A few weeks ago I started thinking about how to discuss investing with residents, as I have been half-invited to talk with them about financial topics.
I had planned to talk about investing, but realized there were a number of steps a person should go through first before committing money : first, making sure the investor actually has some money they can invest, and then explaining why risking their money in investments beats hiding cash under their mattress.
I have been putting off the discussion of investing–mostly talking about stocks and bonds–because the more I think about them, the more complicated they feel.
Last week I tackled an introduction to stocks, and this week I am attempting to tackle bonds.
What Is a Bond?
When you buy a bond, you are involved with loaning money. You offer (pay) money, and are promised a return of your money in so many years (the day you get your money back is the maturity date). To compensate you for putting your money at some risk, and for tying it up, you are offered interest on it. These used to come with coupons, which you would bring to your bank to get your interest. Nowadays, if you buy an individual bond, I suspect you get the interest deposited electronically.
So basically, when you buy bonds, you are making a loan to an entity, with plans to get the money back, but also to earn interest on it in the meantime. Your interest rate is higher than at the bank, because your money isn’t 100% secure.
In the last decade or so, the returns on bonds have been lower than for stocks. That might make a person wonder why they should bother investing in them.
However, that has not always been true.
Returns on stocks and bonds do not always correlate. That is to say, when stocks are doing worse, bonds may do better; and vice versa.
This can help reduce the effect on your portfolio by any wildness of stock market swings, which might help you sleep better at night. Oh, the stock market dropped 25%? Eek! But look, my portfolio only dropped 10%–that’s a bummer, but seems a lot better than 25%.
One of the advantages of bonds, at least high quality bonds, is that your risk of losing principal is usually low. And the interest rate, or the coupons, can represent a stable source of income.
What are the Risks?
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The most obvious risk is that you might not get your money back. These are investments, not necessarily safe or guaranteed places to put your money.
If you loaned your money to an entity who couldn’t pay it back, you may not see your money again at the maturity date. Though, to be fair, as a bondholder, you are higher up in line for repayment than a stockholder.
There are credit-rating agencies (Moody’s and Standard & Poors are 2 of the big names here) whose job it is to assess the likelihood that someone will pay back the money. A high grade (AAA or AA) bond is very likely to be paid back. Somewhere around BB or Ba (depending on the scale), a bond is considered to be more “speculative.” That doesn’t mean imaginative, that means you might lose your money.
Junk bonds are bonds that are speculative (or highly speculative); you might earn very high interest rates on these, to compensate you for the risk that you might lose your principal.
The value of your bond may go up and down if interest rates change.
Let’s say you have a bond for $1000, and you are supposed to get 4% interest on that every year. At the end of ten years (the maturity date), you get your $1000 back.
If interest rates stay stable, a 4% return will seem equally good throughout those ten years, so you could probably sell your bond at any time for $1000, since the buyer knows they will get that money back at the end.
However, if interest rates go up, say to 8%, you would hard pressed to find someone interested in your bond. Why should I pay you $1000 for that bond, since I will only get 4% each year? they might reasonably ask. I’d rather buy a different bond, one that earns my 8% on the same money. In that case, you would have to lower the price on your bond, to entice them to fork over money.
Interest rates going down aren’t always a great thing; Bonds can be “called”
You might think, then, that as a bond holder, having interest rates go down might be a great thing.
If you have a $1000 bond returning 4% interest each year, and interest rates drop to 2%, you are in clover. Who wouldn’t want to buy your bond, and get more interest that they could get elsewhere? In fact, you could probably sell your bond for more than $1000, telling people they are lucky to get it.
The issue may be that whoever issued that bond doesn’t want to pay double the going rate of interest. They can’t just decide to give you less, but they may call the bond. That means they can decide to pay off their loan to you early.
Last week you were gloating over earning a ton of interest, much more than those poor slobs trying to invest their money. Now you have a paid off bond, and don’t know where to put the cash in your pocket.
Who issues bonds?
Generally speaking, there are 3 major issuers of bonds in the US: companies, local governments, the federal government. Other countries also issue bonds.
Corporate bonds
A company might issue a bond because they want to raise money, but they don’t want to dilute the value of their stock prices. Or maybe they aren’t a publicly traded company.
So if the company wants to build a factory, or pay off a higher interest debt, they might issue bonds. Give us money now, they offer, and we’ll pay you 6% on it (0r maybe 4% these days). This can be a good deal for them, if the interest rate is lower than what they might pay otherwise; and it can be a good deal for you, since high interest savings accounts don’t pay that much these days.
Municipalities
Let’s say your city wants to build a new elementary school. They need a couple hundred million dollars to get the job done, but plan to get that back over the next ten years with an increase in the school taxes. This plan gets approved by the local tax payers.
Your city would issue a bond to raise the money quickly, and then use the increased taxes to pay the coupons and, eventually, the principal of the bonds.
If you buy these bonds, you get a break on taxes yourself. No, you don’t get to weasel out of the school tax. But you won’t have to pay federal taxes on the income, and you might not have to pay the state tax either. That depends on whether you live in the same state, or are investing from afar.
The federal government
Lastly, you can buy bonds issued by the national government.
In the USA, that means Treasury notes/bills/bonds. Apparently notes are for bonds of less than 1 year’s duration. T-Bills have durations from 2 to 10 years. Treasury Bonds have a 30 year duration. These are considered pretty safe, being backed by the US Government.
You can also buy bonds of other countries, who might be just as reliable, or maybe less so. If you buy foreign bonds, you assume another risk: currency risk. That is to say, if you spend $1100 to buy a 1000-Euro bond with a 5 year duration, at the end of 5 years you will get back 1000 Euros. But those 1000 Euros may be worth less (or more) than $1100 in 5 years.
Can you diversify?
You might recall that last week, I wrote about mutual funds and ETFs as a way to spread the risk of a company failure. This can keep you from losing your shirt (and slacks, and shoes), because you aren’t investing in just 1 or 2 companies; you might be investing in 100s.
You can do something similar, by investing in bond funds. These are funds that purchase bonds of various types, spreading your risk a bit.
They prevent you from putting all your eggs in one basket–for example, buying only bonds from Puerto Rico (which stopped paying interest on their bonds a few years ago).
On the other hand, you do lose the assurance of preserving your capital. If you buy a $1000 bond that matures in 10 years, you know you should have $1000 in hand in 10 years. With a bond fund, that may not be true.
However, you can pick bond funds to take advantage of other beneficial aspects of bonds, like buying state-specific funds, to reduce your state tax on that bond income.
I think I will stop here after having written 1500 words about bonds.
I hope it goes without saying (but I will say it anyway), that this is for educational purposes only. Please don’t make your investing decisions based solely on my meandering attempts to review the basics on stocks and bonds.
What do you think about this introduction to bonds? Too basic? Too much information? Have you had to teach this information to others before?