FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 6.1: Bonds
The great thing about bonds is that they are safe. Put your money into the right kinds of bonds, and you can rest well at night confident that your money is secure. The problem with bonds is that all that safety comes at a price: They don’t grow very fast. Bonds don’t have the same appeal as stocks because you can’t get rich quickly in a bullish bond market. That can’t happen because everyone agrees on the growth before you buy the bonds. The upside isn’t that great, but bonds can be attractive because there is a firm foundation and your principal is very safe. That leads us to our big question: What is a bond anyway?
I’ve said it over and over again throughout this book: Debt is bad. I’m going to go back on that one just a little. Debt can be a good thing if you borrow money and that borrowing allows you to make more money than you are losing in interest. If you can borrow money at 5% interest and invest it at a guaranteed 10% return, then you’d be a fool not to do it. I think this is a bad idea for individual investors because most of us lack both the discipline and the opportunity to make this work. Businesses and governments, on the other hand, do it successfully all the time.
Let’s say, for example, that your local university wants to build a new classroom building because enrollment has increased 50% over the last five years and they don’t have anywhere to put the necessary new classes. Big government buildings cost a fabulous amount of money. Let’s say that the university has consulted with a design and construction firm and has a bid for ten million dollars. It turns out that much of the time the best way to borrow that kind of money (if you are a government or a government agency) is to sell bonds to the public.
The university will pay an investment firm to do the amazing amount of paperwork such an “offering” calls for, and then they will sit back and watch the money roll in as investors buy up the bonds. The university is basically saying that if you loan us a specified amount of money, we will pay it back in a specified amount of years and also pay you a specified amount of interest. Bonds are often referred to as fixed-income securities because you know exactly what the interest rate is before you buy.
The Federal government does this sort of thing on a regular basis; everyone has heard of a “savings bond.” These bonds are issued by the United States government. Because Uncle Sam is so trustworthy and has a couple of hundred years of paying off debt, everybody trusts in U.S. Bonds. Nothing is 100% safe, but U.S. government issued bonds are about as safe as it gets. Because of all that safety, they get away with paying interest rates that aren’t very good. Why sell bonds? Even banks don’t have the billions and billions of dollars laying around that they’d need to keep Uncle Sam in cash. If they did, they probably wouldn’t want to tie it up for as long as Uncle Sam wants it. Bonds can spread billions of dollars among millions of investors and make that sort of borrowing possible when no other method exists.
Big companies can do this as well. Let’s say Ford Motor Company (F) wants to build a new factor that will cost $5 Billion. That’s such a fabulous amount of money, no bank can lend the amount necessary to fund the new project. Ford is a massive company, but still, they can’t sacrifice that amount out of their operating budget; workers wouldn’t get paid if they did. Ford could sell $5 billion worth of corporate bonds and pay them off over a protracted period of time. The logic is that the new facility will add billions of dollars in revenue, and the low rate of borrowing the money will be more than compensated for by the increase in revenue that the new facility will provide.
We can see from this example that buying bonds from companies is much riskier than buying them from the government. If Uncle Sam gets in a bind, Congress can raise taxes enough to pay off the debt. Companies can’t do that! Before buying a corporate bond, you have to understand if the company can afford to pay off the debt if the investment is a big flop and doesn’t make the kind of returns that the company thought it would. There is a risk that the company could go belly up and you’d lose your investment. Rarely would you lose all of it because the bankruptcy court would force them to pay you back through a liquidation of corporate assets.
Why would you ever buy corporate bonds instead of government bonds? Because these companies know you will prefer the safety of government bonds, so they entice you to loan them the money by paying better interest rates. Huge, stable companies that no one can imagine going bankrupt pay better interest rates than government bonds, but not as much as smaller companies that represent more risk. You can go all the way down to buying “junk bonds” that pay pretty high-interest rates, but represent a huge risk because the underlying companies are small and unproven.
