The Straits Times
Geoff Howie
26/10/2013
INVESTORS generally invest for two reasons.
First, they attempt to cash in on the price returns, which are reflected in the rise in the market price of the specific share upon liquidation.
Second, they benefit from the potential earnings that are periodically paid out to shareholders, otherwise also known as dividend returns.
A good investment opportunity should entail both strong price and dividend returns. However, some investors tend to focus on potential price returns with little regard for dividend returns, or vice versa.
In this second issue of the Mind Your Money Series, we will look at the concept of price returns and the factors that drive the growth and decline of market prices of different stocks.
Next month, we will explore dividend and total returns.
•What influences price returns
From most investors' point of view, parting with cash to purchase a company's stocks serves one purpose: wealth accumulation in the future because the investors believe that there are potential price gains to be reaped.
So it follows that the price of a stock not only indicates a company's current value, but also reflects the growth that investors expect in the future.
An investor can choose to invest in blue-chip stocks, which are those of well-established companies with stable cash flows and strong management teams, as outlined in the Securities Investors Association (Singapore) Investment Guide Book.
Typically, blue chips pay regular dividends and would have had considerable long-term price returns in the past.
Otherwise, the investor can also consider growth stocks, which are shares of rapidly growing firms. Such companies typically plough back their earnings into the business, and hence their shares tend to experience more price fluctuations.
•What sort of price returns have Singapore stocks showed in the past?
Consider the Straits Times Index (STI).
Like every stock market in the world, Singapore's stock market has a key stock market index - the STI.
In the same way the consumer price index (CPI) measures how much prices of goods and services have moved during a certain period, the STI is a barometer of how much the Singapore stock market has moved over a certain time.
The CPI is made up of a basket of certain goods and services. Similarly, the STI is made up of a basket of stocks of 30 companies.
If one were to look at the current STI stocks that have been listed for at least five years, it is clear that many have performed creditably.
Of the 30 stocks comprising the STI, 27, or 90 per cent, were listed more than five years ago.
Over these five years, the 30 stocks have shown price movements ranging from a 5 per cent fall for Singapore Airlines to a 270 per cent rise for Genting.
If the price movements were arranged from the lowest to the highest, the median (or statistical middle) of the price moves of the 27 stocks would be a 68 per cent rise by Noble Group.
Do remember, though, that past price movements of stocks do not mean they will behave in the same way in future.
In other words, past performance is not a guarantee of future returns.
Suppose an investor wants to start investing in stocks. How can he start?
A good way is to undertake a regular and long-term investing strategy by using regular share savings plans, which was covered by this column last month.
•Using the Price-to-Earnings Ratio (P/E Ratio)
Apart from considering the price moves of a stock over time, investors also may want to review its price-to-earnings ratio, or P/E ratio.
The P/E ratio of a company is calculated by taking the price of one share and dividing it by the earnings per share.
The P/E ratio of a company can be compared with the P/E ratio of another company to determine whether one is higher- or lower-priced compared with the other if their earnings were the same.
If the P/E ratio of company A is higher than that of company B, then one may surmise that company A is higher priced than company B for their respective earnings.
The P/E ratio of an entire industry can be calculated by averaging the P/E ratios of all companies within that sector.
P/E ratios may vary vastly when comparing one market with another, or one industry with another.
While it is a useful measure, it is not the be all and end all when it comes to investment decisions. As investors, we should always try to obtain as much information as possible before investing.
The writer is a market strategist at Singapore Exchange.
Saturday, October 26, 2013
Monday, October 14, 2013
Paying for value in health care
The Straits Times
Loke Wai Chiong
14/10/2013
THE introduction of universal health insurance through MediShield Life is the Government's latest move to keep health care affordable and to provide peace of mind to Singaporeans.
However, there is concern in some quarters that rising costs will soon place medical care out of the reach of many if nothing is done to keep costs in check. Universal coverage may ease the financial burden of a serious illness when it strikes. But there is still silence on the broader issue of long-term affordability.
If health-care costs continue to rise uncontrollably, it will not be enough to increase medical savings or collect higher premiums when the insured person is younger. The fundamental challenge is to control costs.
Globally, there are four commonly adopted payment systems. The first is fee for service, where every individual activity is separately paid for. The second is the block grant or block budget system, which refers to a wholesale budget for a hospital. The third is episode-based payment through diagnosis-related groups. This system classifies inpatient and day surgery cases into one of hundreds of possible groupings according to the patient's diagnosis and treatment. The final payment system is called capitated general practitioner (GP) payment. This is a fixed, risk-adjusted sum paid by a patient (or for a patient) regardless of actual use.
In all these systems, hospitals are paid for treating a patient for a given condition and not for the results achieved.
By increasing volume, hospitals can increase their income, regardless of the quality or appropriateness of the care provided. In other words, delivering high-quality health care efficiently does not always generate higher revenues for hospitals or doctors.
In fact, there are perverse incentives for health-care providers willing to provide only mediocre care, since doing so can bring in even more revenue. For example, medical complications such as in-hospital infections can result in longer hospital stays, thus producing more revenue for the provider.
The current payment modes reflect and perpetuate the failures of existing health-care systems. We may be paying for disjointed, uncoordinated medical advice, when we should be receiving holistic care with an integrated outcome.
Singapore has tried the first three of the four payment systems listed above. Today, it operates a hybrid model suited to its health-care policy and needs.
There have also been early steps towards a system more focused on population health and treatment outcomes. These include the organisation and integration of services into Regional Health Systems, the opening up of Medisave for primary care of chronic diseases and the development of the Chronic Disease Management Programme for General Practitioners.
Globally, policymakers and insurers are considering the benefits of a value-based contracting payment system. This is a system in which patients pay only for good, effective and agreed-upon or contracted outcomes of care, rather than the processes that go into it.
However, it is not easy to implement such a system.
Most systems find it easier to reward process compliance. For example, doctors may focus on improving indicators which yield the most points, or which "check the boxes". This may involve complying with various processes such as calling for a blood test to be done biannually, rather than developing ways to improve outcomes.
