First things first: a bond is nothing more than a loan.
Here is a demonstration: Jack is the Chief Financial Officer of a large business named Real Estate Empires. He is responsible for all financial decisions of the company. His mission is to find enough money to finance the construction of a 500-million-dollar building. How does Jack finance a building that size and come up with that money for his corporation? Like everyone else, he would start at the bank.
Let’s assume that Jack approaches the bank personnel to request a loan. The factors we discussed during Lesson 1 will apply here. The first step is to look at the wealth of the company. If the company proves that they can handle such a loan, the bank will lend the money.
How will the bank issue the $500 million needed for Jack’s business? They will do it through bonds. The bank will make 500,000 bonds and sell them to investors at $1,000 each. The bank’s goal is to sell ALL those bonds. While one investor starts by purchasing 1,000 bonds, others may buy 100 bonds and so on. The bank gains interest by charging extra for $5 each bond sold, so it becomes $1,005 per bond. That 5-dollar difference is called the underwriting fee. The underwriting fee is the portion of the gross underwriting spread that compensates the securities firms which underwrite a public offering for their services. The bank makes money basically by selling bonds.
Now, the investors get their bonds and pay $1,005 for each. Once they hold that paper, they receive a coupon rate of 5%. It goes to the Par value, not the price they pay for the bond; take note of that. Again, with these bonds, the bank makes 5% a year on a thousand dollars. So every single year, they make $50. The bank pays twice a year. If any of these investors had one bond, they will receive $25 after 6 months of owning it and another $25 on the next 6 months. They keep getting this for the total term of the bond which is 30 years. This is very important. At the end of 30 years, they have received their thousand dollar Par value investment back. That would be paid by Jack’s company.
Jack’s company would also be making the coupon payment of that 5% with each payment. After the bank sells the bonds, the relationship at that point is now between Jack and the investors.
Let me recap this real fast to see how the flow money would occur during the transaction:
Jack needed $500 million dollars, and the bank supplies that. After he receives the money, the bank now has 500,000 bonds that will be sold to the investors. If they don’t sell the bonds initially, the investors and the bank will continue to hold the bonds and the bank will receive their coupon payments of 5%. If the bank does sell the bonds to the investors (which they need to because they don’t want to be responsible such a sizeable loan and will pass it on to the investors), the relationship is now between Jack and the investors. Jack’s company will continue to make 5% of coupon payments to the investors every 6 months for 30 years. The investors are getting paid 5% on that initial investment. The bond matures after 30 years. Jack’s company now has to pay all those investors or whoever holds the bonds. All the investors receive thousand dollar payments.
Who issues bonds? There are two divisions – corporation and the government. What we just discussed is a corporation. To raise money, one of the corporation’s options is to get the bank to issue bonds.
The government does the exact same thing. The bank will check if the government has the capability to repay the bonds. Fortunately, they can, because they have the luxury on a federal level to print more money. They neither have state dollars nor world dollars, but only federal dollars. The state and local government have to remain within their boundaries, watch their balance sheets, and make sure the revenues they bring in are not exceeding the expenses they have.
The interest rate that the government makes the bond for will be in correspondence to their ability to pay that off when you get into the federal level. Warren Buffett considers this as a risk investment, because the federal government has the ability to print more money if they need to and that causes inflation in the long run. We’ll talk about that as we get into more advanced lessons in course 2.
The federal government’s bond is considered zero, because they only need to print more money to fulfill payments made via coupons. Talking about the risks associated with bonds – the first risk is whether the company or the government would have a failure.
Let’s go back to Jack’s company. Although he might have a good interest rate, that’s a long run – 30 years. 15 years later, the company might have a new management and board of directors. The direction the company might take could become increasingly risky and their inability to continue making coupon payments could start showing up in the market. People start trading that bond much lower, because they anticipate the coupon payment to sustain.
The next risk is when the interest rates change the bond value, the market value of that bond will also change. Let’s assume that you bought a 5% federal bond and 2 years later, the interest rates went down to 4%. Here you are holding that 5% bond, and 2 years later the best people can buy are 4% bonds. There’s an enormous advantage that you have since you’re holding a bond that is paying a high interest rate than what people can get at 4%. The value of your bond on the market goes up significantly based on that change.
The last risk is inflation. If you go out and buy a 5% bond and inflation throughout the term of that bond is 4%, all the more money you’re going to make relatively speaking is 1%. When figuring out the value of a bond, you absolutely have to subtract the inflation that occurs during the duration you own the bond. Take note of that. We’ll talk about all those factors much more in course 2.
General Motors experienced bankruptcy during 2000 to 2009. When something like this happens, the order of distribution for the equity that remains in the company goes like this: the presidents, the bondholders, the preferred share holders, and then the common share holders.
Let us talk about common shares. You’d be relaxed to receive distribution for what was remaining in that company if it was bound to fail. One great thing about bonds is that your level of risk is a lot lower than dealing with common shares. If something negative occurs, you’re the first person to receive payment if there any money left. However, lots of times when talking bankruptcy, there’s nothing really left.
Why would you invest on a bond? A lot of people don’t see the value in it, because they probably only see a little coupon rate of 5%. Investing in bonds is absolutely just as important as investing in stocks. This is so fundamental to Warren Buffett’s investment approach. You need to pay attention to this:
Here is a Dow Jones industrial average through our last market crash in 2008. What I did is I looked up as to what the 30-year federal rate back in the beginning of 2007 was. That bond rate was around 5%. If you haven’t gone through the first lesson and don’t understand what the price to earnings ratio is, I recommend you go back first before continuing here.
During that same time in 2007, the average price to earnings ratio on Dow Jones was 27. Remember, if you took the reciprocal of our price to earnings ratio, it would give us a pretty generic and rough estimate of what our return would be. Taking the reciprocal which is 1 divided by 27 (27 is the price to earnings ratio), we get 3.7%. Look at the federal bond, which we established as almost zero risk investment and it’s making 5%. If you invest in the Dow Jones industrial average and your P/E is 27, you can only expect 37% return. Obviously, the bond is a better choice for investment. Why? You’ll make 5% of those 3.7%. Trading took off like wild fire back in 2007; everyone was involved in their stock market. The bond is where Warren Buffett and smart value investors would have been, because they know they’ll get a better return. These wise investors weren’t predicting anything; they simply choose the better value. At this point, it was a bond.
In 2009, a 30-year federal bond is now at 2.3%, because the federal government was trying to stimulate the economy to drop the interest rate. The average price to earnings ratio for stocks is 15. The reciprocal is 1/5. Return is 16.7%, which almost doubled when compared to two years prior to that. The return of bond is now 2.8% and stocks are 6.7%. On an average, which is better? The stocks are! That’s what Buffett and other billionaires are doing. They buy all these stocks when they are cheap and also they buy companies that have very little debt. They were always investing in bonds and stocks when they should have been.
Assume that you bought a 30-year federal bond back in 2007, because it was in 5%. The price was $1,000 per bond back then. We hold on to that bond until 2009 when interest rate struck down to 2.83%. When that interest rate struck, the best anybody can find is 2.83%, BUT are you holding onto to a 5% bond?! Who doesn’t want to buy a 5% bond when interest rates are that low? Your bond now becomes more valuable in the market because you’re holding a 5% bond when everyone else is holding 2.83%. The value would have changed approximately up to $418. When you add 2 years of coupon payments, the value goes up to $518. That’s about 25% return for owning the bond in just 2 years. Therefore, investing in bonds is important.