividend that you think is a very good long term investment. You have only held the stock for three months and the market for financial stocks looks like it is going to decline. You don’t want to sell the stock because of the high dividend, tax implication (it would be a short term gain) and you like the stock. You could use an inverse leverage derivative financial sector index ETF to hedge your risk with the stock.
Please do your homework (as you should do on any investment) before buying derivative ETFs. You should always understand the underlying assets of the derivative, tax implications, advantages and disadvantages, selling strategies (i.e. stop orders) etc.
Next week, I will write about bonds. Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks and Mr. C (need to talk with him).
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.
Paul
Today my topic is investing in derivative Exchange Traded Funds (ETFs) and other information about derivatives. What is a derivative? It is a security, the price of which is related to one or more underlying assets. An example of the underlying assets can be commodities (i.e. Gold, Natural Gas or Oil), currencies (i.e. US or foreign), options, stocks, bonds, stock indexes, etc. It is a contract between two or more parties. Its price fluctuates with the price of the underlying asset and some derivatives can be highly leveraged. The most common types of derivative are future and forward contracts, options, swaps and stock indexes. Underlying other derivatives are such things as weather, amount of rain, number of sunny days, etc. Virtually anything that bears risk in one direction or the other can be a type of derivative.
Why and how are derivatives used for hedging against risk and investing? They can be used to hedge risk, speculate, maximize profit whatever direction the market or assets go and to help manage portfolios. The following is an example of how derivatives can hedge risk for sellers and buyers. A farmer who plants wheat wants to reduce his risk of losing money and the possibility of losing his farm if the price of wheat is low at the end of the growing season. At the beginning of the planting season he sells his future wheat via a derivative contract to a manufacturer that uses wheat as a raw material. The farmer knows what he will be paid at the end of the growing season for a bushel of wheat and the manufacturer knows what the cost of his raw material will be. This reduces the risk of both the farmer and the manufacturer. This is one of the reasons why derivatives have become so popular: they enable risks to be traded efficiently. If you review the 10K reports of major corporations you will see that many of them use derivatives to hedge against risk. For example, corporations that sell goods worldwide will use currencies derivatives to hedge against currencies risk. Natural Gas (NG) drilling corporations sometimes use future contracts to hedge against risk for some of their production. They at times use future contracts to know what price they will get for NG over the next year, thus improving their ability to plan and reducing risk to the corporation.
You can also use derivatives for investing by using ‘exotic’ or ‘simple’ ETFs. Exotic ETFs use, for example, interest rate swaps and forward one month future contracts. A simple ETF might use the Standard and Poor’s (S&P) 500 index. An example of an exotic ETF is the following: in the summer of 2008 you determined that the financial sector was going to have a major drop in stock prices. You could have used an inverse (also known as ‘bear’ or ‘short’) derivative to play this opportunity. Inverse derivative ETFs could have been used for this investment (you could have shorted the financial sector 2 or 3 times). If you think the oil sector is going to increase its profits and that oil corporation share prices will increase you could use an Oil stock index ETF (simple) or leveraged ETF (exotic) to take advantage of the increasing share prices. You can maximize your profit whatever direction the market is going by using derivative ETFs.
If you are going to use exotic ETFs you should have a very good understanding of the underlying assets and the advantages and disadvantages of using these financial products. You may want to ‘Google’ exotic ETFs and read up on their associated pros and cons. For example, the US government looks at the underlying assets to determine tax rates. Some exotic ETFs can be taxed at ordinary gains and not long term gains if the asset is held over one year (you could use these ETFs in your deferred tax account). The Commodity Future Trading Commission is reviewing whether it should put limits on energy future trading ETFs using one month forward contracts. Examples of these ETFs are OIL (tracks Oil) and UNG (tracks Natural Gas).
Derivative ETFs can also help you manage your portfolio to maximize your profit and tax liability. For example you buy a financial corporation stock that pays a high dividend that you think is a very good long term investment. You have only held the stock for three months and the market for financial stocks looks like it is going to decline. You don’t want to sell the stock because of the high dividend, tax implication (it would be a short term gain) and you like the stock. You could use an inverse leverage derivative financial sector index ETF to hedge your risk with the stock.
