Let's Talk about Bonds (Part 1)
By Gary Silverman, CFP®
When I write about investments, I tend to speak mostly about the stock market. Stocks are the asset class people think of; and the one that tends to bring on more of the panicky or euphoric mindset. Yet there is another 500-pound gorilla in the room. Let’s talk about them. Let’s talk about bonds.
First, a note to my economists: Forgive the generalities I’ll be using. Now go back to predicting the next financial calamity.
Bonds are just a type of loan that you can trade. And you all know about loans. Someone wants money, a second someone is willing to loan the money in exchange for interest while they wait to get their money back. This is how a car loan works, a mortgage, student debt, credit cards, and bonds.
There are many, many flavors of bonds out there, but I’m going to restrict my talk to a “normal” bond. In my example, (fictional) Company QRS wants to build a new corporate campus in Wichita Falls. It will be nice. It will also cost them $50 million. As they have better uses for their cash, and as interest rates are really low, they decide to issue $50 million in bonds.
Issuing means they write up a nice little contract that offers to pay 5% interest if someone would loan them $1,000 for 20 years. They then make 50,000 copies of that contract (I’ll save you the math: $1,000 50,000 times is $50 million). Then they hire someone to go sell the bonds.
In this fictional example, we’ll assume that they are successful and get all the bonds issued at that 5% rate (in reality it can get a little more complicated). Now they have their funding, owe $50 million, can build a new building, and need to pay $2.5 million in interest each year. Twenty years from now, they will pay back the original $50 million that they borrowed.
In this process, you might have been one of the people who were part of that issuance, giving up $1,000 in exchange for a $50 income stream each year. In 20 years, you’ll get your $1,000 back. Of course, the income stream and the payback depend on the company.
A company that is well-established, has good earnings, and whose prospects look good into the future can borrow at a low rate of interest because people are less fearful of something going wrong. The iffier the company, the higher interest rate it would have to offer to get people to take the risk and loan them money.
What if after five years, you, the bondholder (lender) need some money? You can’t just go back to the company in year five and ask for them to cash in the bond early. The agreement was for 20 years and the company does not have to buy the bond back from you. So instead you will need to go find someone else who will buy the bond from you. If you find someone, great! But realize they might not give you the $1,000 you’ve sunk into the bond.
More about that next week.
Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing.