In the previous segment of our five part series we got to learn about – Houses and Apartments and how buying a house is different than living on rent. In case you haven’t read then you are most welcome to check out our previous blog post.
As we have mentioned earlier in our previous
segments, we will post an excerpt from the book ‘Learn to Earn’ by Wall Street investor and Hedge fund Manager, Mr.
Peter Lynch, where we understood there are five basic ways to invest money- by putting it in a savings account or something similar, buying
collectibles, buying an apartment or a house, buying bonds and buying stocks.
This segment will cover the fourth investment
strategy - ‘buying Bonds’ which will give us an insight to what happens when
you buy a bond and the related Pros and Cons. It’s a stretchy one but trust us,
the knowledge is worth it.
Have a good read.
Bonds
You’ve probably heard newscasters talk about “the bond market,” “the
rally in bonds,” or “the decline in bond prices across the board.” Maybe you
know people who own bonds. Maybe you’ve wondered, “What is a bond?”
A bond is a glorified IOU. It’s printed on fancy paper with doodles
around the border and artwork at the top, but its purpose is no different from
the purpose of the IOU that’s scrawled on a napkin. It’s a record of the fact
that you’ve loaned your money to somebody else. It shows the amount of the loan
and the deadline for paying it back. It gives the interest rate that the
borrower has to pay.
Even though it’s called “buying a bond,” when you purchase one, you aren’t
really buying anything. You’re simply making a loan. The seller of the bond,
also called the issuer, is borrowing your money, and the bond itself is proof
that the deal happened.
The biggest seller of bonds in the world is Uncle Sam. Whenever the U.S.
government needs extra cash (which these days is all the time), it prints up a
new batch. That’s what the $5 trillion national debt is all about—it’s owed to
all the people who’ve bought the government’s bonds. Individuals and companies
here and abroad, even foreign governments, have loaned the $5 trillion to Uncle
Sam. They’ve got the IOUs in their safety deposit boxes to prove it.
Eventually, these people have to be paid back—that’s what the deficit crisis
is all about. In the meantime, the government has to pay the interest on the $5
trillion worth of loans—Uncle Sam is going broke trying to keep up with these
payments. This is the mess we’ve gotten ourselves into. The government owes so
much to so many that more than 15 percent of all the federal taxes goes to
paying the interest.
The type of bond that young people are most likely to get involved in is
the U.S. Savings Bond. Grandparents are famous for giving savings bonds as
gifts to their grandchildren. It’s a round-about way of putting money in their
grandchildren’s pockets. Instead of handing them the money directly, the
grandparents lend it to the government, by purchasing the bond. Over the years,
the government pays back the money, plus interest—not to the grandparents, but
to the grandchildren.
The U.S. government is not the only seller of bonds, in spite of its
constant need for money. State and local governments also sell bonds to raise
cash. So do hospitals and airports, school districts and sports stadiums,
public agencies of all kinds, and thousands of companies. Bonds are in abundant
supply. They’re for sale in any stockbroker’s office. You can buy them as
easily as you can open a savings account or buy a share of stock.
Basically, a bond is quite similar to the CDs and the Treasury bills
we’ve already talked about. You buy them for the interest you’ll get, and you
know in advance how much interest you’ll be paid and how often, and when you’ll
get your original investment back. The main difference between bonds and CDs or
Treasury bills is that with CDs and Treasuries, you get paid back sooner (the
period varies from a few months to a couple of years), and with bonds you get
paid back later (you might have to wait five years, ten years, or as long as thirty
years).
The longer it takes for bonds to pay off, the greater the risk that
inflation will eat up the value of your money before you get it back. That’s
why bonds pay a higher rate of interest than the short-term alternatives, such
as CDs, savings accounts, or the money market. Investors demand to be rewarded
for taking the greater risk.
All else being equal, a thirty-year bond pays more interest than a
ten-year bond, which in turn pays more interest than a five-year bond, and so
on. The buyers of bonds have to decide how far out they want to go, and whether
the extra money they make in interest on, say, a thirty-year bond is worth the
risk of having their money tied up for that long. These are difficult
decisions.
At current count, more than $8 trillion worth of bonds of all varieties
are owned by investors in the United States, making bonds a more popular
investment than stocks. Meanwhile, investors also own more than $7 trillion
worth of stocks traded on the major exchanges (and that doesn’t count the ones
traded in regional or pink-sheets exchanges), and there’s a continuing debate
over the merits of one versus the other. Both have their good points and their
bad points. Stocks are riskier than bonds, and potentially far more rewarding.
To understand why this is true, let’s look at two choices: one where you buy
McDonald’s stock, and the other where you buy a McDonald’s bond.
When you buy the stock, you’re an owner of the company with all rights
and privileges. McDonald’s makes a bit of a fuss over you. They send you their
reports, and they invite you to the annual meetings. They also pay you a bonus,
in the form of a dividend. If they have a really good year at their sixteen
thousand hamburger stands, they might raise the dividend, so you get an even bigger
bonus. But even without the dividend, if McDonald’s sells another zillion Big
Macs and all goes well, the stock price will rise. You can sell your stock for
more than you paid for it and make money that way.
