Bond or Bonds
Talking heads are always discussing what is happening in the “Bond Market”. Many suggest that Bonds are less risky than stocks.
Are your friends talking about the bond fund in their 403-b? Come on, I know they are not discussing the World Cup, or whether Lost is really lost…
You may hear terms like:
- Junk Bonds
- Corporate Bonds
- Municipal Bonds
- Government Bonds
- Tax-Free Bonds
- Hi-yield Bonds
- Samurai Bonds
So WHAT the heck is a Bond?
A Bond is a basically a piece of paper, just like a stock certificate is a piece of paper, on which is written the promise to pay back a certain amount of money and interest.
How do Bond’s work?
The Purple Haze Condom Company, needs to build a new plant to make condoms-business is great. (Hey, don’t forget I am a gynecologist!) The condom company does not have enough money in the bank to build the factory-or they have the money, but the company CEO, John Dick, wants his own private jet. So they want to raise the 25 million another way.
They have three options to raise money:
- Borrow from the bank. (if their credit is good enough)
- Sell part of their company ( by selling stock shares).
- Sell Bonds.
The condom company and it’s consultants, put their heads together and decides-which of the above ways to raise money. Which will be the cheapest and least risky for the company?
If they decide to sell bonds, they have several more decisions to make or are made for them:
- They decide how long it will take for the bond to mature. The Maturity date is the date the full amount of the bond will be repaid to the bondholder (purchaser) usual face value of $1,000.
- The interest rate is then decided by bond experts-they judge the amount of interest to be paid on the bond, to get the public or large investors, such as pension funds, to buy.
- The bond has to be rated. A company such as Moodys, or Fitch, or Standard and Poors, comes in. They study the companies’ books, and management. They issue a rating, and the higher the rating, the lower interest rate the condom company will have to pay to get people to buy their bond. Supposedly, the higher the rating, (AAA) the lower the interest rate, because the risk of the company going out of business is lower. The ole high risk, high reward-low reward scenario!
- Another expert tells them when the time is right to put the bonds on the market.
Going back to the Purple Haze Condom Company-The CEO, Mr. Dick says,” I agree with the consultants,” “We will sell 25 million dollars worth of 30 year bonds at a yield of 5% to build the most efficient, safe, and environmentally friendly condom factory in all the world!”
“I am so proud that Moodys has studied our company and decided we were worth a AAA rating! We don’t have no junk in the trunk!”
“And I will visit the new factory, on my new G-5 jet, with my girl..I mean my personal assistant-to welcome all the new employees of The Purple Haze Condom factory!” “Maybe President O will give me one of those special medals, and allow me a night in the Lincoln bedroom for decreasing unemployment, (and giving his campaign $$$$).
The press releases are written, and the Bond salesmen go to work. They convince enough people to buy the bonds to raise their 25 million bucks to build the factory. The bonds are sold to pension fund managers, mutual fund managers, the Sultan of Oman, and his three hundred princely children!
And a certain gynecologist chooses to buy ten bonds and plans to use the interest to help pay for his nursing home care.
What did I get when I bought my 10 bonds for $10,000? (remember they were $1,000 each)
- A piece of paper that says the The Purple Haze Condom Company will pay my $1,000 back in 30 years for each bond.
- Each year during that thirty years, I will get an interest payment of $500-either once or divided into two payments. That payment will help pay for one of my 365 days of nursing home care-maybe….
- I might decide I need more of these bonds the way nursing home care costs are going up!!!
What were my benefits of buying the bond?
(Besides helping to make the world safer from AIDS, and unintended pregnancies, and giving the CEO an excuse to get out of town with his PA?)
- A fairly safe investment that returned 5% annually for thirty years. (rated Triple A!) Then I get my 10,000 bucks back to invest again, if I am still around. If not, I am sure my children will toast me, when they get the check. (They may be surprised when the check goes to my scholarship fund….:)
What were my bond risks during that time?
- Investment risks-what if the Purple Haze Condom Company went out of business because of poor quality control issues or a shortage of latex, or the company CEO kept flying and skipped the country with the companies’ money? I might get a little of my money back when the factory was sold, but it is not guaranteed. The rating agency might say they were sorry….(probably not!)
- Interest rate risk-What if I needed to sell my bond in a hurry to raise money to buy the night nurse at the nursing home a diamond.The interest rate on my bond is 5% but new bonds have a 7% rate. I would have to sell my $10,000 bond at a discount. Who wants a 5% bond when you can get a 7% bond-so my bond will sell for less than the $10,000 face value to make up for the lower rate.
- Market risk: Again, if I needed to sell the bond to raise money quickly, but the overall stock and bond market had dropped that week-my bond would have to be discounted even further to get anyone to buy it.
In summary, bond investing is complicated. I did not talk about the many different bonds out there. I will leave that for Bonds-Part Two. But most experts feel that bonds are safer overall than stocks, but certainly not risk free, as Enron, World-Com, Lehman, and many other bondholders have found!
A diversified bond portfolio of various types and maturity lengths, is important- just like the diversification of stocks. It helps lower your risk. Most 403b or other retirement funds, have many different bond mutual fund choices to invest.
- Do you understand bonds?
- Do you own any bonds or bond mutual funds?
- Do you have a favorite bond or bond mutual fund?
- Where did the term “clipping coupons” come from?