Doctors, insurers and patients all have differing access to and understanding of medical information. This makes it difficult to determine what sort of care is appropriate and necessary, and can lead to providers gaming the system. For instance, providers can introduce unnecessary or more expensive tests, treatments and services to get higher revenue when it comes time for reporting and claiming payment.
In fact, it would seem almost too complex to put the patient's medical problem central in the payment system, given the broad scope of medical problems that patients may present with, and the challenge to define where care processes "begin" and "end". For example, does the care for a patient who has undergone hip surgery end when he leaves the hospital or when he is able to walk independently?
For a contracting value system to work, three building blocks must be in place. The first is to delineate care services into "units of care". This means paying only for integrated care services or products that lead to an effective final treatment outcome based on best available evidence, and which is agreed upon by both the patient and the doctor.
Payment could be on a per illness basis, such as treatment for an acute heart attack or a fracture. It could also be based on per year of care and continuous across primary (such as GP) and hospital care settings - for example, chronic diabetes care.
The second building block determines what and how to measure the core outcomes that patients and professionals aim to achieve. These must be both measurable and meaningful. These are easier to identify once the types of care are determined.
Take a patient's recovery from a heart attack. The measures to evaluate whether the hospital has done its job could include high rescue rate, low mortality and morbidity as measured three months after the heart attack.
For frail elderly people with multiple chronic diseases, measures could be based on the quality of life, low readmission rates, and the patient's sense of empowerment and self-management of the ailments concerned.
The third building block of a contracting value system is then to contract for desired outcomes. Payment for medical services is made when contractual terms are fulfilled.
These three building blocks will enable an environment which encourages care organisations to be holistic and innovative in delivering the best possible care to their patients.
In Singapore, the development of such integrated care outcomes and indicators is already under way, although time will be needed to work out all the necessary building blocks.
The day may soon come when payment by the Government or the insurer to the health-care provider is ultimately tied to the achievement of better health of the patient and the population.
Value-based payment or payment for outcomes may turn out to be the most important factor in ensuring that MediShield Life becomes a sustainable solution.
stopinion@sph.com.sg
The writer is director of Global Healthcare Centre of Excellence, KPMG in Singapore. KPMG is a network of professional services firms.
Loke Wai Chiong
14/10/2013
THE introduction of universal health insurance through MediShield Life is the Government's latest move to keep health care affordable and to provide peace of mind to Singaporeans.
However, there is concern in some quarters that rising costs will soon place medical care out of the reach of many if nothing is done to keep costs in check. Universal coverage may ease the financial burden of a serious illness when it strikes. But there is still silence on the broader issue of long-term affordability.
If health-care costs continue to rise uncontrollably, it will not be enough to increase medical savings or collect higher premiums when the insured person is younger. The fundamental challenge is to control costs.
Globally, there are four commonly adopted payment systems. The first is fee for service, where every individual activity is separately paid for. The second is the block grant or block budget system, which refers to a wholesale budget for a hospital. The third is episode-based payment through diagnosis-related groups. This system classifies inpatient and day surgery cases into one of hundreds of possible groupings according to the patient's diagnosis and treatment. The final payment system is called capitated general practitioner (GP) payment. This is a fixed, risk-adjusted sum paid by a patient (or for a patient) regardless of actual use.
In all these systems, hospitals are paid for treating a patient for a given condition and not for the results achieved.
By increasing volume, hospitals can increase their income, regardless of the quality or appropriateness of the care provided. In other words, delivering high-quality health care efficiently does not always generate higher revenues for hospitals or doctors.
In fact, there are perverse incentives for health-care providers willing to provide only mediocre care, since doing so can bring in even more revenue. For example, medical complications such as in-hospital infections can result in longer hospital stays, thus producing more revenue for the provider.
The current payment modes reflect and perpetuate the failures of existing health-care systems. We may be paying for disjointed, uncoordinated medical advice, when we should be receiving holistic care with an integrated outcome.
Singapore has tried the first three of the four payment systems listed above. Today, it operates a hybrid model suited to its health-care policy and needs.
There have also been early steps towards a system more focused on population health and treatment outcomes. These include the organisation and integration of services into Regional Health Systems, the opening up of Medisave for primary care of chronic diseases and the development of the Chronic Disease Management Programme for General Practitioners.
Globally, policymakers and insurers are considering the benefits of a value-based contracting payment system. This is a system in which patients pay only for good, effective and agreed-upon or contracted outcomes of care, rather than the processes that go into it.
However, it is not easy to implement such a system.
Most systems find it easier to reward process compliance. For example, doctors may focus on improving indicators which yield the most points, or which "check the boxes". This may involve complying with various processes such as calling for a blood test to be done biannually, rather than developing ways to improve outcomes.
Doctors, insurers and patients all have differing access to and understanding of medical information. This makes it difficult to determine what sort of care is appropriate and necessary, and can lead to providers gaming the system. For instance, providers can introduce unnecessary or more expensive tests, treatments and services to get higher revenue when it comes time for reporting and claiming payment.
In fact, it would seem almost too complex to put the patient's medical problem central in the payment system, given the broad scope of medical problems that patients may present with, and the challenge to define where care processes "begin" and "end". For example, does the care for a patient who has undergone hip surgery end when he leaves the hospital or when he is able to walk independently?
For a contracting value system to work, three building blocks must be in place. The first is to delineate care services into "units of care". This means paying only for integrated care services or products that lead to an effective final treatment outcome based on best available evidence, and which is agreed upon by both the patient and the doctor.
Payment could be on a per illness basis, such as treatment for an acute heart attack or a fracture. It could also be based on per year of care and continuous across primary (such as GP) and hospital care settings - for example, chronic diabetes care.
The second building block determines what and how to measure the core outcomes that patients and professionals aim to achieve. These must be both measurable and meaningful. These are easier to identify once the types of care are determined.
