To be a truly successful investor, it’s important to understand the nature of any investment that you wish to undertake; by knowing how it can increase in value or supply an income, recognising the level of risks that the investment may bring, and ensuring that the investment type is ideally matched with your financial objectives.

Last week we discussed ways to invest by lending money in the financial markets. As we explained, large corporations, financial institutions and governments can create investments that allow them to borrow money from the investing public for their short-term financing needs or long-term capital requirements.

Investors can lend money to these entities by purchasing a variety of money market instruments that will turn over within 12 months, or by entering into longer-term bond contracts.

A common feature of these investments is that they will have a stated interest rate, which is the cost of borrowing money, and they will indicate a specific date when the investors’ funds will be repaid.

Increasing asset value

Investing in the money market can be the perfect opportunity for investors with limited means to increase their asset value, as most instruments require smaller entry amounts. The fact that these instruments can generally be converted back into cash easily and quickly is an incentive for investors who may not be able to tie up their funds for a long time.

Money market instruments can help to build investors’ wealth by allowing them to earn a higher rate of interest than what is usually available on regular savings accounts. Some options also offer investors the opportunity to compound their interest payments, so that their principal amounts grow with each maturity period, thereby providing more returns.

As bonds require investors to lend their funds for longer terms which could extend to 20 years or more, these instruments usually provide even higher interest rates. Although they do not have the option of compounding their interest payments, bond holders can plan to earn a specific amount of money from their investment for a longer term.

In addition, bond holders may be able to resell their investments on the secondary market and further increase their wealth. Although the bond has a face value that determines how much the investor should get back upon maturity, the instrument also has a market value that can fluctuate. This provides investors with the possibility of selling their bonds at higher prices to make a profit.

Considering the risks

When you lend money, you expect the borrower to pay for the use of your money and return your original principal as agreed in the contract. There is the possibility that the borrower may not be able to make interest payments on time or in the stated amount, or may default on the entire sum owed. Another element of risk is that the terms of the contract might become unattractive to you.

The recent Jamaica Debt Exchange (JDX), in which the Government of Jamaica changed the original terms of their bond contracts, resulted in many investors receiving lower interest rates and having their principal repayments rescheduled. However, under normal circumstances, purchasing government debt securities should be less risky than lending to commercial entities.

One inherent risk in long-term debt is that you may purchase a bond and lock into a good interest rate at that time, but as the years go by the rate may no longer be attractive. Your funds could also be tied up as you may be unable to resell the bond in the secondary market without making a loss on your original investment amount.

While money market instruments may present fewer of these long-term risks, the fact that the interest rates are only guaranteed for shorter periods can actually be a problem. If the market interest rates have fallen, you run the risk that your funds may have to be reinvested at a lower return upon maturity.

Respecting your investment objectives

To determine if investing by lending money is right for you, you must first consider what you want to achieve from your investments. Don’t invest just for the sake of it; the types of assets you choose should always help you to attain your financial goals.

As they are mainly issued by solid entities such as the government and large financial institutions, money market instruments are ideal for investors who have the need to preserve their principal and cannot afford to lose any of their money. They are also better suited to persons who require a current income stream in the short term.

On the other hand, bonds can be perfect for investors who wish to earn fixed, predictable income for the medium or long term, and may not need to get back their funds quickly. They can also be attractive to persons who wish to actively trade instruments in the bond market to make a profit from possible price differentials.

We will continue to look at other ways to invest your money and achieve your goals in future columns.

Copyright © 2011 Cherryl Hanson Simpson. No reproduction without written consent.

Originally published in The Daily Observer, October 6, 2011

Read another article about Bond Investments:

Get A Bang For Your Buck With Bonds

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Cherryl is a financial consultant and coach, founder of Financially S.M.A.R.T. Services. See more of her work at www.entrepreneursinjamaica.com and www.financiallysmartonline.com. Contact Cherryl