Please do your homework (as you should do on any investment) before buying derivative ETFs. You should always understand the underlying assets of the derivative, tax implications, advantages and disadvantages, selling strategies (i.e. stop orders) etc.
Next week, I will write about bonds. Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks and Mr. C (need to talk with him).
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.
Paul
Monday, February 8, 2010
Natural Gas
Today my topic is investing in Natural Gas (NG) using Natural Gas sector Exchange Traded Funds (ETFs) and why NG may be a good investment. I already own two Canada Trade Corporations that produce NG and Oil, Penn West Energy Trust (PWE) and Pengrowth Energy Trust (PGH) both of which have paid a high monthly dividend. I also own Advantage Oil and Gas Limited (AAV) which was a Canada Trust but has converted to a corporation. (Canada is in the process of changing their Corporate trust tax laws; in the next couple years almost all Canada Trusts will convert to non-trust corporations,)
NG is an extremely important source of energy for reducing pollution and maintaining a clean environment. NG is the cleanest of the fossil fuels - much cleaner than coal and oil. For a long time, until the 1950s, it was regarded as a useless by-product of oil production. It now provides 23% of all the energy used in the world and demand continues to grow. The major difficulty in the use of natural gas is transportation and storage due to its low density. Natural gas pipelines are economical, but are impractical across oceans. There is also a foreseeable shortage of pipeline capacity in the US and it is difficult to go over high mountains because of NG’s low density (particularly problematic for California).
NG is also important because it is abundant in the US and Canada which is why we import very little of it. The US has the 6th biggest reserves in the world. Russia has the largest reserves in the world and exports a lot of NG to Europe. Europe has very little NG and that’s why France and other European countries are building nuclear power plants so as not to be dependent on Russia for their energy. The more the US uses NG for energy, the more it helps with the import / export balance of payments and reduces US dependency on OPEC countries.
There is lot of good information available on the T. Boone Pickens website about the Pickens Plan and how NG could improve the environment and help the US get off its oil dependency: http://www.pickensplan.com/theplan/. Some of the highlights from the Pickens Plan:
“By aggressively moving to shift America's car, light duty and heavy truck fleets from imported gasoline and diesel to domestic natural gas we can lower our need for foreign oil - helping President Obama reach his goal of zero oil imports from the Middle East within ten years.
Nearly 20% of every barrel of oil we import is used by 18-wheelers moving goods around and across the country by burning imported diesel. An over-the-road truck cannot be moved using current battery technology. Fleet vehicles like buses, taxis, express delivery trucks, and municipal and utility vehicles (any vehicle which returns to the "barn" each night where refueling is a simple matter) should be replaced by vehicles running on clean, cheap, domestic natural gas rather than imported gasoline or diesel fuel.”
With the advantages of NG over other fossil fuels so obvious, it should drive up the overall demand for NG and increase the revenue, profitability and stock prices of NG exploration, production, equipment and service (for example, companies that run NG pipelines) corporations. New technology over the last year has unlocked trillions of cubic feet of natural gas in the US and Canada, meaning energy producers do not have to deal with difficult political environments overseas. Major oil companies have started to do Merger and Acquisition of NG companies in an effort to increase their NG business component. For example, Exxon Mobile bought XTO Energy for an all-stock deal of $31 billion to increase their play in NG. Will other major oil companies like Chevron, Shell, BP, etc. follow suit and buy NG corporations? If the answer is yes, it will increase the stock price of NG corporations.
There are a number of Oil and NG exploration & production index ETFs, for example, FCG, IEO and XOP. These are all low net assets (less than $450 million) ETFs with $.30 bid / ask spreads for FCG and XOP and $.90 bid / ask spread for IEO. The turnover is very high for FCG (you may only want to buy FCG in a tax exempt account). FCG had the highest growth for 1 year of 41.92% but the highest expense of $.60. I will add FCG and IEO to my blog watch list.
If you are interested in investing in leveraged Oil and NG ETFs there are two (which have the same advantages and disadvantages of derivative investing that I will be blogging about next week).
- Ultra Oil & Gas ETF (DIG) targets returns that are 200% of the daily performance of the Dow Jones U.S. Oil & Gas Index.