Take a patient's recovery from a heart attack. The measures to evaluate whether the hospital has done its job could include high rescue rate, low mortality and morbidity as measured three months after the heart attack.
For frail elderly people with multiple chronic diseases, measures could be based on the quality of life, low readmission rates, and the patient's sense of empowerment and self-management of the ailments concerned.
The third building block of a contracting value system is then to contract for desired outcomes. Payment for medical services is made when contractual terms are fulfilled.
These three building blocks will enable an environment which encourages care organisations to be holistic and innovative in delivering the best possible care to their patients.
In Singapore, the development of such integrated care outcomes and indicators is already under way, although time will be needed to work out all the necessary building blocks.
The day may soon come when payment by the Government or the insurer to the health-care provider is ultimately tied to the achievement of better health of the patient and the population.
Value-based payment or payment for outcomes may turn out to be the most important factor in ensuring that MediShield Life becomes a sustainable solution.
stopinion@sph.com.sg
The writer is director of Global Healthcare Centre of Excellence, KPMG in Singapore. KPMG is a network of professional services firms.
The big picture about bonds
The Business Times
Cai Haoxiang
14/10/2013
A FRIEND, upset at how his mother was sold a financial product, recently told me this story.
His mum was convinced by her banker to buy a complex product which involved the bonds of four foreign companies with coupons ranging from 3 to 5 per cent.
Now, 3 to 5 per cent sounds good. But if she knew how bonds worked, she would have asked what the yield of the bonds were.
In this case, her banker did not mention yields at all. Worse still, the product sold was just a derivative on the underlying bonds. The buyer has no legal ownership of the underlying bonds.
My friend cancelled the deal immediately upon finding out. It was unclear what kinds of gains could have come out of it. But it was clear that the bank would make a spread from selling such a product. The banker would make a nice commission. Meanwhile, the risks to the client are complex and might not justify the gains promised.
How do coupons factor into bond pricing? Are higher coupons good?
Before we answer these questions, we have to first understand how bond prices are affected by a major item: interest rates.
The inverse relation
If the US government defaults on its sovereign debt obligations in the coming weeks by failing to raise its debt ceiling, one of the first and most serious consequences will be a rise in interest rates.
This will happen if US Treasuries, previously thought to be the safest asset in the world, face a sell-off.
When investors are not willing to pay as much to lend money to the US government, the US government will need to pay a comparatively higher interest on the bonds it issues to attract investors back.
New bonds will thus yield more for investors. While this can be seen as a good thing, this situation arises because the investors are taking more risk. They are signing up to lend money for a long period of time to a government that might not be able to borrow more to pay them back.
The first relationship in the bond world that beginners learn is the inverse relationship between prices and yields.
When prices fall, yields go up. When prices rise, yields come down.
This can be hard to understand at first. Falling prices is not a good thing for the owners of any asset. So why then do falling prices come with improving yields - which is a good thing?
To figure this out, you have to decide whether you are a bondholder or a potential bond buyer. If you currently own bonds, then falling prices does not seem good because if you really need to sell your investment, you can get less for it.
But falling prices, which are caused by rising interest rates, should not bother you if you have money to reinvest.
After all, you have locked in some gains by buying the bond. You will keep receiving interest payments until the end of the bond's term, by which you will then get the original value of the bond, known as the par value, together with the final interest payment.
If interest rates rise, it just means that your current investment, locked in at an earlier yield, isn't as attractive compared to others now. You won't lose money if you don't sell the bond, assuming the government or company you lent money to does not go bankrupt.
Rather, you can invest more money in bonds at a better yield, now that interest rates are higher.
So while falling bond prices mean that you are sitting on a paper loss, you need not realise the loss, but can continue to hold the bond till maturity and collect the originally agreed-upon interest payments. Most people hold bonds to maturity and are not bothered by fluctuations in between.
Meanwhile, the higher yields that bonds are trading at, given higher interest rates, mean that you can lock in better returns on current investments as a potential bond buyer.
Similarly, rising bond prices are not a good sign for potential bond buyers, for this means that they are not able to get as good a yield on their investments.
But for current bondholders, this means they can sell their bonds for a profit, and reinvest the money elsewhere for hopefully better returns.
Coupons aren't everything
Now we bring in a common feature of bonds that confuse people: coupons.
Coupons refer to the interest payments that issuers of bonds give out, usually twice a year.
For simplicity, we will assume these payments are made once a year. Obviously, the larger the coupons are, the more one would pay for the bond. But if one has to pay a higher price, the bond is not as attractive.
A similar logic applies to how this bond is actually priced.
Let's say a company plans to issue a bond that pays a 10 per cent coupon out of every $1,000 lent to the company. It will borrow $1,000 for 20 years. The $1,000 here is called the face or par value of the bond. This represents the sum of money that the company will repay the investor at the end of the borrowing period.
At a 10 per cent coupon rate, an investor that holds this bond will get $100 every year (10 per cent of $1,000) for 20 years. At the end of the 20th year, he will get the final $100 coupon payment together with the $1,000 face value.
Without even going into the calculations, we can see an investor will get $2,000 worth of coupon payments over the lifetime of this bond.
A 10 per cent coupon thus sounds like a great deal. Right?
Here's the catch.
It usually will not cost an investor only $1,000 to buy this particular bond.
If prevailing interest rates were lower than 10 per cent, a bond with this 10 per cent coupon becomes very attractive. Investors would be willing to pay more to buy it.
The bond's price would typically adjust instantly to a price higher than $1,000. It will trade at a premium.
It will cost an investor way more than $1,000 to get hold of this stream of interest payments of $100 a year.
In fact, if such a deal came out today, and interest rates are 3 per cent - meaning that investors can only get a yield of 3 per cent in the market - this 20-year bond with a 10 per cent coupon will actually cost the investor $2,041 to purchase!
There is no way that the investor can get a yield of more than 3 per cent if 3 per cent was the prevailing interest rate. All bonds issued will lock in a yield of 3 per cent. If their coupons give a higher rate, their prices will automatically adjust upwards.
