Bonds: the good, the bad and the truly junk
This is the second part in a general overview series on bonds for the ordinary layperson.
Those wishing to delve into the finite intricacies of bonds (and there are many) are encouraged to go to Investopedia: Bond Basics Tutorial http://www.investopedia.com/university/bonds/ or purchase one of these books — second-hand they can be obtained through Amazon for as little as a penny plus postage.
Investments: An Introduction, tenth edition, by Herbert Mayo — provides as great backdrop for the whole investment environment.
The financial theoreticians, who really don’t need my simple explanations, would probably want to reference the bond bible The Handbook of Fixed Income Securities, Eighth Edition by Frank J. Fabozzi and Steven V. Mann (only 1,840 pages including all of the math computations), with much new material, including electronic trading, macroeconomic dynamics and the corporate bond market, leveraged loans, structured and credit-linked notes, and exchange-traded funds.
Why do we even need to know about bonds, especially after these incomprehensible descriptions?
Well, for starters, our international insurance and reinsurance business (AIG and others in mid-1990s) launched the innovative risk-linked securities known as catastrophic reinsurance bonds for special situations just such as Hurricane Nicole, which Bermuda endured on Thursday.
Further, two bond-related items that are coincidentally very relevant to our bond narrative made the news last week, and because bonds almost always are an allocation of investment portfolios (read your pension).
First, Bob Richards, Minister of Finance, announced that two tranches of Bermuda Government bonds were being rolled over — or refinanced — before their principal maturity repayment dates, meaning that the existing bond issues were to be fully paid, and new bond issues would be placed into capital markets for sale. Why would he do this? There is a very good financial reason in my book. I call it pre-empting the higher cost of carry.
Then, in an astonishing coincidence after my discourse of last week, it was announced on Monday that the Trump Taj Mahal in Atlantic City had closed its doors for good due to “no path to profitability.” While the Taj still bears Donald Trump’s name, the owner of record was identified as Carl Icahn. Mr Trump owned the Taj only briefly from 1988 until 1991 when the shareholders filed the casino operations for bankruptcy protection, leaving the financing creditors to renegotiate a considerable haircut.
But rather than getting into these esoteric processes, let’s start at the beginning.
Like the old liquorice candy saying, regular easy-to-understand bonds are “good and plenty.” The global bond market is staggeringly massive. We tend to think that global capital investment markets circle around stock trading, probably because stocks are linked to companies we know. This is not so — in length and breadth, the currency and bond markets dominate the trading scenes.
An estimated 700 billion in bond dollars, in volume, trade daily from an asset base of $140 trillion, more than twice the size of the stock market as well as four times the volume.
Can you wrap your head around the zeros in that trillion? $140, 000, 000, 000, 000. Yet, in spite of bond size and volume, most of us know little about bonds and what they are, who issues them, how they work, what they are made of, when they are available, and how they are priced and valued.
Also, most of us do not know how to judge what is a good bond and which should be avoided, and why we should even want them.
A bond is a promise to pay. It is not an equitable share (otherwise known as ownership) of a company. A bond is a formalised, legalised loan. You buy the bond — the company or the government owes you repayment of the principal plus interest at a specified time.
Bonds are not open-ended, they have a shelf life. See our example of a paper bond issued in 1976 by Montgomery Ward. Bonds in major capital markets today are held only in electronic format in an investment or broker’s account, making it a bit harder for the small investor to picture exactly what he/she is buying.
The “Monkey Ward” bond comes with a face value of, generally, $1,000 (or other currency; it has a stated interest rate, often called the coupon rate on this convertible bond of 9.60 per cent annually; it lists a due date of when the principal will be repaid — 1995, and an identifying number, along with very fine print legalese describing various terms and conditions. Montgomery Ward went out of business in 2000. Wonder whether those bondholders got their money back? That is always the question with bonds. Will I?
Stocks and bonds are often confused. How could they not be when the pieces of paper look pretty similar?
However, the difference between the two securities is vast. Stocks can appreciate almost infinitely. Bonds cannot because they have a set maturity date to return your principal. See if you can find two very old blue chip companies still in business today — whose share values have grown astronomically since original incorporation. Send me your answers, but only if you have time after Nicole cleanup.
Bonds are not company ownership, because you, the bondholder, are a creditor. But in order of repayment you get preference over company shares. Stockholders have an equity share in a company; they have input, they can vote and they may be entitled to a dividend after the expenses of the company are touted up. Stocks are generally deemed higher risk than bonds. That is a debatable point as we shall see later on.
Bonds can generally hold their principal value in the open market better than stocks. However, bonds, too, can lose principal value in times of volatile market interest rates, serious company failures, and to my mind, the worst scenario when a government defaults on payments to bondholders.
It happens more than you might realise; think Argentina.
Next week: your introduction to investment risk, bond credit ratings and other information. Who issues bonds and why? What type of structure do they take? Coupon payment versus yield is not the same. Why does anyone want them? How are they priced, valued and sold? How do you know what’s good and what’s bad?
Also cat bonds discussed, and heavily discounted oil industry bonds with high interest rates. Why do high-cost government sovereign debt bonds have such low interest rates, and other charming titbits. What is going on there?
And finally, as I wrote this article on Thursday our beloved island was undergoing yet another major assault from nature. My thoughts and prayers are with all Bermuda residents adversely affected by Hurricane Nicole.
Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Pondstraddler Life, financial perspectives for Bermuda islanders with multinational families and international connections on the Great Atlantic Pond. Contact: email@example.com
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