- UltraShort Oil & Gas ETF (DUG) targets returns that are 200% of the inverse of the daily performance of the same index.
Next week, I will write about how derivatives work and their advantages and disadvantages. Should you be investing in derivative ETFs? What are the rewards and risks of investing in these ETFs? Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Other topics
In April I will be starting a financial website and in the summer I will be kicking off a financial podcast with Fullstacks and Mr. C (need to talk with him).
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.
Paul
NG is an extremely important source of energy for reducing pollution and maintaining a clean environment. NG is the cleanest of the fossil fuels - much cleaner than coal and oil. For a long time, until the 1950s, it was regarded as a useless by-product of oil production. It now provides 23% of all the energy used in the world and demand continues to grow. The major difficulty in the use of natural gas is transportation and storage due to its low density. Natural gas pipelines are economical, but are impractical across oceans. There is also a foreseeable shortage of pipeline capacity in the US and it is difficult to go over high mountains because of NG’s low density (particularly problematic for California).
NG is also important because it is abundant in the US and Canada which is why we import very little of it. The US has the 6th biggest reserves in the world. Russia has the largest reserves in the world and exports a lot of NG to Europe. Europe has very little NG and that’s why France and other European countries are building nuclear power plants so as not to be dependent on Russia for their energy. The more the US uses NG for energy, the more it helps with the import / export balance of payments and reduces US dependency on OPEC countries.
There is lot of good information available on the T. Boone Pickens website about the Pickens Plan and how NG could improve the environment and help the US get off its oil dependency: http://www.pickensplan.com/theplan/. Some of the highlights from the Pickens Plan:
“By aggressively moving to shift America's car, light duty and heavy truck fleets from imported gasoline and diesel to domestic natural gas we can lower our need for foreign oil - helping President Obama reach his goal of zero oil imports from the Middle East within ten years.
Nearly 20% of every barrel of oil we import is used by 18-wheelers moving goods around and across the country by burning imported diesel. An over-the-road truck cannot be moved using current battery technology. Fleet vehicles like buses, taxis, express delivery trucks, and municipal and utility vehicles (any vehicle which returns to the "barn" each night where refueling is a simple matter) should be replaced by vehicles running on clean, cheap, domestic natural gas rather than imported gasoline or diesel fuel.”
With the advantages of NG over other fossil fuels so obvious, it should drive up the overall demand for NG and increase the revenue, profitability and stock prices of NG exploration, production, equipment and service (for example, companies that run NG pipelines) corporations. New technology over the last year has unlocked trillions of cubic feet of natural gas in the US and Canada, meaning energy producers do not have to deal with difficult political environments overseas. Major oil companies have started to do Merger and Acquisition of NG companies in an effort to increase their NG business component. For example, Exxon Mobile bought XTO Energy for an all-stock deal of $31 billion to increase their play in NG. Will other major oil companies like Chevron, Shell, BP, etc. follow suit and buy NG corporations? If the answer is yes, it will increase the stock price of NG corporations.
There are a number of Oil and NG exploration & production index ETFs, for example, FCG, IEO and XOP. These are all low net assets (less than $450 million) ETFs with $.30 bid / ask spreads for FCG and XOP and $.90 bid / ask spread for IEO. The turnover is very high for FCG (you may only want to buy FCG in a tax exempt account). FCG had the highest growth for 1 year of 41.92% but the highest expense of $.60. I will add FCG and IEO to my blog watch list.
If you are interested in investing in leveraged Oil and NG ETFs there are two (which have the same advantages and disadvantages of derivative investing that I will be blogging about next week).
- Ultra Oil & Gas ETF (DIG) targets returns that are 200% of the daily performance of the Dow Jones U.S. Oil & Gas Index.
- UltraShort Oil & Gas ETF (DUG) targets returns that are 200% of the inverse of the daily performance of the same index.
Next week, I will write about how derivatives work and their advantages and disadvantages. Should you be investing in derivative ETFs? What are the rewards and risks of investing in these ETFs? Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Other topics
In April I will be starting a financial website and in the summer I will be kicking off a financial podcast with Fullstacks and Mr. C (need to talk with him).
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.
Paul
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