Thus, it is more accurate to say that investors are willing to pay $2,041 to get a cash flow of $100 a year for the next 20 years, getting back $1,000 in the final year, to get a yield of 3 per cent. This also assumes coupons are reinvested at 3 per cent. Getting the number $2,041 requires a financial calculator. You need to put in the coupon payments every year ($100), the number of years (20), the expected "future value" at the end ($1,000), and the expected interest rate or yield (3 per cent), before computing the "present value" to find out what this stream of payments is worth today.
The 10 per cent coupon rate is not as useful here.
Thus investors have to be wary of only being quoted the coupon rate. They have to ask what the yield of the bond actually is.
Larger coupons lead to lower price volatility
Larger coupons, however, are still useful to have. This is because having a larger stream of regular payments will be a comfort to investors if interest rates change suddenly.
If interest rates change, the prices of bonds with smaller coupons or no coupons will change the most dramatically.
Let's take the example of the previous 20-year $1,000 bond with a 10 per cent coupon, that was issued when interest rates were at 3 per cent.
Once bonds are issued, bond prices will depend on how many coupon payments are left, as well as the interest rate investors can get on other investments.
Ten years in, halfway through the life of the bond, ten $100 payments will have already been made. If interest rates are still at 3 per cent, meaning that investors still expect to yield 3 per cent from similar bond investments, this bond will be worth $1,597.
Now, let us say interest rates spike to 6 per cent. The value of this bond will drop to $1,294 - a 19 per cent drop. If the coupon was just $50 a year, meaning an original coupon rate of 5 per cent, the equivalent price drop will be from $1,171 to $926 - a larger 21 per cent drop.
If the coupon was even smaller, say $20 a year, the price drop will be 23 per cent.
Looking at the yield of a bond is important when buying them, more so than the coupon rate. But in this case, being paid a larger $100 coupon helped cushion the negative price effects of an interest rate spike.
Again, if you don't plan to sell your bond before maturity, this would not make a difference. You would just buy new bonds at higher current yields.
Other effects on bond prices
A lower interest rate environment means more volatile bond prices if there is a rate hike.
If current yields are at 3 per cent, and there is a three percentage-point shock upwards, the bond price of a $1,000 10-year bond paying $50 annual coupons would fall by 21 per cent. If current yields were far lower, at 0.5 per cent, and there was a similar shock to 3.5 per cent, prices would fall by more, 22 per cent to be exact.
This is why the current low interest rate environment means bonds are risky to hold if one plans to sell them at some point.
Another factor that affects the sensitivity of bond prices is the length of time before the maturity of the bond.
If the bond has a long maturity date, meaning there are a lot of interest payments to be made, a change in interest rates would result in a sharper movement in prices.
For example, if the above example of a $50 coupon and 3 per cent yield applied to a 30-year bond, prices would fall by 38 per cent if interest rates spiked 3 percentage points up, higher than the 21 per cent fall for a 10-year bond.
To conclude, coupon rates, interest rate changes, length of maturity and the current interest rate environment all have effects on bond prices.
To measure the sensitivity of the price of a bond to interest rate changes given all these factors, investors use a calculation known as duration. We will discuss this in a future piece.
Cai Haoxiang
14/10/2013
A FRIEND, upset at how his mother was sold a financial product, recently told me this story.
His mum was convinced by her banker to buy a complex product which involved the bonds of four foreign companies with coupons ranging from 3 to 5 per cent.
Now, 3 to 5 per cent sounds good. But if she knew how bonds worked, she would have asked what the yield of the bonds were.
In this case, her banker did not mention yields at all. Worse still, the product sold was just a derivative on the underlying bonds. The buyer has no legal ownership of the underlying bonds.
My friend cancelled the deal immediately upon finding out. It was unclear what kinds of gains could have come out of it. But it was clear that the bank would make a spread from selling such a product. The banker would make a nice commission. Meanwhile, the risks to the client are complex and might not justify the gains promised.
How do coupons factor into bond pricing? Are higher coupons good?
Before we answer these questions, we have to first understand how bond prices are affected by a major item: interest rates.
The inverse relation
If the US government defaults on its sovereign debt obligations in the coming weeks by failing to raise its debt ceiling, one of the first and most serious consequences will be a rise in interest rates.
This will happen if US Treasuries, previously thought to be the safest asset in the world, face a sell-off.
When investors are not willing to pay as much to lend money to the US government, the US government will need to pay a comparatively higher interest on the bonds it issues to attract investors back.
New bonds will thus yield more for investors. While this can be seen as a good thing, this situation arises because the investors are taking more risk. They are signing up to lend money for a long period of time to a government that might not be able to borrow more to pay them back.
The first relationship in the bond world that beginners learn is the inverse relationship between prices and yields.
When prices fall, yields go up. When prices rise, yields come down.
This can be hard to understand at first. Falling prices is not a good thing for the owners of any asset. So why then do falling prices come with improving yields - which is a good thing?
To figure this out, you have to decide whether you are a bondholder or a potential bond buyer. If you currently own bonds, then falling prices does not seem good because if you really need to sell your investment, you can get less for it.
But falling prices, which are caused by rising interest rates, should not bother you if you have money to reinvest.
After all, you have locked in some gains by buying the bond. You will keep receiving interest payments until the end of the bond's term, by which you will then get the original value of the bond, known as the par value, together with the final interest payment.
If interest rates rise, it just means that your current investment, locked in at an earlier yield, isn't as attractive compared to others now. You won't lose money if you don't sell the bond, assuming the government or company you lent money to does not go bankrupt.
Rather, you can invest more money in bonds at a better yield, now that interest rates are higher.
So while falling bond prices mean that you are sitting on a paper loss, you need not realise the loss, but can continue to hold the bond till maturity and collect the originally agreed-upon interest payments. Most people hold bonds to maturity and are not bothered by fluctuations in between.
Meanwhile, the higher yields that bonds are trading at, given higher interest rates, mean that you can lock in better returns on current investments as a potential bond buyer.