Nevertheless, there are no guarantees that McDonald’s will prosper, that
you’ll get a bonus, or that the stock price will rise. If it falls to less than
what you paid for it, McDonald’s won’t reimburse you. They haven’t promised
anything, and they aren’t obliged to pay you back. As an owner of the stock,
you don’t have a safety net. You must proceed at your own risk.
When you buy a McDonald’s bond, or any bond, for that matter, it’s a much
different story. In that case, you’re not an owner. You’re a lender, giving
McDonald’s the use of your money for a fixed period of time.
McDonald’s can have the greatest year in hamburger history, and if
you’re a bondholder, they won’t even think about sending you a bonus. Companies
are constantly raising the dividend on their stock to reward the stockholders, but
you’ll never hear of a company raising the interest rates on its bonds to reward
the bondholders.
The worst part about being a bondholder is watching the stock go through
the roof and knowing that you won’t see a penny of the gain. McDonald’s is a perfect
example. Since the 1960s, the stock (adjusted for splits) has soared from
$22.50 to $13,570 and investors have made 603 times their money, turning $100
into $60,300 or $1,000 into $603,000. The people who bought McDonald’s bonds
were hardly as fortunate. They collected interest payments along the way, but
aside from that, they broke even.
If you buy a $10,000 ten-year bond and hold it for ten years, you get
your money back plus interest, and nothing more. Actually, you get back much
less because of inflation. Let’s say the bond is paying 8 percent a year, and
the inflation rate over that ten-year period is 4 percent. Even though you’ve collected
$8,000 in interest payments, you’ve lost almost $1,300 to inflation. Your
original $10,000 investment is now worth $6,648 after ten years of 4 percent
annual inflation. So the whole ten-year investment has left you with less than
a 3 percent annual return, and that’s before taxes. If you figure in the taxes,
your return approaches zero.
The good thing about a bond is that even though you miss the gain when the
stock goes up, you also miss the loss when the stock goes down. If McDonald’s
stock had gone from $13,570 to $22.50 instead of the other way around,
stockholders would be crying and bondholders would be laughing, because
McDonald’s bonds aren’t affected by the stock price. No matter what happens in
the stock market, the company must repay its debts to the bondholders on the
date when the loans terminate and the bonds “come due.”
That’s why a bond is less risky than a stock. There’s a guarantee
attached to it. When you buy a bond, you know in advance exactly how much
you’ll be getting in interest payments, and you won’t lie awake nights worrying
where the stock price is headed. Your investment is protected, at least more protected
than when you buy a stock.
Still, there are three ways you can get hurt by a bond. The first danger
occurs if you sell the bond before the due date, when the issuer of the bond must
repay you in full. By selling early, you take your chances in the bond market,
where the prices of bonds go up and down daily, the same as stocks. So, if you
get out of a bond prematurely, you might get less than you paid for it.
The second danger occurs when the issuer of the bond goes bankrupt and can’t
pay you back. The chances of this happening depend on who is doing the issuing.
The U.S. government, for example, will never go bankrupt—it can print more
money whenever it wants. Therefore, the buyers of U.S. government bonds are
repaid in full. It’s an ironclad guarantee.
Other issuers of bonds, from hospitals to airports to corporations,
can’t always offer such a guarantee. If they go bankrupt, the owners of the
bonds can lose a lot of money. Usually, they get something back, but not their
entire investment. And sometimes, they lose the whole amount.
When an issuer of a bond fails to make the required payments, it’s
called a default. To avoid getting caught in one, smart bond buyers review the financial
condition of the issuer of a bond before they consider buying it. Some bonds
are insured, which is another way the payments can be guaranteed. Also, there
are agencies that give safety ratings to bonds, so potential buyers know in
advance which ones are risky and which aren’t. A strong company such as McDonald’s
gets a high safety rating—the chances of McDonald’s defaulting on a bond are
close to zero. A weaker company that has trouble paying its bills will get a
low rating. You’ve heard of junk bonds? These are the bonds that get the lowest
ratings of all.
When you buy a junk bond, you’re taking a bigger risk that you won’t get
your money back. That’s why junk bonds pay a higher rate of interest than other
bonds—the investors are rewarded for taking the extra risk.
Except with the junkiest of junk bonds, defaults are few and far
between.
The biggest risk in owning a bond is risk number three: inflation. We’ve
already seen how inflation can wreck an investment. With stocks, over the very
long term, you can keep up with inflation and make a decent profit to boot.
With bonds, you can’t.
Conclusion
Mr. Peter Lynch has explained us everything about bonds from the
definition to the types to real life examples. He has described the perks of
buying a bond which ensures returns. He has also made us aware of the associated
risks. All in all, one should think wisely before buying a bond since there are
different types which come with different types of risks. With all these we
assume that you have got an insight into how the bond market works and all the
pros and cons of buying a bond. In the next post we will learn about the most
popular investment strategy ‘buying Shares’.
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