Last week, I tried to give a basic description of stocks, starting from the time they are created to the time they are then bought and sold on an exchange. This week, I will look at bonds in the same light. This should help you to understand the idea of a bond and why a company (or government) would issue one.
Think of bonds as loans. By this stage in my life, I know all too well what a loan is! My parents have loaned me many a dollar for a variety of different undertakings, most of them resulting in me spending (as opposed to investing) the money on dumb things and having to work to pay it back over time. Luckily for me, my parents didn't charge me any interest for borrowing their money or some of my loans could have been rather expensive propositions.
The easiest description of a bond would be to think of it as the I.O.U that I would have written my parents for their money. When a company needs money and doesn't have enough cash from the day-to-day business, they can write a giant I.O.U to whomever is willing to lend them the money. Let's take our baseball cap company from the previous post. Since we have been in the cap-making game for quite a while, we are looking to try something else with our business in order to grow it. We decide after doing some research that making T-shirts would be a good step forward. The problem is that we don't have enough cash to build the T-shirt factory or buy the equipment necessary to make the shirts themselves. We need a loan. For this example, let's assume that the bank will not loan us the money directly, so we have to issue a bond (write the big I.O.U.). We have to decide on how much money we are going to need and what rate of interest (the money that we have to pay our lenders each year for being nice enough to loan us the cash) we are willing to borrow at. If we make our interest rate too low, then nobody will want to buy our bond. If we make it too high, then of course everyone will want to buy our bond but it will cost us too much money in interest payments for the loan to be worthwhile. You wouldn't borrow money from a friend if they were going to charge you 20% interest each year, would you?? There are some factors that go into deciding how our bond interest rate will be set:
1) The Overnight Lending Rate (Bank Rate). This is the rate that we hear about on the news, that the government sets. It is the rate that one bank can lend to another overnight. The government looks at the health of our economy, amongst other factors, before setting the rate. Right now, since our economy is in such a fragile state, our bank rate is 0.25-0.5%. If times are good, there is the possibility of inflation, which would cause the government to raise the overnight rate, which makes borrowing money more costly, slowing business down somewhat. The trick is to not raise the rate too much, which would cause a recession, since lending would slow down too much. In the 1980s when inflation was a huge concern, the overnight rate got as high as 21%. Anyone trying to get a mortgage back then will remember these times all too well. I admit, this is a very simplified explanation of the overnight rate, but anyone who has a mortgage would know how the overnight rate can affect the rates they are charged. Simply put, the lower the bank rate, the lower we can set our bond rate and still have it be competitive. I'll say more on the bank rate another time.
2) Company Quality. As with any loan, you wouldn't want to lend money to a company that you didn't think could easily pay you back. If you did, then you would want a higher interest rate to compensate you for the extra risk you are taking with your money. This is a big part of how rates are set. If a company with a spotty track record of profits and losses tries to borrow money and sets a relatively low interest rate, nobody will lend them money by buying their bonds. As a rule, riskier companies need to pay higher rates of interest to get loans. There are companies such as Moodys or Standard & Poors whose job it is to rate other companies 'credit quality', or their ability to make good on their loans. It's the same for us if we go to the bank to get a loan but haven't been paying our other bills - makes it tough to get that loan.
3) Time. Just like a regular loan, a bond's interest rate will be higher, the longer the company needs the money for. If you are only borrowing funds for a year, you don't need to be paying too much interest. On the other hand, if you want to borrow funds for 30 years, this is much longer that you are asking me to have my funds tied up with you. Therefore, you will have to pay me more interest.
When we have these criteria set (the size of the bond and the interest rate, or coupon, we are prepared to pay) then we alert the public to see who wants our bond. If we've priced it right, then we should have no problem raising the money we need.
As we know, governments also issue bonds. In Canada, we have Government of Canada bonds (Canadas), Canada Savings Bonds (CSBs), Provincial Bonds, municipal bonds (munis) and also bonds for certain crown corporations, such as Canada Housing Trust. The government is issuing bonds for the same reasons that companies are; building roads, schools, hospitals and other types of public investment. They pay off the bonds through taxes, which is effectively the main income source for the government. We are lucky that our financial system is in such good shape (i.e. we have a good economy that generates lots of tax revenue and we don't have a lot of debt, relatively speaking), so that our government bonds are very safe. Other countries such as Iceland aren't so lucky. The entire country had to declare bankruptcy about a year ago. So indeed, different governments have different ratings on their bonds, depending on the health of their economy.
So let's say you like the idea of owning bonds. How does one buy them? There is a bond market, but not really a bond exchange, so to speak. Each bank will buy bonds and have an inventory of different bonds at any given time. To buy bonds, you have to phone up your banker or advisor and see what kind of bonds they have available. The advisor will ask you which ones you are looking for, so there are considerations to this question as well. To answer them, we have to understand how bonds move (and yes, they do move) in price. If you want to sell bonds, you sell them to your bank's bond department and they will give you a bid for that bond, similar to selling a stock but without the stock exchange. The price that they will give you is determined by a few factors:
Let's say you buy a 10-year Bank of Nova Scotia bond with a coupon of 5% (that means the bond will pay you 5 cents for every dollar they issue) and you buy it on the first day the Bank issues their bond, so you pay $100. You buy $100,000 of this bond, so each year, you get $5,000 in interest (hence the 5% coupon). All is good. However, here's the tricky part. Interest rates go up so 6 months down the road, the Bank of Nova Scotia issues another 10-year bond but this time, the coupon is 6%. What do you think happens to the price of your bond if everyone can get the same company bonds with a higher coupon? That's right. The price of your 5% bond goes down until the yield of your bond (the coupon divided into the market price) equals about 6%. The laws of supply and demand! Why would I want your 5% bond when I can get one that pays 6% from the same company? Odds are if you wanted to sell your bond before it matures (at the end of the 10-year period), you would only be able to get about 85 or 90 cents (or $90,000 of your original $100,000 investment) for your bond. Yes, if you hold your bond for the entire duration, you will likely get your full investment back. The moral of this story though is to not buy long duration (I'd say more than 6 or 7 years) bonds during times of very low interest rates because you know rates are going to rise and when they do, nobody is going to want your bond that has a low coupon. If you do, then be prepared to hold them to maturity if we get rate increases because of inflation.
It's a lot to digest, I know. Feel free to ask questions in the comment section and I will either email you or answer directly.
The other risk of buying bonds is the obvious one: bankruptcy. If the company doesn't have the money to pay you back, then you are out of luck. So think twice when looking at bonds with very high yields (over 10% these days) because odds are that something is not right.
What would I do right now for bonds?
1) Buy short to medium term bonds and be prepared to hold them to maturity. It may not happen this year but eventually, interest rates will rise.
2) Buy good quality. If you aren't comfortable with buying the stock of a company, don't buy the bonds. You can look at government bonds but the yields usually aren't that attractive, although they are normally very safe.
3) Diversify. Just like stocks, it's always good to own a few different bonds in case something unpredictable happens to one of yours. At least you would be insulated.
There is so much more I could tell you about bonds; the world's bond market makes the world's stock markets look tiny. Please feel free to answer questions about this - I'd welcome the dialogue.
Thanks for reading.
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