Many of our articles deal with equities (generally meaning stocks) and their respective traits (their returns, volatility, what drives their price, etc.). People like to learn about stocks because “they’re sexy” (some say). Yet, equally important to your future (directly or indirectly, as I’ll shortly show) is their counterpart; bonds (fixed income by any other name). You should know about them because bonds play an important role in our global economy and in your portfolio. It may also surprise you to learn that in the United States in 2016, there were roughly $200 Billion[i] of new share (i.e. stock) issuances. However, there were $1.5 TRILLION of new corporate bonds issued, 700% more than the oft-touted equity offerings!
Lest the education get too long in this letter, let’s just focus on the particulars of exactly WHAT a bond is and how it works. More particularly, let’s focus on corporate bonds, that being those bonds issued by companies vs. by countries. The latter operate much the same way, and many of the attributes will be understood by focusing on corporate bonds.
Bonds are created instruments (called ‘debt securities’ as opposed to ‘equity securities’ for stocks) in that companies have the freedom to create them, or not. If a company wants to raise money to invest in new products, or build new buildings, it really only has three options to do so;
- It creates a ton of profits and has all this idle cash just sitting on their balance sheet to spend. For instance, Apple is accumulating cash at the rate of $3,600,000 per hour[ii] – but yet again still they borrow and issue bonds.
- It believes it can issue stock to the public, wherein those new shares sold are bought by ‘shareholders”, and those shareholders are now legally entitled to a piece of the future company profits. If the company makes no profits, the stock is probably not worth anything, so the risk to shareholders is naturally higher than the risk to bondholders. Of course, people buy stock in the hopes it goes up, which is what makes capitalism work.
- And lastly, it can create debt. Different than creating a share, where the sorry slob shareholder has to trust management to make profits to make his share valuable, the creation of debt immediately places an obligation on the company to repay the debt…generally at a fixed rate of return (called the “coupon” rate) over a fixed period of time (called the “term”). The bondholder is not an owner in the company, but a lender to it. And that is the crucial difference; a bond holder has to get paid regularly whether things are going well or poorly, whereas the value of share prices are fully at the whims of capitalism and the stock market. A company’s stock can lose 90% of its value, but as long as the company can pay, it must pay its debt.
Bondholder agreements most commonly protect the repayment of debt with higher order of requirements on the company. These agreements (often called covenants) are sometimes backed by specific collateral of the company, in the same way the bank holds the actual title on a personal home until the mortgage is paid off by the homeowner. However, some companies in the world are much riskier to lend to than other companies, and this characteristic is called their credit risk. The way bondholders are compensated for lending monies to riskier companies is to receive a higher coupon rate on the debt that they lend. Companies that don’t pay their money back have technically defaulted on their obligation.
Now that we have set the foundation for bonds, let’s talk about how they fit into your portfolio;
- The bonds are like ballast to your ship. Stocks may go down, but good quality bonds don’t go down. You ONLY own high-quality bonds, and these are called investment grade bonds.
- You can seek higher returns on bonds, principally by buying what are known as High Yield bonds. In a wonderful renaming game, Wall Street has changed what formerly was known as “junk bonds” to “high yield” bonds, because you have to admit it’s just hard to sell junk. At Wellspring, we want your bigger returns to come from your stocks, not your bonds. Thus, you can get really high returns right now on Puerto Rican bonds…but fortunately you don’t own any of them because there’s not a strong belief they will get repaid. We simply like the fixed in Fixed Income to mean something.
- The bonds earn some money. Right now, they do not earn a lot of money because interest rates are low, but cash sitting in savings accounts earn close to nothing, so we’re taking what we can get (maybe 2-4%).
- And lastly, when the stock market goes down, as it inevitably will do at some point, it would be nice to buy some stocks when they are on sale. Where do you get that money? Voila! It will come from the high-quality bonds that you own, that people love to buy from you as safe investments when stock markets go down.
Thus, in summary, bonds place a crucial role in the economy and you are part of that lending. But, we are only going to lend to people who will repay it. As Will Rogers was once recorded to have said: “I’m not as concerned about the return on my money as the return of my money”. We concur.
[i] “Broken Dealers” (The Economist, April 22, 2017)
[ii] “Apple Cash Hoard To Top $250 Billion” (Tripp Mickle, Wall Street Journal, April 30, 2017)