What is a bond?
If you’ve ever read an article about investing, the term “bonds” always come up in one way or another. Usually it’s something about bonds being a “safe haven” or maybe something about a “flight to safety” in the bond markets.
But what IS a bond?
A bond is debt
What is a bond? It's debt, issued by a company.
There are two ways a company can grow:
- A company can take its net profits and reinvest them into growth initiatives
- They can borrow money to spend on growth initiatives., effectively borrowing against future assumed revenues.
The first is accomplished without using "leverage," or borrowed money. The second is accomplished by borrowing money (using leverage) to grow.
Why do companies issue debt?
Debt is issued for a variety of reasons, but the usual reason is to fund growth.
It's important to remember that growth doesn't HAVE to be financed with debt.
Unlevered (sans-debt) Example:
Boka Bowla, a bowling ball equipment manufacturer, makes $1.5 million net profits. It has a commitment to spend 50% of net profits on growth initiatives.
Due to a great quarter, the board is able to acquire Bowlico Rock, a competitor for $1mm. Boca Bowla has absorbed market share, added future revenue (and presumable net profit), and as a result of using no leverage on the deal, is now in a better position with no additional risk.
Levered (with debt) Example:
Chatterpiller, a private SMS chat application, has small revenue of $100,000 annually and a net profit of $15,000. Due to its improved user interface and some proprietary gadgetry, the company is experiencing rapid growth and wants to take advantage of its next-best-thing status. Since it's not in a financial position to make the acquisitions, it issues $10mm in debt and snaps up 3 of its smaller competitors, grabbing huge market share while simultaneously increasing margins, brand awareness, and customer acquisition.
Is this a good thing? The company has to pay back $10mm + interest for the debt. It has added a lot of leverage to its balance sheet. If the added revenues and increased margins justify the debt, then it makes sense. If not, then it doesn't.
Why do people buy bonds?
Like any lending arrangement, people buy bonds because they are interested in lending money in exchange for an interest payment.
Why does the bank give you a loan? Because they have the funds laying around, and they need it to be earning a return. The bank lends you the cash to buy a house, you pay them back + interest, and everyone wins (usually). You get to use leverage to buy a hard asset and the bank gets to (likely) double or triple its money and then some over time.
If you're buying a bond, then YOU are the bank. YOU are lending money, and as a result, YOU are getting paid the interest. Adding lending to your mix of investments gives you diversification into a different asset class, and also gets you a steady stream of income.
How do I buy a bond?
Buying a bond is fairly straightforward. You pick out the company whose debt you'd like buy, you look for any outstanding debt they have in the bond market, you check the price, and you buy it. It's also extraordinarily complex.
- What's the credit rating?
- Why?
- What's the interest rate?
- When is the debt due?
- Why did they issue debt?
- What's the spread?
- Is it callable? i.e. is there an embedded call option?
- How much debt do they have?
- Is their business model sustainable?
- What kind of debt is it?
- Etc. etc. etc.
In short, buying a bond is simple, but analyzing the risk behind that bond is extremely difficult. Furthermore, do you buy a single bond, or a basket of bonds, or a bond mutual fund, or a bond ETF? What even ARE all of those things?
It's a confusing landscape. In future posts, we will dig into each of those topics one at a time. For now, at least you'll understand what a bond is and why you might want to own some.
If you'd like help investing in bonds, please reach out and schedule a free introductory call with us. We'd love to talk to you!