Similarly, rising bond prices are not a good sign for potential bond buyers, for this means that they are not able to get as good a yield on their investments.
But for current bondholders, this means they can sell their bonds for a profit, and reinvest the money elsewhere for hopefully better returns.
Coupons aren't everything
Now we bring in a common feature of bonds that confuse people: coupons.
Coupons refer to the interest payments that issuers of bonds give out, usually twice a year.
For simplicity, we will assume these payments are made once a year. Obviously, the larger the coupons are, the more one would pay for the bond. But if one has to pay a higher price, the bond is not as attractive.
A similar logic applies to how this bond is actually priced.
Let's say a company plans to issue a bond that pays a 10 per cent coupon out of every $1,000 lent to the company. It will borrow $1,000 for 20 years. The $1,000 here is called the face or par value of the bond. This represents the sum of money that the company will repay the investor at the end of the borrowing period.
At a 10 per cent coupon rate, an investor that holds this bond will get $100 every year (10 per cent of $1,000) for 20 years. At the end of the 20th year, he will get the final $100 coupon payment together with the $1,000 face value.
Without even going into the calculations, we can see an investor will get $2,000 worth of coupon payments over the lifetime of this bond.
A 10 per cent coupon thus sounds like a great deal. Right?
Here's the catch.
It usually will not cost an investor only $1,000 to buy this particular bond.
If prevailing interest rates were lower than 10 per cent, a bond with this 10 per cent coupon becomes very attractive. Investors would be willing to pay more to buy it.
The bond's price would typically adjust instantly to a price higher than $1,000. It will trade at a premium.
It will cost an investor way more than $1,000 to get hold of this stream of interest payments of $100 a year.
In fact, if such a deal came out today, and interest rates are 3 per cent - meaning that investors can only get a yield of 3 per cent in the market - this 20-year bond with a 10 per cent coupon will actually cost the investor $2,041 to purchase!
There is no way that the investor can get a yield of more than 3 per cent if 3 per cent was the prevailing interest rate. All bonds issued will lock in a yield of 3 per cent. If their coupons give a higher rate, their prices will automatically adjust upwards.
Thus, it is more accurate to say that investors are willing to pay $2,041 to get a cash flow of $100 a year for the next 20 years, getting back $1,000 in the final year, to get a yield of 3 per cent. This also assumes coupons are reinvested at 3 per cent. Getting the number $2,041 requires a financial calculator. You need to put in the coupon payments every year ($100), the number of years (20), the expected "future value" at the end ($1,000), and the expected interest rate or yield (3 per cent), before computing the "present value" to find out what this stream of payments is worth today.
The 10 per cent coupon rate is not as useful here.
Thus investors have to be wary of only being quoted the coupon rate. They have to ask what the yield of the bond actually is.
Larger coupons lead to lower price volatility
Larger coupons, however, are still useful to have. This is because having a larger stream of regular payments will be a comfort to investors if interest rates change suddenly.
If interest rates change, the prices of bonds with smaller coupons or no coupons will change the most dramatically.
Let's take the example of the previous 20-year $1,000 bond with a 10 per cent coupon, that was issued when interest rates were at 3 per cent.
Once bonds are issued, bond prices will depend on how many coupon payments are left, as well as the interest rate investors can get on other investments.
Ten years in, halfway through the life of the bond, ten $100 payments will have already been made. If interest rates are still at 3 per cent, meaning that investors still expect to yield 3 per cent from similar bond investments, this bond will be worth $1,597.
Now, let us say interest rates spike to 6 per cent. The value of this bond will drop to $1,294 - a 19 per cent drop. If the coupon was just $50 a year, meaning an original coupon rate of 5 per cent, the equivalent price drop will be from $1,171 to $926 - a larger 21 per cent drop.
If the coupon was even smaller, say $20 a year, the price drop will be 23 per cent.
Looking at the yield of a bond is important when buying them, more so than the coupon rate. But in this case, being paid a larger $100 coupon helped cushion the negative price effects of an interest rate spike.
Again, if you don't plan to sell your bond before maturity, this would not make a difference. You would just buy new bonds at higher current yields.
Other effects on bond prices
A lower interest rate environment means more volatile bond prices if there is a rate hike.
If current yields are at 3 per cent, and there is a three percentage-point shock upwards, the bond price of a $1,000 10-year bond paying $50 annual coupons would fall by 21 per cent. If current yields were far lower, at 0.5 per cent, and there was a similar shock to 3.5 per cent, prices would fall by more, 22 per cent to be exact.
This is why the current low interest rate environment means bonds are risky to hold if one plans to sell them at some point.
Another factor that affects the sensitivity of bond prices is the length of time before the maturity of the bond.
If the bond has a long maturity date, meaning there are a lot of interest payments to be made, a change in interest rates would result in a sharper movement in prices.
For example, if the above example of a $50 coupon and 3 per cent yield applied to a 30-year bond, prices would fall by 38 per cent if interest rates spiked 3 percentage points up, higher than the 21 per cent fall for a 10-year bond.
To conclude, coupon rates, interest rate changes, length of maturity and the current interest rate environment all have effects on bond prices.
To measure the sensitivity of the price of a bond to interest rate changes given all these factors, investors use a calculation known as duration. We will discuss this in a future piece.
Sunday, October 13, 2013
Time the market based on valuations
Those entering market at current levels have good chance of earning satisfactory returns over next 5 years
By Teh Hooi Ling
One of the shrewdest and longest lasting market strategists on Wall Street, Mr Jeremy Grantham, has a bone to pick with some value investors who contend that bubbles and busts can be ignored. You don't have to deal with that kind of thing, they argue, you just keep your nose to the grindstone of stock-picking, said the founding partner of GMO who prides himself and his team as global bubble spotters. These value investors feel that there is something faintly speculative and undesirable about recognising bubbles.
The fact is, the mantra of staying invested, of not timing the market, is not the exclusive purview of value managers. That's the investment adage that most fund managers preach to the retail investors as well. In fact, in The Sunday Times Invest pages recently, the headline for one story is exactly this: "Don't try to time the market, says expert".
