Financial Basics 101 is back! If you read my last blog, you may have guessed that I have been overwhelmed with Back-to-School activities. That would be an understatement, but things have finally calmed down a little now that cross country season has ended. It’s time for me to get back to work! (And yes, Ella had a pretty good first xc season, thanks for asking!) Anyway, if you recall, our last lesson focused on equities. We created a made-up business for my daughter, Ella, to show how she could raise capital by selling shares (stock) of her company. The shareowners, in turn, would hopefully make money as the company grows and profits – either through dividends or by selling their shares for a higher price than what they paid for them.
For growing corporations, the problem with issuing stock is that an initial public offering is a long and expensive ordeal. Plus, every time more shares are created and sold, you dilute the ownership percentage of the current owners, unless they have the ability to purchase more shares. Fortunately, there is another, simpler, less expensive way for companies to raise capital without selling stock. They can issue corporate bonds.
Today’s Lesson: Corporate Bonds
Corporate bonds are a type of debt security or fixed income investment. By issuing bonds, it gives companies the ability to borrow money from investors. Unlike stockholders, investors who purchase bonds have no ownership in the company and have no voice in management. They are simply lending money to the company. Before we get too deep into the weeds of this, I should let you know that there are different types of corporate bonds, but we are only going to look at Fixed Rate right now since they are the most common.
So how does this process work? When a corporation issues bonds, they offer them with a fixed interest rate (coupon rate) and a promise to pay back the principal at a specific date in the future (maturity date). Investors purchase the bonds as a loan to the company with the expectation that they will be paid back for their loan (principal), plus interest (coupon). For fixed rate bonds, investors receive the same coupon payment each time (typically semi-annually) until the bond matures (which is when the principal is paid back). Are you lost yet? Let’s use Ella’s Supreme Slime to help clarify.
- Seren* (also known as "Boo Boo") wants in on Ella’s Supreme Slime profits. She offers Ella $1000 for 10% of the company. Seems fair, right? As much as Ella could use the money to help with expansion, there is NO WAY Ella is going to want to give up a portion of ownership to Seren. Seren is bossy and argumentative by nature. She’s like a tiny dictator and Ella is not going to want Seren’s input on how she should run her business. On the other hand, Ella really needs the money. What can she do? She can issue Seren a corporate bond instead!
Why would a corporation need to borrow money through debt securities? Why can’t they get a loan from a bank? Great questions! Companies often need large amounts of money to help the business grow in some way, like with research and development, buying more property or equipment, or financing a large project. They may also want to refinance existing debt or purchase other companies. Sometimes the money needed is more than the average bank can provide. Plus, bond markets typically offer lower interest rates than bank loans. By issuing bonds, companies are essentially removing the middle man (aka banks).
But why would an investor want to own a bond? You may have noticed that coupons are similar to stock dividends, so why not buy stock instead? The difference is that dividends are not guaranteed. The company must make a profit first and then vote on whether they will issue a dividend or not. Bonds are different because the interest payments are guaranteed. In Seren’s situation, she is receiving income twice a year in the form of a coupon. Plus, once the bond matures, she gets her principal back, which keeps her from spending it in the meantime. Basically, bonds can provide a predictable income stream (return) and preserve capital.
Also, bonds are considered less risky than stocks because bondholders get preference over stockholders at the time of repayment and in the event of a liquidation. That doesn’t mean that there isn’t any risk with bonds though. There is credit risk, which means the company that issues the bonds could default. There is the possibility that the corporation retires the bond before it’s maturity date, meaning they would pay back the principal ahead of time, therefore stopping any additional interest payments (known as call risk). There is also inflation risk. Over time, the coupon payments and principal may not have as much buying power as they did when the bond was originally issued.
Bonds, like stocks, are also tradeable. If Seren needs her money back prior to maturity, she can trade the bond. How much money she would get depends on a number of factors, but we won’t get into all of that today. For now, just know that there are risks that come with trading a bond as well. If Seren needs her money back right away, she may have a hard time trading the bond since the company is owned and operated by a 12-year-old. Who is going to want to buy it from her? This is called liquidity risk. There is also interest rate risk. Interest rates can affect a bond’s value. For example, if interest rates go up and Ella issues new bonds, Seren is going to have a hard time trading her bond for what she paid for it, because the new bonds are going to pay a better coupon than her bond. Why would someone buy her bond at the same price they could purchase a new bond that pays a better coupon? They wouldn’t, and Seren would be forced to sell at a discount (less than what she paid for the bond).
Let’s look at the differences between stockholders and bondholders side by side so you can really see the distinction between the two.
Bonds are generally a safe and conservative option. If the stock market ups and downs scare you, bonds are a good alternative to equities because they can provide some stability in your portfolio. The more bonds over equities you hold, the more conservative your portfolio will be. Think of it as an instrument used to save money rather than to grow money, but with the benefit of a better interest rate than a bank savings account would provide.
I’m going to be honest with you now, of all the financial aspects to review, bonds are one of my least favorite topics, so I apologize if you were bored to tears. I’d love to say that is all you need to know about bonds (mainly because I would love to be done talking about it), but there is so much more! Today we touched on corporate bonds. My next blog, we are going to explore municipal bonds. Just when you thought this topic couldn’t get any more exciting! But it’s still important to know, so hang in there!
In the meantime, if you are interested in learning more about corporate bonds and how to incorporate them into your portfolio, please click here or check us out on Facebook and Instagram (links are below!). I hope everyone is enjoying the beautiful fall weather and everything pumpkin like I am. Mmm…I can’t get enough pumpkin lattes and cookies! I’m so basic sometimes it hurts. Or VSCO if you’re in middle school. (If you’re not, don’t ask.) Until next time…Cheers!
*Boo Boo is my nickname for Seren. I couldn’t tell you why, but it’s better than her original nickname which was Chubbernut Squash.
Bonds have fixed principal value and yield if held to maturity. Prices of fixed-income securities may fluctuate due to inflation, credit and interest rate changes. Investors may lose money if bonds are sold before maturity.
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