After setting up your emergency fund, you should consider paying your high-interest and short-term debts such as credit cards to potentially free up cash for your investments, and you can start with a clean slate.
Once you have enough cash in your savings account and your debts paid, you need to consider what to do with more income earned. Should you keep all your money in cash?
Protect your money from inflation
Keeping your money in cash would be great if we did not have inflation. However, as an economy grows, there is more demand for goods, and prices tend to rise; this means that if an apple costs 2 dollars now, in one year, it may cost 2.50 dollars. Therefore, your money will lose its value (or purchase power). Prices can also decrease sometimes. When prices drop, we speak about “disinflation”. Let us keep it simple and talk about inflation for the moment.
If we were to keep all our money in cash, we would be able to buy fewer things with our money in one year because most prices of goods across the economy would be higher. Because we cannot control inflation, but we know it happens and it is outside our control, we need to prepare for it.
We need to keep up with inflation.
That is the main risk of holding all our money in cash that our money losses its purchase power in the future.
To keep your money’s purchase power, you may invest in cash equivalents such as treasury bills, bank certificates of deposit or corporate commercial paper (short-term debt issued by corporations); these cash equivalents could help you keep up with inflation.
What are corporate bonds?
Corporate bonds are a fixed-income investment and one of the ways public companies raise money for their projects or operations from investors. Sometimes companies go to banks to ask for loans, but sometimes the money they need is much more than a bank can lend. Then a company would have the option of issuing shares or bonds to raise money. However, raising money through issuing shares would give every shareholder a bit of ownership of the company, diluting ownership, which is why a company may prefer to issue bonds. With bonds, the company (bond issuer) gets to raise money and becomes a debtor or owes money to the bondholders. In exchange, bondholders receive fixed interest payments called coupons, plus the return of their principal once the bond matures. However, they are not entitled to ownership in the company.
Nevertheless, if the company you invested in were to go into liquidation, as a bondholder, you may not recover all your capital). On the other hand, shareholders receive their money back after bondholders. In other words, corporate bonds are a way to finance a company and earn a fixed income and are less risky to invest in than shares.
How corporate bonds may fit into your investment portfolio
Once you have set up your emergency fund in a cash savings account, you could decide to start your investment portfolio with a defensive strategy. For example, you could invest in fixed-income securities because that would help protect your money from the volatility of the financial markets.
Benefits of Corporate Bonds
The benefits of investing in corporate bonds include the following:
- Creating a fixed income for yourself: By investing in corporate bonds, you receive a coupon payment based on a fixed interest rate set when you buy the bond and receive your initial investment back at maturity or when the term ends (unless the company experiences unexpected adverse events).
- Protecting your capital: If you hold your bond until it matures, you receive the face value of the bond (unless the company experiences an unexpected adverse event).
- Keeping up with inflation: The value of inflation-linked bonds goes up and down according to how the Consumer Price Index (CPI) changes, so your purchase power is protected.
- Flexible bond market: If you need to sell your bond before maturity, you may be able to in the secondary market at the bond price the market determines so you do not need to worry about being unable to access your money. However, you could lose money if the price you sell your bond is lower than the price you paid.
Risks of corporate bonds
- Liquidity: Corporate bonds lock your money away until maturity; therefore, if you need your money back due to an emergency, you risk losing money when selling a bond in the secondary market. That could happen if the price at which you sell your bonds is lower than the price at which you bought them. However, you could overcome this risk by keeping your corporate bonds until maturity.
- Interest rates: If interest rates go up, the price of your bond in the market could decrease if you sell at a lower price than what you paid you could lose money. However, if you hold the bond to maturity, you could overcome this risk.
- Credit risk: There is a risk that the company goes into liquidation you may not receive your money back.
A way to assess what bonds are of investment grade is to look at their credit rating (set by agencies such as Moody’s and Standard and Poor’s). Their ratings differ, but they range from investment-grade bonds to junk bonds.
Consider investing in government bonds to stay on the side of investment. They include treasury bonds or municipal bonds. Treasury bonds are issued by the Australian government, whereas local governments issue municipal bonds. Both are issued to support government operations and projects. Although these bonds have a lower risk, their yield is lower than the yield of corporate bonds.
Be sure to speak to your financial advisor before making any investment decisions.
Disclaimer: The information and any advice provided in this article has been prepared without considering your objectives, financial situation or needs. Because of that, you should, before acting on the advice, consider the appropriateness of the advice, having regard to those things.
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