Investing Basics Bonds Part 1

I’m a big believer in understanding the basic concepts of what you are invested in. Each asset class has its own unique characteristics, risk profiles and short and long term performance. Understanding why these investments act the way the do will help you have faith in the process of investing within them. The next few investing basics posts will cover the main types of investment categories that most professional investors will come across.

What is a Bond?

The first basic investment is a bond, which really is just an IOU from a borrower that needs money for some purpose. The main components of a basic bond are:

  1. The principal – the total amount of loan being lent.
  2. The term (also known as maturity date) – over how long a time period the borrower has to pay the total loan/ principal back. This can be fixed where there is no option for early repayment or can be variable and paid back at any time.
  3. The interest rate (also known as yield or coupon value)- this is the fixed percentage of the total loan that is paid typically on an annual basis as compensation to the borrower. The payment of the interest by the borrower does not change the principal amount owing at the end of the term noted above.

A bond sounds quite simple in concept. Like most things, it can be made as complex as anyone can dream up. The easy part to understand is that there are different quality of borrowers in the investing universe. Anyone who has lent money would know the expectation of having your loan repaid is highly dependent upon who you lent to. A $500 loan to a person making $100,000 per year compared to someone who is unemployed has a very different likelihood of repayment and therefore a different risk profile.

Bond Credit Rating

Your personal credit score is part of how most lending institutions determine your likelihood of repayment of debt. It has significant bearing on both the amount of credit you can receive as well as the effective interest payment you need to pay to compensate for your risk profile as a borrower. Remember that no one is forcing the lender to give you a loan and therefore the terms of the loan need to be acceptable to both parties.

There are ratings agencies such as Moody’s or Standard and Poors (S +P) that play the role of evaluating the credit rating for entities in the investment world. This may range from an excellent AAA grade, which implies almost guaranteed repayment, to junk bond status which implies the borrower has a very real chance of bankruptcy also known as default risk. There are many factors that determine the default risk of governments or corporations such as current existing debts, interest rate environment and profitability, but this is beyond the scope of our discussion. Most of the time these ratings agencies do an excellent job evaluating the risk and therefore most investors will give excellent borrowing terms to the AAA grade borrowers and loan shark type borrowing rates for the junk bond borrowers.

As an aside, an excellent example of the blind faith of the investment world to the rating agencies’ opinions is in the financial book turned movie “The Big Short”. Mortgage Backed Securities (MBS’s) were given AAA grade stamps of approval despite very few people really understanding what underlying assets were within them as they had been repackaged so many times. This had a huge part to play in the financial meltdown of 2008/2009. Watch the movie if you haven’t already – the adaption makes it easy for anyone to understand and the story is well represented.

Types of Bonds

The are many categories of bonds that represent the different types of borrowers who exist in the world:

Government bonds

Government bonds are typically the safest types of bonds to buy as an investor. Developed nations like Canada offer bonds to investors in order to finance government spending that is beyond the taxable budget they have. Government bonds can be further broken down into bonds issued by a nation, province/state, or even municipal region. Each type of government has its own spending requirements that are constantly changing.

The USA offers treasury notes that are AAA grade and are generally considered the safest asset class in the whole investment world. Currently these are typically yielding 0.5-2% depending on the duration of the bond, which can be a few months to 30 years. The low amount of interest reflects the high probability of repayment. The reason why government bonds are generally considered quite safe is because a government has a guaranteed future revenue stream through taxes.

Government bonds can still be risky – Zimbabwe has had interest rates between 9-16% in the last decade secondary to the real risk of government insolvency or further rapid inflation that would make the purchasing power lower with the dollars you receive back from the loan. Even developed nations like Portugal, Spain, Ireland and Greece went through difficult economic times where their interest rates climbed higher secondary to the risk of default. The reason things settled down for these governments is that the European Union effectively stepped in like a parent “guarantor ” to backstop all the outstanding loans for these struggling nations. Otherwise these governments would not be able to find investors willing to loan the government money without the interest rate being quite high to compensate for the risk.

Developed nations’ government bonds are widely considered the “risk-free rate” for all investment class comparison. This is because any excess risk taken by lending to another type of safe borrower or investing in a stock should be compensated with a better expected return than what the risk free rate is. This sounds complicated so I will give an example.

If Joe Blow down the street offered you a loan for 2% interest, would you pick him or the government of Canada who also offered 2%? Yet if Joe offered terms of 20% interest, the additional 18% above the risk-free rate may be adequate to compensate for the risk of never getting your loan repaid. Unfortunately, you will rarely find 20% loan terms as an investor – you will only have the chance to pay them if you carry credit card debt!

Guaranteed Investment Certificate (GIC)

A GIC is a name given to a type of bond in Canada that is offered by banks or major lending institutions. It is also a very safe asset since it is “guaranteed” to be paid back plus a little interest. Recently, the yield is also in the 0.5-2% range and tracks the Central Bank of Canada lending rate.

