Some people, when they hear the word investing, immediately think of the stock market. Sometimes they inaccurately expand the scope of that term to include virtually anything that has to do with investing in a company, such as IBM or General Motors.
But there are many ways to invest in private companies, and the stock market, per se, is just one of them.
In addition to investing in stocks, individuals may also choose to invest in bonds issued by private corporations for the purpose of raising capital.
But stock and bonds are not remotely the same thing. They’re as different as boats and airplanes – they may get you where you want to go, but at higher speeds, by differing means and sometimes, with different levels of risk and comfort.
Bonds are really nothing other than a loan.
When you invest in a bond you are actually loaning your money to the corporation (or bank or municipality) who issued it. And like any loan, there are two things you need to know before you invest – the annual rate of return (interest) you’ll receive, and that length of the bond’s active life, which is known as the term of the bond.
Stocks aren’t loans, they’re actual shares of ownership. With bonds you own nothing, other than the right to collect interest on your money (again, which you’ve loaned to the issuing company) and to be fully repaid at the end of the term.
Like stocks, however, you can invest in bonds in two ways – you can obtain them upon original issue by a corporation, in which case the company takes your loaned money to do with as they please, or you can buy them from another investor on the secondary market, who is person who receives your money in that case. There are bond markets for this purpose, just as there are stock markets for trading previously-owned stocks, often in those same companies.
When you invest in original issue bonds, the company commits to pay you a stated rate of interest – say, 5% — over the entire term of the loan, which is normally 30 years (though there are shorter-term bonds, too). A record is kept of who owns the bonds, and interest is paid to the bond holder twice a year. When the bond matures, the company sends the full face amount of the bond to the holder of record at that time.
The Secondary Market for Bonds
Many bonds, however, are bought and sold one or more times over the life of the bond in the secondary bond markets. The company still owes the face amount, payable at the end of the term, and they still pay out a fixed rate of interest to the current bondholder, as reflected on their updated records.
In essence, they’ve received the proceeds of the loan, and they don’t’ have a say in, or even a stake in, who holds the bond from that point forward.
But when you invest in bonds on the secondary market, you may not pay the face value of the bond itself (which is usually $1000). The amount the bond is worth in the secondary market is a function of two things: the current market interest rates for bonds of similar ratings (quality bonds pay lower interest than less safe bonds, as determined by established credit rating bureaus) determines whether the face amount of interest warrants a selling price that is either less than, or more than, the face amount of the bond itself.
If the current market rate is precisely the same as the face amount of interest to be paid, then the price of the bond would be the face value. But that rarely happens.
The Numbers Don’t Lie
For example, let’s say a bond is issued at 5% interest. Then, a year later, interest rates go up in general, and similar quality bonds are being issued at 7%. Who would pay $1000 for a 5% return when other bonds are paying 7% on the same amount? Answer: nobody. So those “used” bonds would sell at a discount in the secondary market, at a level that makes the fixed 5% payout ($50) equal to a 7% return on the amount invested, which would be a little over $714.
Why $714? Because the payout from the issuing corporation (not the person who sold you the bond in the secondary market) will still – and always – be $50 a year (5% of the $1000 face value). That doesn’t change. So, to make the $50 interest payout equate to a current market rate of 7%, the price needs to be about $714, because $50 is about 7% of $714.
Like stocks, bonds can be complicated. But they offer a different approach to investing because, unlike stock prices and dividends, companies are obligated to pay out the interest on the bonds they issue, no matter what. So, by that measure, they are a more conservative investment, offering less risk and very little upside.
The 31 Flavors of Bonds
To add to the confusion, not all bonds are corporate bonds. Banks also issue bonds, school districts and other municipal entities issue bonds to raise money, and there are many types of government bonds, including U.S. Savings Bonds. The basics are pretty much the same, including secondary marketing pricing, but the safety factor of government bonds is much higher, meaning, as a rule, that they pay less interest in return.
Like stocks, there is a bond for every investment need. The key resides in understanding your goals as they relate to risk tolerance, liquidity and rate of return. All of these are trade-offs that go into the investment-making decision process.
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