When it comes to creating your diversified financial portfolio, you know it’s important to figure out how stocks and bonds fit into your overall investment plans. But honestly, do you know the difference between a stock and a bond? And specifically, are you aware of the various types of bonds that exist, and how they can help or hinder your overall portfolio growth?
You’re probably more familiar with stocks–shares or equity in a corporation. Even if you don’t invest in stocks, you probably read and hear news regularly from Wall Street about the rising or falling stock market on any given day.
Stocks even have an impact on our culture–they are often influenced by societal trends and they even have starring roles in the storylines of many great films, including Wall Street, The Wolf of Wall Street, and Trading Places.
Bonds, on the other hand, represent debt obligations, allowing corporations and governments (at the local, state, and federal levels) to borrow money. They are less ingrained in our day-to-day culture.
The truth is, most people don’t understand bond markets like they do stock markets. We’re going to help right now to get you up-to-speed on some important bond basics, or maybe refresh your memory if you’re already familiar with them.
Before we get started, we promise not to overwhelm you with too many details filled with financial jargon. Instead, we’ll provide you with just enough information to help you determine if bonds may be a good choice for your investment needs.
What are Bonds, and Can an Analogy About Pizza Help Me to Understand Them?
Bonds are loans that corporations use to raise money from investors, upfront. Bonds are used most often to grow a business.
Corporations hire banks or investment banks to issue bonds to the public. By issuing bonds, the corporation is actually borrowing money from investors, which is different than buying the stock of a company where you own a “piece-of-the-pie.”
Speaking of pie, at Granite Investment Advisors, we use what we call the Pizza Analogy to put some clarity around bonds:
Imagine that you own a small pizza shop in your town. You’ve established your business and of course, you have the best pizza around.
You’ve reached the point where you want to–or actually need to–expand your business, whether it’s adding more seating, moving to larger space, or opening more locations. There’s no doubt that you’ll need financing for your growth and you know you have a few options, but you are unsure of which one is best.
First, you could simply save your cash. Not the best option since you need the cash to grow immediately.
Second, you could bring in a partner to work with you. By doing this, you’ll most likely need to give up some ownership (read-equity) in your business. You probably opened your shop to be your own boss, so it’s a big decision whether you’re willing to give away some of your ownership.
Third, you can go to your banker for a loan. This option would allow you to keep your equity ownership but would increase your overall debt burden.
Any of these three options can work for a small, growing business. Even after you decide on which works best for your needs, these options continue to be available to you as you to expand.
Now let’s say you have really grown and you are thinking of franchising or going public. Down the road, you may consider issuing stock to the public in the form of shares. Like taking on a partner, this would decrease your overall ownership. However, you’d be able to infuse your business with the cash you need to accelerate your growth today.
Once your company reaches a large enough size (for example, Domino’s pizza valued at $12.4 billion) you may decide to issue your own debt rather than going to a bank for a loan.
In this scenario, you would issue a bond with an interest rate that is required to be paid to the bondholders over a specific amount of time. The interest rate required would be determined by a number of factors. Some of these include:
- Current interest rate environment when issuing the bonds
- The size of your company
- The size of outstanding loans/debt on your company’s balance sheet
- The amount of cash flow generated from your company to service the annual interest expense and pay back the bondholders
- The rating received by the third-party agencies (Moody’s and S&P)
Traditionally, large companies with strong balance sheets pay less in interest than weaker competitors. As your pizza business grows and improves its financial footing, your borrowing cost decreases.
Think of it this way, when an individual is looking to borrow, a bank looks at their credit score. Typically, a higher credit score and income coincides with a bank lending more money at better (lower) rates. The same holds true with corporations in the public markets.
Using the analogy of a pizza shop to explain how bonds work focuses on the benefit to the business while looking at various options to ensure growth.
But how does this work if you’ve been a long-time fan of this fast-growing pizza shop and you want to invest in their future by purchasing the bonds they decide to issue? By purchasing the pizza shop’s bond, you need to realize that they are actually borrowing money from you and other bondholders. Since you’ve purchased a bond, you receive no equity in the business. However, there is a legal obligation for the pizza shop to pay you back at the end of the bond term, along with interest owed to you that was paid along the way.