Contrary to popular belief, this is not a government loan. This is a loan from a corporate banking entity such as Royal Bank, TD or BMO. These corporations will take your deposit and likely loan it out at a better interest rate via a mortgage or credit line product to a different borrower. Just like our government bond example above, an investor should decide the risk of the loan by the likelihood of the corporate entity not being able to pay the loan back, ie. a default/bankruptcy event.

Banks can and do default more often than a government would and normally pay a higher interest rate to compensate for this risk. A normal business has no way of “guaranteeing” they will pay back a loan. Random economic or business specific events can create a “black swan” event, which means a low probability events that have dramatic outcomes since they were felt to be so unlikely to occur. The recent Great Financial Crises would be an example of this and banks like Bear Stearns and Lehman Brothers were essentially in default before being rescued by the US government.

A GIC can be guaranteed simply because the Canadian government is willing to act as the guarantor on the loan. The Canadian Deposit Insurance Corporation (CDIC) is a Crown corporation that guarantees the chequing and saving deposits as well as GIC’s up to $100,000 per client for all it’s CDIC financial institution members in the event the institution defaults or is in bankruptcy. This may seem like an unlikely event, but has occurred 43 times since the CDIC was formed in 1967(at least it hasn’t been one every year!) Overall, the banks are getting a pretty sweet deal with GIC’s. In essence, a GIC gives the borrower a smaller than usual interest payment since the loan is “guaranteed”, but the guarantee is from you, the Canadian taxpayer.

Corporate Bonds

The last major class of bonds we will discuss (there are many more types) are the ones offered by businesses or corporate bonds. A business will need capital or equity to be able to:

i)facilitate its basic operations

ii)make improvements to its equipment

iii)expand/grow its business

iv)return capital to its shareholders via dividends or share buybacks

v)Pay existing debt

Capital allocation is the term used for how a CEO selects between all these options in any given business environment.  An excellent business will be able to generate all the capital it needs from operational profits to facilitate the above expenditures. Many businesses will need to take on some form of borrowing to cover all the different types of capital spending noted above. Small businesses will often go to a local bank to try to get a loan as they are left with few other options.

Medium or large businesses would go to the financial markets to create a loan offering for multiple investors to be able to participate. A huge loan prospectus document is created by the company and whatever bank they hired for help. The prospectus details all the proposed lending terms which a potential investor should read before agreeing to act as a borrower. Once the loan offering has been completed, a certain number of investors hold a bond certificate that shows they are owners of the loan.

Clearly the same basic concept of risk applies to corporate bonds like was discussed regarding government bonds above. Walmart has a higher likelihood of bond repayment vs. your cousin’s start-up business he is running out of his garage. Rating agencies like Moody’s also produces investment grades for corporate bonds ranging from AAA to junk bond status. Companies that begin to take on excessive amount of debts or have lower profits from a downturn in business may have their ratings cut. A worse rating won’t change what the business is required to pay on bonds they have already issued in the past. A rating agency cut or debt downgrade will affect the investor who holds an existing bond and may want to sell it before its final maturity date.

A worse rating will affect the future borrowing ability for a business and will mean higher interest rate costs on a future bond offering. For some businesses, the higher interest payments can be the start of a vicious cycle of inability to keep up with capital allocation plans or future debt payments and can lead to a business bankruptcy event.

Bankruptcy and Bonds

A bankruptcy event tells the tale of why bonds are considered safer assets than stocks. Upon a default/bankruptcy event, the courts will sell off whatever assets remain in the business to any willing buyers such as equipment, buildings, patents or land.

The first people to receive money from the asset sale of a bankrupt company are the bondholders (this can get complicated as there is different levels of  “senior” bondholders who may have first access to the assets before other “junior” bondholders but we won’t get that deep). The amount of assets in bankrupt company is rarely zero, unless it was a very risky/speculative bond.

Only after all the debt has been paid will the “stockholders”, who are considered the owners of the business, receive whatever is leftover. This amount can be often be zero for stockholders unlike the bondholders. I find this simple summary as a nice way to think of the difference between bondholders and stockholders of any given company:

  1. Bondholders have a claim to the assets of a company without any claim to the profits of a business.
  2. Stockholders primarily have interests in a share of the profits of a company. They may receive some assets from a failed, unprofitable business, but only after all debts have been paid.

Part 2 Primer

Some of you that hold bond funds may wonder why the quoted value keeps changing if each bond has a guaranteed interest payment and a fixed maturity date after which you receive your loan principal back.

This is because a bond investor will have a choice:

  1. They can hold their bond and collect the interest payment for the full duration of the borrowing term. At the end of the term, they can collect the full principal amount they initially lent.
  2. They can hold for a certain period of time and then choose to sell their bond certificate/rights to another individual in the secondary financial market where bonds are traded on a daily basis all over the world by millions of investor participants. It is in this setting that a bond’s relative value fluctuates when compared to the millions of other bonds available for purchase.

In Part 2 of this bond series, I will explore how a bond’s value changes over time and evaluate long term historical bond performance compared to inflation. Have you invested in bonds before? Did you understand what they hell they were? Did you feel your financial advisor explained what you were investing in? Let me know what your experiences have been like and feel free to ask any questions.

 

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