Bonds

Bonds

The great thing about bonds is that they are (mostly) 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, and any change in value comes from changing interest rates and trading activities.  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?

Caveat:  It’s Just a Matter of Time

Your research methods professor probably told you that recency is essential when dealing with technical information.  If you use 36-year-old books to write your research paper, you will likely not be relating the current state of the art.  Financial information certainly falls into this category where recency is critically important.  As I write this, equity markets have done wonderfully well for several years, but seem to be faltering.  Interest rates are meager, but the Fed has committed to raising them in the mid-term.  Inflation is at historic lows, and will likely rise shortly.

Much of what is said in this book is said in the context of what is mostly a zero percent interest rate.  If those rates climb as the Fed tells us they will, then bonds and other debt securities will become much more attractive.  When bonds start paying 8%, it may well be time to reevaluate your investment plan.  This suggests that you cannot rely on cookie cutter portfolio allocation strategies and must understand security markets in particular and macroeconomics in general.  There may be no free lunches on Wall Street, but investing time in your financial education will pay handsome dividends.

I have said it repeatedly throughout the first book in this series:  Debt is evil.  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.  A bond is a certificate that represents a loan made by the bondholder to a government or business for a specified amount of money that will be repaid at a specified time along with a specified amount of interest.

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.  Significant 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 fantastic 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.”  The United States government issues these bonds.  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 is such a fabulous amount of money; no bank can lend the amount necessary to fund the new project.  Ford is an ultra-massive company, but still, they can’t sacrifice that amount out of their operating budget; workers wouldn’t be paid if they did.  Ford could sell $5 billion worth of corporate bonds and pay them off over a protracted period.  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.

Investors refer to borrowing money in an attempt to make even more money leverage.  Stock traders are wary of companies with too much “leverage on the balance sheet” because companies that borrow too much may have a hard time paying back the money they owe and still operate the business profitably.  Individual investors can also use leverage by borrowing money to make investments.  This is most often done using margin, which is money borrowed from your broker using your portfolio as collateral.  Leverage can magnify gains, but it also amplifies losses.  Do not do it.

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 cannot 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 liquidation of corporate assets.

Why would you ever buy corporate bonds instead of government bonds?  Because these companies know that 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 pose 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 do not 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.  Do not let all that lingo scare you.  Bonds are pretty easy to understand.  There isn’t much to be gained for the average investor from buying bonds directly; as we will discuss in depth later, you can buy a whole basket of different bonds that fit different profiles by purchasing a mutual fund.

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 tremendous amount of money from individual investors and purchase 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 am not saying anything about CREF, they are an excellent firm.  I am 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.  However, 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 is just stupid.  No one in their twenties has any business in bonds; you cannot get rich at 4%.  It is just that simple.  Bonds do have a place, however, as a part of a properly diversified portfolio.

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