Bonds are Still Purchased “Over the Counter”
While our Pizza Analogy helps to simplify what bonds are and how they work, it’s important to realize that adding bonds to your portfolio can be complicated. When our investment advisors look at bonds as investment opportunities for you, we’re careful to look at the company sizes and the actual bond issuance size that is being issued to the public.
This is what sets Granite Investment Advisors apart from other firms that seek out bonds for their clients.
We generally purchase lots of larger bonds from bigger companies–typically companies with a couple of billions of dollars in market cap. This is because the bond market does not trade like the stock market, and at this point, it’s not digitized in the same way as the stock market.
To this day, the bond market is still called the “Over-The-Counter Market.” When you want to purchase a bond, your trader may call multiple bond desks to get the best price for a specific bond issuance.
This can be time-consuming, as it requires multiple phone calls and a lot of human interaction. Unlike the stock market where you can go online and hit a submit button to place your order, there’s more skill needed in trading bonds–skills ranging from understanding where a bond should be priced on the day you trade it, to understanding the traders and which ones will work with you versus taking advantage of you.
Which Bonds Should I Learn More About?
Now that you better understand what bonds are and how they are acquired, it’s important to understand that there are a variety of bonds available to you. Three of the most popular bonds that you should know about include the following:
1. Corporate Bonds
Just like the Pizza Analogy discussed earlier, a corporate bond is a debt security issued by a corporation and sold to investors to raise money to grow the business.
2. Treasury Bonds (T-Bond)
T-Bonds are issued by the US government with little risk of default and are considered primarily risk-free from default.
3. Municipal Bonds (Muni Bonds)
Muni Bonds are issued by a state, municipality, or county to fund projects that require capital expenditures. Projects include construction of highways, bridges, and schools.
Bond Investment Strategies – Ships and Ladders
Determining which bonds are best for your investment portfolio requires many considerations, including the risk you’re willing–or not willing–to take when it comes to your money.
Bonds have the potential to be less volatile than the stock market. Because of this, we look at bonds as a ballast to give stability to a portfolio. Just as a ship needs a bit of ballast to remain upright, especially during times of turbulence on the sea, your investment portfolio should include a ballast, like bonds, to add stability.
This is not to say that you can never lose money with bonds; it’s just that bonds tend to be less volatile in the long term. That said, 2018 has been one of those years when interest rates have risen, and many bond investors were down a bit– in some cases 3 – 4%. However, that doesn’t seem like a lot when you compare it to the 30+% dips that can happen in the stock market.
Keep in mind that the price and value of bonds tend to drop as interest rates go up. This is why we offer a Ladder Bond Portfolio–it’s structured similarly to the Fixed Income Funds Portfolio. When yields go up, bond prices come down. It’s an inverse relationship.
The goal when purchasing bonds is to hold them to maturity. Of course, there may be times when something may happen with a company that would cause you some discomfort and you sell your bonds early (although that’s typically the exception). With the plan to hold bonds until maturity, we “ladder” the portfolio so that bonds are maturing every year, for the next six or seven years.
If bonds are held to maturity and interest rates steadily (not aggressively) rise, the cash received from the maturing bonds can be used to purchase another bond at higher interest rates. Over time, the overall return smooths out, reducing your worry about rising rates because you’re confident that your ladder will always provide fresh capital to reinvest at higher rates. This approach is especially appealing to retirees who are living on a fixed income.
Working With an Investment Advisor
When it comes to bonds and your investment strategy, some basic knowledge is helpful for you to begin the conversation with your investment advisor. You truly need a professional who understands the bond markets to help you make the right decisions and to monitor their impact on your overall investments.
As you’ve just read, there’s a lot to cover when it comes to bonds. We can guide you through the process to determine what works for your needs today and in the future.
Give us a call at 603-226-6600 and tell us if our Pizza Analogy helped you to better understand bonds, or you can send us a note online with the questions you’d like us to address.