Investing As a Lawyer: Bonds Explained
Executive Summary
Bonds are one of the many asset classes that lawyers can consider investing in. Bonds are different from stocks because instead of owning a part of a business or a group of businesses, a bond represents debt. By owning a portion of a company’s debt, an investor is entitled to the predictable income stream of interest payments. These payments are not without risk and the risks of bonds are not the same as the risks of stocks. After understanding the risks involved with investing in bonds, investors can begin looking at the pros and cons of the different types of bonds available in the bond market. By understanding both the options available and the risks present, lawyers can make more informed investment decisions when saving and investing.
If you are interested in investing, you have likely heard of bonds. Even when people talk about the Federal Reserve and rising interest rates, you may have heard someone mention bonds. Bonds can play a role in a diversified portfolio, but before making a financial decision, it is better to understand what they are first. So what are bonds, and why are they worth lawyers understanding?
Bond is Debt
When a company is trying to grow, they have three options to fund its growth:
- pay out-of-pocket
- find outside investors
- use debt to fund growth
Cash is king for a business, just like the cash in an emergency fund is a keystone component of a lawyer’s financial life. Cash can be used to research and develop new products, market current products, and pay for the current expenses of the firm. When companies grow their business, cash to pursue opportunities is critical. So how do companies get more cash?
When a company is growing on its own, it can take a while to build up enough cash to go out and make a significant investment in the current business. In the time it can take to save up this money, competitors may have the time to surpass and beat them in the market. Time is of the essence. For many companies, slowly saving will take too long to pay for all company investments out-of-pocket without risking the current business. So business leaders typically look elsewhere to fund their business.
One option is for the company to sell some of its stock in exchange for cash. The investors willing to pay for shares of ownership become owners. Businesses can add investors who then have an incentive to see the company continue to grow and raise cash to spend on hopefully productive investments.
But not every business wants to sell ownership for cash. So another option is for companies to take on debt that they will repay over time. A bond is a debt issued by companies or governments. The idea is to receive a large amount of money today, use that money to invest in the business, and then have the future revenue of the investment pay off the debt. Issuing debt allows companies to maintain complete control of their business. As long as their sales grow faster than the debt’s interest rate, the business will be better off.
The way it works is a company called Company A needs $1 million to buy a fancy piece of equipment that will increase its revenue by 4% each year for the next ten years. The business doesn’t want to use its current cash or sell its ownership to raise $1 million, so it will issue a bond for $1M. Six investors will give Company A $1 million. One investor offers $500,000 or 50%, and the other five investors each offer $100,000 or 10%. So Company A issues a $1M bond where one investor owns 50%, and the other five investors hold 10% of the bonds issued. The bonds have an interest rate of 3%, so annually, Company A will pay its bondholders $30,000 in interest payments. Bonds typically pay their interest semi-annually, so every six months, the bondholders will receive $15,000 over the next ten years. At the end of 10 years, Company A will pay the bondholders back their initial investment of $1 million.
Every six months, the bondholder who owns 50% of the bonds issued will receive $7,500 (50% of $15,000). The other investors will each receive $1,500. After ten years, the final payment will include $15,000 of interest plus the $1 Million borrowed initially. The bondholder with 50% of the bonds will receive $507,500, and the other bondholders will receive $101,500.
Hopefully, at the end of 10 years, every party improved. If the issuer has grown faster than the 3% interest rate, issuing the bonds was worth it. The bondholders also benefitted because over the ten years, in total, they earned $300,000 of interest and received back their $1 million.
By purchasing a bond, an investor benefits from the financial success of the issuer without the volatility of stock ownership. It also provides the investor with a predictable income stream.
The Risks Involved
Investors can never be 100% certain that they will receive their bond payments. So lawyers need to consult with a financial professional before investing in bonds to understand all the risks involved and how bonds fit into your goals and objectives. This blog post is not advising you to buy and sell bonds. Instead, it is for educating you about bonds so you will make more informed financial decisions.
In the above example, the bondholders received their payments, and Company A was in a better position after ten years. Every bond issuer has this goal, but real life does not work like that. Not every bond will make its payments in full and on time. Bondholders can lose money by purchasing bonds if the issuer does not make their payments.
Bondholders also have an option to buy and sell bonds issued to them. When you buy a bond, you may purchase a previously issued bond that is now trading in the market. If you own a bond in the market, you can hold it until the end. You can also sell it later for hopefully more money than you bought it. While you own it, you are the bondholder, so you are entitled to your portion of the interest payments on the bond.
So what are some of the risks for bondholders?
Interest Rate Risk
When you buy a bond with a 3% interest rate, you will receive a 3% interest payment each year, typically with two semi-annual payments. If every bond for sale is equal, the value of your bond will not change. But what happens if a bond issuer now issues a bond for 4%?
Now the market has both 3% bonds and 4% bonds. If you need to sell your 3% bond, you will not be able to sell it for the same price as the 4% bond. A rational buyer would choose the 4% bond (all else equal) over the 3% bond because the 4% bond earns more interest than the 3% bond. To sell the 3% bond, a bondholder would have to sell their bond at a discount to entice investors to buy the 3% bond over the 4% bond.
The opposite is true if a bond issuer issues a 2% bond for sale. Now, the 3% bond (all else equal) is worth more than the 2% bond. So the owner of the 3% bond can sell their bond at a higher price than the 2% bond.
Future bond interest rates are affected by a lot of factors including but not limited to:
Supply and demand
Inflation
The financial condition of the issuer
Government fiscal and monetary policy
The bond market is constantly changing, but a fundamental lesson is that owning a bond provides you with a fixed interest rate. If interest rates for bonds gradually increase, the price of your bond will decrease. Vice versa, if interest rates for bonds decrease, your bond’s price will increase.
Reinvestment Risk
Reinvestment risk deals with the chance that bondholders won’t find as good of an investment in the future as they have right now.
If you bought a bond that offers a 10% interest rate ten years ago, you are probably proud of your investment if all of the bonds today have a 2% interest. But what happens when your bond matures? What do you do with the proceeds?
If you want to reinvest that money from the 10% bond back into other bonds, you will have to accept buying a 2% bond. Now, instead of earning 10% interest every year, you only receive a 2% interest payment.
Like interest rate risk, the market for bonds is constantly changing, and nearly every bond has a maturity date where the bond issuer pays back the initial amount raised.
Default Risk
As stated above, the payment on your bonds is never definite. Both government and companies can default on their payments meaning bondholders do not receive their payments on time and in full. If a bond issuer decides not to make their payments, it is considered a default.
When governments and companies are financially strong, there is less risk of default than weaker governments and companies. So how can you tell which issuers are strong and weak?
Rating services help investors by issuing credit ratings on bond issuers regarding the likelihood of a default by the issuer.
Each issuer has a range of ratings that they put on each bond issuer. These issuers and their ratings are:
S&P (AAA - D)
Moody’s (Aaa - C)
Fitch (AAA - D)
The highest ratings are for only the strongest issuers. The lowest ratings are typically for issuers who have already defaulted on some or all of their bonds.
If you are an investor looking at a AAA bond with a 3% interest rate or a D bond with a 3% interest rate which would you choose?
Assuming you do not like to lose money, you will likely choose the AAA bond with a 3% interest rate. When lower quality bond issuers need to issue debt to raise money, they will have to offer a higher interest rate than comparably stronger issuers to attract investors.
When investing in bonds, lawyers should consider if the higher interest rate from a weaker issuer is worth the extra interest compared to a stronger issuer with a lower interest rate.
When an issuer does default, it may go through bankruptcy proceedings. In this case, bondholders have a higher priority when receiving payments than stockholders. If a company has $100 million of bonds outstanding and files for bankruptcy with $50 million of assets, the bondholders would receive the $50 million, and stockholders would have nothing.
Inflation Risk
Have you heard about inflation lately? If you have, you may not have considered how inflation affects bonds. Inflation is the general increase in prices. Depending on the rate of inflation, prices will increase at different speeds. In a high inflation environment, prices can go up rapidly. Inflation can be a problem for bondholders.
A lawyer owns a $1,000 bond with a 3% interest rate. Every six months, it pays her $15 of interest. Her tradition is to take the $15 and buy herself a nice lunch. When she first bought the bond, the $15 interest payment paid for her lunch. After a few years, the lunch she originally bought for $15 now costs $20, but Laura continues to receive only a 3% interest rate paying her $30 per year.
Lawyers need to be aware that inflation can slowly or quickly erode how much proceeds from bonds pay for goods, services, and other investments.
Types of Bonds
Both governments and companies can issue bonds. The types of bonds are different, but they each have similar characteristics like an interest rate and payments twice a year.
Corporate bonds
Companies issue corporate bonds to fund various initiatives. There are three types of corporate bonds:
Investment Grade
High Yield
Foreign
Investment-grade bonds are corporate bonds with a high credit rating from the rating issuers. Since the default risk on investment-grade bonds is not as high as the default risk for high-yield bonds, investment-grade bonds can offer a lower interest rate on their bonds. High-yield bonds, therefore, will offer a higher interest rate on their bonds due to their lower credit rating.
Foreign companies issue foreign corporate bonds, and their payments are either in dollars or a foreign currency. The foreign currency payments can complicate bond investments because it introduces foreign currency risk. Depending on the exchange rate between dollars and the foreign currency of the issuer, the payment value can fluctuate.
Government Bonds
The United States and foreign governments can issue government bonds.
Foreign government bonds may issue their payments in foreign currencies like foreign corporate bonds. As stated above, this can add additional risks to bond investments based on the changes in exchange rates.
U.S. Government bond payments have the backing of the full faith and credit of the United States government. The U.S. government has a strong track record of making payments on time and in full. While the U.S. government can default on payments, it is unlikely, and most investors view U.S. government bonds as “risk-free”. Government bonds include:
Treasury Bonds
Agency Bonds
Savings Bonds
Municipal Bonds
Treasury Bonds
Given the low default risk of treasury bonds, they will have comparatively low-interest rates. These bonds can mature in a few days or up to 30 years. Treasury bonds are also exempt from state taxes.
The types of bonds include:
Treasury Bills (a few days to 1 year)
Treasury Notes (2-10 years)
Treasury Bonds (10-30 years)
Treasury Inflation-Protected Securities (the principal amount changes based on inflation over 5-30 years).
Agency Bonds
Agency bonds are issued by federal agencies and may or may not have the backing of the full faith and credit of the U.S. government. Agency bonds without the assurances of the U.S. government have credit and default risks. Lawyers may have heard of some of the agency bond issuers like:
Ginnie Mae (Government National Mortgage Association)
Fannie Mae (Federal National Mortgage Association)
Freddie Mac (Federal Home Loan Mortgage)
These issuers and other federal agencies create bonds for specific agency purposes. These bonds can have different interest rates from other government bonds and vary in how they are taxed.
Savings Bonds
The Treasury of the United States issues savings bonds. They have the backing of the full faith and credit of the U.S. government. Unlike other bond types, savings bonds do not trade in the market. Instead, they are bought and redeemed through the Treasury department. Investors have two types of savings bonds:
Series EE
Series I
These bonds are relatively safe, are tax-exempt from state and local taxes, can be gifted, and may be exempt from federal taxes if used to pay for qualified higher education.
Municipal Bonds
States, cities, counties, and other local governments issue municipal bonds. One feature of municipal bonds is their tax advantages. Income from municipal bonds is generally exempt from federal taxes and sometimes state taxes if the bondholder is a resident of the issuing state. Municipal bonds fall into two types:
General Obligation Bonds
Revenue Bonds
Similar to U.S. Government bonds, general obligation bonds have the backing of the full faith and credit of the issuer. Unlike a U.S. Government bond, this is not a “risk-free” backing. Instead, municipal government bonds do carry default risk. General obligation bonds ensure they can afford the payments through voter approval of a tax to fund the bonds.
Revenue bonds are different because instead of being funded by voter-approved taxes, revenue bonds pay the bondholders through revenues from a specific project. Revenue bonds may build a toll road or a bridge with a toll, and then the revenue from the tolls pays back the bondholders. Unlike other bonds where bondholders have some recourse if the revenue bond issuer defaults, revenue bonds are non-recourse. Meaning bondholders of a toll road do not have a claim to the toll road if it defaults.
Final Takeaways
Bonds offer a less volatile exposure to corporate growth. It also offers investors exposure to governments through some potentially tax-advantaged bond options.
Owning bonds also allows for predictable income through the semi-annual payments of interest. Even though it is predictable, bonds are not free of risks.
Like other investments, lawyers should understand the risks associated with investing in bonds and how bonds work. Once understood, bonds are an investment for lawyers to consider adding to their portfolios. As seen in the Map to Investing, bonds can play a role in diversifying your investments.
Bonds can be used in an investment portfolio to diversify across asset classes. Bonds like all investments have risks and benefits that should be carefully considered before investing. If you are interested in learning more about investing and building a diverse portfolio, talk with a financial professional. Investment management is a key component of the Developing Financial Process. Together we will work to understand your objectives and create an investment strategy that aims to achieve your goals. Schedule a free Meet & Confer today to learn how investment management can fit within a financial plan to help you achieve your financial goals!
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.