If you can picture the stock market as a body of water the size of Lake Michigan, then the bond market would be the size of an ocean. Stocks get all the press, but the market is actually pretty small. Once you have a good idea of what a bond is it’s easy to see why for many conservative investors they are more than worth their wild.
What Is A Bond?
A bond is an agreement in which a creditor makes a single payment to a debtor an in return receives a promise from that debtor to be paid a series of small payments on the debt for a fixed amount of time and then to have the initial payment redeemed to them in full at time of maturity. In this structure the creditor is known as the bondholder or lender while the entity selling the bond is also known as the issuer or borrower. The series of small payments are called “interest payments” or “coupons.”
For example, you might become a creditor of the General Electric Corporation (G.E.) by giving them $1,000 in exchange for a five year bond with 3% annual coupons. This means that the company will pay you 3% of $1,000 or $30 each year for five years. At the end of five years you will get your initial investment back of $1,000 plus the last coupon payment of $30 and you will have successfully loaned G.E. some money. This is all assuming the company will still be in business in five years.
Why Buy Bonds?
There are two really good reasons to buy bonds.
- To make money
And I’ll go over each reason below.
Making Money on Bonds
I once attended a conference and got a ticket for a free beer after one of the meetings. I wasn’t thirsty at the time and ended up selling my ticket to another attendee for what amounted to cab fare back to my hotel. That’s an example of a secondary market, the buying and selling of obligations after they are issued. Bonds have a huge secondary market and because of the coupon feature and the redemption at maturity you can make quite a bit of money.
For example let’s say you bought your 3% coupon bond from G.E. and the day after all the interest rates in the world dropped to 1%. No one could get a savings account or investment product that earned more than 1%. Suddenly your 3% coupon payments look really good to other investors since they can only earn 1% everywhere else. You’d be getting offers to sell that bond to them for much more than the $1,000 you originally paid – you can do so if you wish and realize an instant profit. Whenever rates drop the value of bonds goes way up, making it smart to buy them if you can get high coupon payments from sources that you believe will not default.
When a company goes under, if you’re a bond holder you still actually have something. You get paid first. Only until the company pays you off do the stockholders get anything in a default event. For example when Delta went bankrupt in 2005 the bond holders could walk in (over the bodies of the Delta stockholders) and confiscate and sell off all those planes and runway rights and big office buildings and mechanical shops and every piece of equipment related to the business. It’s typical in these cases for the decision to be made in court with the bondholders being given an immediate offer based on company value or the option to restructure the debt – make more coupon payments but for less money, that sort of thing.
Delta is a huge company and the bonds could still be worth 50% of their face value just due to their infrastructure. Even better still, if you think Delta’s bonds are worth 50% of their original value in bankruptcy and panicked investors start selling them at 10% of face value just to get rid of them, you can buy those bonds up cheap and when Delta goes to court and is ordered to pay 50% of the value you can get a big profit.