The bond market is pretty quirky, and there is a lingo that goes with it. Often (depending on the type of bond) you don’t have to wait until the company gives you your loan amount back to collect the interest. Interest payments are made on a set period, and the specified interest rate is referred to as the coupon. The date when the borrower will pay you back the amount they borrowed (called the face value) is known as the maturity date. Don’t let all that lingo scare you. Bonds are pretty easy to understand.
Let’s say you invest in a bond with a face value of $1000 and a coupon of 10% and a maturity date ten years in the future. That means that the bond issuer will pay you $100 a year for ten years, and then give you your $1,000 back. You may get the $100 at one time, or the bond may pay interest semiannually and you’d get a $50 check twice per year. In reality, bonds can be a pain for the individual investor (unless you are talking about U.S. Savings Bonds). Many investors choose to buy bonds through buying shares of a bond fund. Bond funds pool a huge amount of money from individual investors and buy tons of bonds with it. When you invest in the fund, you own shares of it, and these trade like stocks.
My retirement account is with a company called TIAA-CREF. They have a bond fund in which I can invest my retirement account or any percentage of it that I choose. The CREF Bond Market Account ended 2016 with a return (interest rate) of 3.47%. (I’m not saying anything about CREF, they are a fine firm. I’m just using this performance to illustrate that bonds have a low return in general). If all you want your retirement fund to do is hedge inflation, then this fund did a pretty good job. If you are 65 years old, then this is where at least half of your funds should be. But if you are young, these anemic returns will never make you wealthy. Investment experts say that you need to increase your “bond exposure” a fraction as you age and get closer to retirement. Call me a risk enthusiast, but that’s just stupid. No one in their twenties has any business in bonds; you can’t get rich at 4%. It’s just that simple.
If you hold onto your bonds to maturity, you are guaranteed to get your money back as I described above. You can also sell them early. Bonds can be traded on the open market like stocks. When you get into this game, the value of the stock can rise and fall just as stock prices do. When stocks are traded in the market prior to maturity, then a number of great importance to the investor is yield. The yield of a bond is the coupon amount divided by the price. This gives us a ratio of interest to price.
It is important to keep in mind that the amount of the interest payment doesn’t change even if the value of the underlying bond does change. Let’s go back to our earlier example: Let’s say you invest in a bond with a face value of $1000 and a coupon of 10% and a maturity date ten years in the future. What happens if the price drops to $800? Then the yield shoots up to 12.5% ($100 / $800 = .125). That sounds great! But what if bond prices go up and the underlying bond is worth $1200? Then the yield falls to 8.33% ($100 / $1200 = .8333).
The biggest influence on what bond prices will do in the market is the prevailing interest rate. When the Federal Reserve changes interest rates, the market listens! When interest rates go higher, the prices of bonds in the market fall. This raises the yield of the older bonds and brings them into line with newer bonds being issued at higher interest rates (coupons). The converse is also true. When interest rates are cut, the prices of bonds in the market goes up. This causes a decline in the yield of the older bonds and brings them into line with newer bonds being issued at lower interest rates.
Cities and states can offer bonds for sale to the public, but the investment instrument of choice for many Americans are bonds backed by good old Uncle Sam. We’ll focus on those popular (if not profitable) “marketable securities” offered under the protection of the full faith and credit of the United States Government. You may have noticed from the 30 seconds your local news dedicates to financials that there are different kinds of government bonds. There are treasury bonds, treasury notes, and treasury bills (known to many investors as T-bills). T-bills aren’t considered bonds from a technical standpoint because of their very short period of maturity (they mature in less than 1 year). Notes are the middle ground between T-bills and bona fide bonds. Notes mature anywhere from one to ten years. Securities called bonds by the U.S. Government will mature at least ten years from the date of issuance.
This section is intentionally short because these investments are never really a good idea unless you are about to retire, retired, or are placing risky bets on interest rates. It is worth noting that placing risky bets in any market is stupid, and making risky bets on instruments regarded as “safe” is no less stupid.
References and Further Reading
Bonds issued by the U.S. Government are available direct to the consumer via the Treasury Direct website maintained by the U.S. Department of the Treasury at the following site:
If you want to know how creditworthy a business is, you need to look no further than the company’s rating by Moody. Visit the Moody website to learn more: