BONDS
“The name’s Bond… James Bond.” Sorry, but I just couldn’t resist. This installment is about bonds that trade on the stock market. A bond is a way for a company or government to raise funds by promising to repay those people who buy them on a set date in the future and in the meantime, pay them a fixed rate of interest. It is an instrument of debt, unlike James Bond, who is an instrument of death, sorry again. Please don’t unfriend me.
We consider bonds one of the safest and most stable forms of investment and financial planners often recommend that up to 60% of your investment portfolio should be in bonds. Let’s look at some aspects of bonds that will be of interest to you (pun intended).
The principal amount of a bond offering is normally in the millions of dollars. Individuals can usually purchase bonds in multiples of a thousand dollars. Institutional investors like pension funds, insurance companies, mutual funds, banks and others will buy large blocks of bonds however, the smaller investor can do the same in smaller quantities if they want. When a bond is first issued, it will carry a competitive interest rate based on the prevailing rates and the safety of the organization issuing the bond. Governments use this form of raising capital frequently and depending on the country, state, province, or municipality that is doing it, the interest rate reflects the ability of the issuer to repay the principal amount and maintain the interest payments. The stronger the institution offering the bonds for sale, the lower the interest rate needs to be.
Government bonds are safe because their ability to pay is almost 100%. A government can raise taxes on their citizens and companies in an unlimited fashion, so there is almost no chance they will renege on their financial responsibilities. Keep in mind, that is not true of every country in the world, and that kind of approach may lead to many other consequences that are beyond our scope in this article.
CRYPTOCURENCY OR DIGITAL CURRENCY ARE TOPICS THAT ARE GETTING INCREDIBLE TRACTION IN THE FINANCIAL WORLD AND IN EVERYDAY NEWS REPORTS RIGHT NOW. IF THERE IS ENOUGH INTEREST, I WILL DEVOTE THE NEXT SEGMENT OF THIS SERIES TO EXPLAINING DIGITAL CURRENCY. I HAD NOT PLANNED TO DO THIS BUT THERE IS INCREDIBLE INTEREST BECAUSE THERE ARE OVER 1500 DIFFERENT DIGITAL CURRENCIES AND PEOPLE ARE WONDERING – IS IT TOO LATE? CAN OR SHOULD I GET INVOLVED? HOW? ARE THE RISKS AS BIG AS I HAVE HEARD? SARCASM ALERT: DON’T TELL YOUR BANKER OR MUTUAL FUND REP THAT YOU ARE GOING TO LEARN ABOUT DIGITAL CURRENCY, THEY WILL TELL YOU THAT JUST LEARNING ABOUT IT WILL CAUSE YOU TO LOSE YOUR HOUSE ALONG WITH YOUR MIND!
You recall that we talked about “yield” when we discussed common and preferred shares, and that becomes a very important part of any explanation of bonds. We have learned that yield is simply the percentage that you, the investor, will receive from the organization that you have invested your money in. However, it is important to understand that risk must be considered. The higher the risk, the higher the initial interest rate or yield. If the market judges one investment to be riskier than another, then the investor will demand a higher rate of return or higher yield. This is clear in the interest offered by a federal government compared to the interest rate that is demanded from a municipality who is also offering a bond for sale. The municipal rate is higher because the risk is greater. The municipality has a much smaller tax base to cover their bond obligations.
Let’s suppose that our fictional company, Orange, plans to build a new manufacturing plant and wants to offer a $1,000,000 bond for sale to potential buyers. How would they become an attractive investment for you and I? We would need to do some comparisons with other opportunities like putting our money into a savings account or buying a federal government bond instead. If we could safely invest our money at 2% elsewhere but Orange wants to attract some of that money, they will need to make the yield or interest rate more attractive because the risk is higher for a small company.
One other thing we will cover regarding bonds since they, like stocks, trade on the stock market. Let’s pretend that we bought $1,000 bond from Orange and they are paying an interest rate of 3%. We have decided that we want to sell it, but interest rates have gone up and a similar bond would need to offer a yield or interest rate of 6% in order to be successful in raising the capital. What happens? Why would someone pay $1,000 for a bond and only get a return of 3% when they could get double that return on a different one? In order to sell our bond, we will need to compensate the buyer by lowering the $1,000 bond price so that they will get a 6% return. Just like common stock, all investment opportunities become a function of risk and reward. The opposite is also true, if interest rates drop then we would expect the price of the bond would increase.
This is a very rudimentary explanation of how bonds work and like everything else in the investment world, you will want to do more research on your opportunities before plunging in. Another source of investment industry knowledge is an online site called Investopedia and gaining knowledge before taking action will help you avoid being “shaken, not stirred”. I know – enough!
We will continue to explore the world of investing and the stock market and the many options that are available for the person who wants to grow their financial nest egg in the next segment. You can receive this information directly to your inbox by subscribing to this blog. Of course, we welcome your comments and we would never share your information with anyone else.