There are lots of merits to the "don't time the market" advice. The thing is, the average retail investor tries to time the market based on news flows, or the price movements of the market.
Will the US Federal Reserve start tapering next month? Is that company going to win that lucrative contract? Is there going to be a reverse takeover of this stock? I will only buy when I can discern a clear uptrend momentum, some say.
Let me tell you this. The chances of getting the timing of your stock purchases or sales correct based on news flow and price movements are not good. There are bigger players who can react faster to the news, more sophisticated investors with better access to the news, or can analyse the situations better although I won't place my bets on anyone being able to consistently do that. The modern economy is infinitely complex. And funds are flowing so quickly around the world that an uptrend can easily turn into a downtrend the next day. These are but market noise.
What Mr Grantham refers to in terms of spotting bubbles relates to recognising when markets are overvalued, or conversely, when it is undervalued. Bubbles happen because of investors' euphoria and greed, and the fear of career risks by people in the financial sector.
As the former chairman and CEO of Citigroup, Mr Chuck Prince, famously said: "As long as the music is playing, you've got to get up and dance." Such behaviours will bring market valuations to extreme levels in either directions.
But there is a central truth to the stock market: Underneath it all, there is an economic reality. There is arbitrage around the replacement cost. And the price of an asset has to be justified by the earnings that it can generate.
Say because of a bull market, the shares of a company that owns a factory are now worth $100 million. If somebody can build a similar factory with the same production capacity at $50 million, that somebody is going to do it.
The $100 million factory is going to face competition from the $50 million new factory, and its earnings will be affected. Shareholders, who bought the shares of the $100 million factory, will not see the return they expected when they bought their shares.
They will be disappointed, and they will sell the shares leading to a decline in the share price. The result could be that the $100 million company now has a market value of $60 million.
Now, let's say a third tycoon comes to town. Building and material costs have not risen. He discovers that he can build another factory also at a cost of $50 million. He does that and now there is even more competition in the market. The first factory may not be able to compete with the new factories, and it starts to make losses. Investors sell down its shares even more. Now the factory which used to have a market value of $100 million is worth only $30 million.
The owner of the second factory is thinking of expanding his capacity because he is able to capture an increasing market share due to better branding. But to build a new factory, it will now cost him $70 million because land cost has risen. He sees that his old competitor's factory is selling for only $30 million. He figures that he can buy that factory, upgrade it at a cost of $10 million, and it will be as good as new. So he offers to buy the first factory at $40 million. After the upgrading costs, he still gets the factory at a cheaper price than if he were to build a new factory from ground up.
So there you have it. Stock prices can't be so high that they are detached from market reality. Neither will they stay cheap for long if they are trading below the replacement cost of the assets they are holding.
Consider the price of the Singapore market, relative to the 10-year average of its earnings per share, as calculated by Thomson Datastream. This is measured by the so-called Graham and Dodd price-earnings (PE) ratio.
In the past 30 years, the highest the market price has gone up to was 33.5 times its 10-year average earnings. That was in August 1987 just before the October 1987 Black Monday crash. The lowest the market has plunged to was 10.3 times its 10-year average earnings. That was in February 2009, the darkest point of the recent global financial crisis.
In the past 30 years, when the Graham and Dodd PE fell below 16 times, the returns of the three portfolios five years later tended to be substantial.
They averaged 15.2 per cent a year for the entire market; 25.4 per cent a year for the low (price-to-book) PB portfolio; and 13 per cent a year for the high PB portfolio. The five-year period starting from the lowest point on our PE chart, i.e. February 2009, has not ended yet. But already, those who entered the market at that point are sitting on, or had made, outsized returns.
There was only one instance when buying into the market at the Graham and Dodd PE of 16 times or below did not pay off handsomely five years later. That was in July 1997, at the onset of the Asian financial crisis. Five years later, in August 2002, the market was still trading at similar levels as it struggled to climb its way out of the dot.com bust and the 2001 terrorist attacks in the United States.
The higher the Graham and Dodd PE, the lower the return five years later. Investors who entered the market at a PE of 26 times or higher had seen a miserable 1 per cent average return a year in the following five years for the market portfolio, 7 per cent for the low PB portfolio and minus 2 per cent for the high PB portfolio.
At that market entry level, chances of an investor suffering capital loss are also elevated. Based on monthly numbers in the past 30 years, the probability of loss five years later (at Graham and Dodd PE of 26 times and above) was 42 per cent for the market portfolio, 12 per cent for the low PB portfolio and a whopping 70 per cent for the high PB portfolio.
Finally, where is the Graham and Dodd PE for the Singapore market now? It's at 14.1 times as at end September. This compares with the average of 20.8 times in the past 30 years.
In the past three decades, there were 25 different months when the Graham and Dodd PE traded between 14 and 16.5 times. For those 25 different months, the market portfolio returned an average 15.5 per cent a year over the next five years. The low PB portfolio averaged 24.8 per cent a year, and the high PB portfolio 14.3 per cent a year. The probability of capital loss for those periods was 1-in-25 for the market portfolio, and 3-in-25 for the low PB as well as the high PB portfolios.
So based on patterns in the past, in so far as companies' earnings are not artificially propped up by low interest costs and barring any structural change in the economic environment, investors who enter the market at current levels have a good chance of earning satisfactory returns from the stock market over the next five years.
stinvest@sph.com.sg
The writer, a chartered financial analyst, is head of research at Aggregate Asset Management, manager of a no-management fee value fund.
By Teh Hooi Ling
One of the shrewdest and longest lasting market strategists on Wall Street, Mr Jeremy Grantham, has a bone to pick with some value investors who contend that bubbles and busts can be ignored. You don't have to deal with that kind of thing, they argue, you just keep your nose to the grindstone of stock-picking, said the founding partner of GMO who prides himself and his team as global bubble spotters. These value investors feel that there is something faintly speculative and undesirable about recognising bubbles.
The fact is, the mantra of staying invested, of not timing the market, is not the exclusive purview of value managers. That's the investment adage that most fund managers preach to the retail investors as well. In fact, in The Sunday Times Invest pages recently, the headline for one story is exactly this: "Don't try to time the market, says expert".
There are lots of merits to the "don't time the market" advice. The thing is, the average retail investor tries to time the market based on news flows, or the price movements of the market.
Will the US Federal Reserve start tapering next month? Is that company going to win that lucrative contract? Is there going to be a reverse takeover of this stock? I will only buy when I can discern a clear uptrend momentum, some say.
Let me tell you this. The chances of getting the timing of your stock purchases or sales correct based on news flow and price movements are not good. There are bigger players who can react faster to the news, more sophisticated investors with better access to the news, or can analyse the situations better although I won't place my bets on anyone being able to consistently do that. The modern economy is infinitely complex. And funds are flowing so quickly around the world that an uptrend can easily turn into a downtrend the next day. These are but market noise.
What Mr Grantham refers to in terms of spotting bubbles relates to recognising when markets are overvalued, or conversely, when it is undervalued. Bubbles happen because of investors' euphoria and greed, and the fear of career risks by people in the financial sector.
As the former chairman and CEO of Citigroup, Mr Chuck Prince, famously said: "As long as the music is playing, you've got to get up and dance." Such behaviours will bring market valuations to extreme levels in either directions.
But there is a central truth to the stock market: Underneath it all, there is an economic reality. There is arbitrage around the replacement cost. And the price of an asset has to be justified by the earnings that it can generate.
Say because of a bull market, the shares of a company that owns a factory are now worth $100 million. If somebody can build a similar factory with the same production capacity at $50 million, that somebody is going to do it.
The $100 million factory is going to face competition from the $50 million new factory, and its earnings will be affected. Shareholders, who bought the shares of the $100 million factory, will not see the return they expected when they bought their shares.
They will be disappointed, and they will sell the shares leading to a decline in the share price. The result could be that the $100 million company now has a market value of $60 million.
Now, let's say a third tycoon comes to town. Building and material costs have not risen. He discovers that he can build another factory also at a cost of $50 million. He does that and now there is even more competition in the market. The first factory may not be able to compete with the new factories, and it starts to make losses. Investors sell down its shares even more. Now the factory which used to have a market value of $100 million is worth only $30 million.
The owner of the second factory is thinking of expanding his capacity because he is able to capture an increasing market share due to better branding. But to build a new factory, it will now cost him $70 million because land cost has risen. He sees that his old competitor's factory is selling for only $30 million. He figures that he can buy that factory, upgrade it at a cost of $10 million, and it will be as good as new. So he offers to buy the first factory at $40 million. After the upgrading costs, he still gets the factory at a cheaper price than if he were to build a new factory from ground up.
So there you have it. Stock prices can't be so high that they are detached from market reality. Neither will they stay cheap for long if they are trading below the replacement cost of the assets they are holding.
Consider the price of the Singapore market, relative to the 10-year average of its earnings per share, as calculated by Thomson Datastream. This is measured by the so-called Graham and Dodd price-earnings (PE) ratio.
In the past 30 years, the highest the market price has gone up to was 33.5 times its 10-year average earnings. That was in August 1987 just before the October 1987 Black Monday crash. The lowest the market has plunged to was 10.3 times its 10-year average earnings. That was in February 2009, the darkest point of the recent global financial crisis.
In the past 30 years, when the Graham and Dodd PE fell below 16 times, the returns of the three portfolios five years later tended to be substantial.
They averaged 15.2 per cent a year for the entire market; 25.4 per cent a year for the low (price-to-book) PB portfolio; and 13 per cent a year for the high PB portfolio. The five-year period starting from the lowest point on our PE chart, i.e. February 2009, has not ended yet. But already, those who entered the market at that point are sitting on, or had made, outsized returns.
There was only one instance when buying into the market at the Graham and Dodd PE of 16 times or below did not pay off handsomely five years later. That was in July 1997, at the onset of the Asian financial crisis. Five years later, in August 2002, the market was still trading at similar levels as it struggled to climb its way out of the dot.com bust and the 2001 terrorist attacks in the United States.
The higher the Graham and Dodd PE, the lower the return five years later. Investors who entered the market at a PE of 26 times or higher had seen a miserable 1 per cent average return a year in the following five years for the market portfolio, 7 per cent for the low PB portfolio and minus 2 per cent for the high PB portfolio.
At that market entry level, chances of an investor suffering capital loss are also elevated. Based on monthly numbers in the past 30 years, the probability of loss five years later (at Graham and Dodd PE of 26 times and above) was 42 per cent for the market portfolio, 12 per cent for the low PB portfolio and a whopping 70 per cent for the high PB portfolio.
Finally, where is the Graham and Dodd PE for the Singapore market now? It's at 14.1 times as at end September. This compares with the average of 20.8 times in the past 30 years.
In the past three decades, there were 25 different months when the Graham and Dodd PE traded between 14 and 16.5 times. For those 25 different months, the market portfolio returned an average 15.5 per cent a year over the next five years. The low PB portfolio averaged 24.8 per cent a year, and the high PB portfolio 14.3 per cent a year. The probability of capital loss for those periods was 1-in-25 for the market portfolio, and 3-in-25 for the low PB as well as the high PB portfolios.
So based on patterns in the past, in so far as companies' earnings are not artificially propped up by low interest costs and barring any structural change in the economic environment, investors who enter the market at current levels have a good chance of earning satisfactory returns from the stock market over the next five years.
stinvest@sph.com.sg
The writer, a chartered financial analyst, is head of research at Aggregate Asset Management, manager of a no-management fee value fund.
Thursday, October 10, 2013
Gold price movements defying logic
The Business Times
Neil Behrmann
10/10/2013
THE big question is why has gold been lacklustre in the face of a US political standoff and monetary easing, a weakness in the greenback, emerging currency upheaval and continued Middle East concerns?
Moreover, President Obama's appointment of Janet Yellen, a quantitative easing (QE) dove, as Federal Reserve chief, should in itself be another bull point for gold. The market expects her to continue with current QE well into 2014.
Since gold's peak of US$1,921 an ounce in September 2011, latecomer investors have had a torrid time. The price slowly sank in 2012 and in the second quarter of this year plunged from US$1,590 to US$1,180 an ounce, then rallied to US$1,420 in August and is now languishing at US$1,320 an ounce.
Most gold watchers focus on the investment and the so-called safe-haven status of bullion, but its demand-supply fundamentals are more complex than that. The market tends to swing between global investment and speculative demand and jewellery and other physical consumption mainly in China, India and other Asian markets.
Gold plunged in June because investors took fright and hedge funds and holders of gold exchange-traded funds (ETFs) dumped their holdings. The subsequent recovery came about because jewellery and other industrial buyers of gold took advantage of cheaper prices and bought.
Investors and speculators are nervous that the political battle between the Democrats and Republicans could cause a slide in equities, commodities, including gold and other risk assets, so they are only prepared to buy on dips. Reflecting their skittishness, gold recently plunged, by about US$40, to US$1,286 an ounce when Russian Premier Vladimir Putin diffused the Syrian chemical weapons crisis and the US began talks with Iran.
The price then rallied above US$1,300, but has not taken off mainly because demand from the two biggest consumers - China and India - has been slack in recent weeks.
According to estimates from Mathew Turner, precious metals analyst at Macquarie Bank, Chinese demand slowed in July and August when the price rallied. Shanghai gold was at a premium of US$40 over the international price at the start of July but since then has slipped to less than US$10. Statistics related to China are a conundrum because of obfuscation on the part of the authorities.
Mr Turner estimates, however, that over and above China's annual gold production of 413 tonnes, the country's net imports from Hong Kong were 818 tonnes in the first eight months of the year compared with 379 tonnes in the same period last year and 643 tonnes for the whole of last year.
An unknown proportion of imports and production could well be going into the central bank's reserves, so it is difficult to gauge consumption. China is completing a week's holiday to celebrate Golden Week, so demand is expected to pick up, especially ahead of Chinese New Year.
India, the world's second-biggest consumer of gold, has been a negative for bullion this year, said Mr Turner. A variety of duties and other import controls and the sharp devaluation of the rupee, which raises the internal price of gold, caused imports to tumble in recent months.
Gold refiners and traders are hoping that Diwali, India's festival and wedding season in November, will boost demand, but others say there could well be a switch to cheaper silver.
Traders and analysts also hope that once the US government shutdown ends and there is an agreement on extending the government's debt limit, there will again be a rush into equities and gold.
Macquarie, for example, predicts an average price of US$1,385 in the final quarter while 18 analysts surveyed by Bloomberg expect prices to rise compared with only eight who are bearish and four neutral.
Neil Behrmann
10/10/2013
THE big question is why has gold been lacklustre in the face of a US political standoff and monetary easing, a weakness in the greenback, emerging currency upheaval and continued Middle East concerns?
Moreover, President Obama's appointment of Janet Yellen, a quantitative easing (QE) dove, as Federal Reserve chief, should in itself be another bull point for gold. The market expects her to continue with current QE well into 2014.
Since gold's peak of US$1,921 an ounce in September 2011, latecomer investors have had a torrid time. The price slowly sank in 2012 and in the second quarter of this year plunged from US$1,590 to US$1,180 an ounce, then rallied to US$1,420 in August and is now languishing at US$1,320 an ounce.
Most gold watchers focus on the investment and the so-called safe-haven status of bullion, but its demand-supply fundamentals are more complex than that. The market tends to swing between global investment and speculative demand and jewellery and other physical consumption mainly in China, India and other Asian markets.
Gold plunged in June because investors took fright and hedge funds and holders of gold exchange-traded funds (ETFs) dumped their holdings. The subsequent recovery came about because jewellery and other industrial buyers of gold took advantage of cheaper prices and bought.
Investors and speculators are nervous that the political battle between the Democrats and Republicans could cause a slide in equities, commodities, including gold and other risk assets, so they are only prepared to buy on dips. Reflecting their skittishness, gold recently plunged, by about US$40, to US$1,286 an ounce when Russian Premier Vladimir Putin diffused the Syrian chemical weapons crisis and the US began talks with Iran.
The price then rallied above US$1,300, but has not taken off mainly because demand from the two biggest consumers - China and India - has been slack in recent weeks.
According to estimates from Mathew Turner, precious metals analyst at Macquarie Bank, Chinese demand slowed in July and August when the price rallied. Shanghai gold was at a premium of US$40 over the international price at the start of July but since then has slipped to less than US$10. Statistics related to China are a conundrum because of obfuscation on the part of the authorities.
Mr Turner estimates, however, that over and above China's annual gold production of 413 tonnes, the country's net imports from Hong Kong were 818 tonnes in the first eight months of the year compared with 379 tonnes in the same period last year and 643 tonnes for the whole of last year.
An unknown proportion of imports and production could well be going into the central bank's reserves, so it is difficult to gauge consumption. China is completing a week's holiday to celebrate Golden Week, so demand is expected to pick up, especially ahead of Chinese New Year.
India, the world's second-biggest consumer of gold, has been a negative for bullion this year, said Mr Turner. A variety of duties and other import controls and the sharp devaluation of the rupee, which raises the internal price of gold, caused imports to tumble in recent months.
Gold refiners and traders are hoping that Diwali, India's festival and wedding season in November, will boost demand, but others say there could well be a switch to cheaper silver.
Traders and analysts also hope that once the US government shutdown ends and there is an agreement on extending the government's debt limit, there will again be a rush into equities and gold.
Macquarie, for example, predicts an average price of US$1,385 in the final quarter while 18 analysts surveyed by Bloomberg expect prices to rise compared with only eight who are bearish and four neutral.
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