Stocks & Bonds – Like Vanilla & Chocolate
“The stock market is never obvious. It is designed to fool most of the people, most of the time”- Jesse Livermore
In our previous blog, the first of the series, we learnt about investing, various asset classes like Equities (Stocks/Shares), Debt (Bonds), Gold, Real Estate and Cash, asset allocation and its importance. In this blog, let us look in depth at two of the most popular yet often ignored asset classes stocks and bonds and understand their importance in our portfolio. Part 1 will focus on bonds and part 2 will be all about stocks
Let us start with resolving the mystery from the previous blog. Bonds and the origin of word coupon. If any of you searched for what I had mentioned, here is the image of the Hessler Coupon bond.
This bond was issued during the Spanish American war of 1898 for $20 paying a 3% coupon rate. When bonds were initially introduced, they came with small coupons as you can see in the picture. To collect the interest, you had to tear off a coupon and submit it at your local bank who would then give you the interest amount. While the bonds have become electronic today, the term coupon has persisted to mean interest payments. Interesting isn’t it? Makes you wonder what other stuff has a name that doesn’t mean anything today but came to be because of its history.
Before we go in depth in bonds, a quick recap on some of the terms we shall be using. A bond is a document issued by the borrower to the lender signifying the debt he has taken. The bond contains the % that shall be paid as interest (Coupon), duration of the debt (i.e the date on which the money will be returned, also known as maturity date) and details of when the coupon shall be paid (Annually, semiannually etc.). The amount to be borrowed is divided into bit sized bonds of certain value called face value. So someone looking to borrow $1 million can issue 1,000 bonds of $1,000 each or even 10,000 bonds of $100 each. Coupon to be paid is calculated on face value.
Now with the basics out of the way, let us look at some interesting aspects of bonds.
A debt instrument can be broadly classified into two categories which are as follows:
Unsecured debt or Debenture as it is called is a debt document that is not backed by any collateral. They depend on the trustworthiness of the government or organization in question. They also pay more coupon due to the risky nature of investment. Bonds are secured by collateral, usually a physical asset like land, factory building etc. and are thus less risky. In case of default, the collateral asset will be sold to recover the money. For all purposes going forward, the term bond shall refer all debt instruments in general unless explicitly specified.
Before we go explaining the subtypes of bonds, an important term that is often thrown around when discussing bonds and which must be understood for one to understand bond is Yield.
Yield is the return one can expect on a bond. How does that differ from coupon? Therein lies the key to unlocking the mysteries of functioning of bond markets. So a bond once issued has a certain maturity period before which it cannot be redeemed. Say you purchase a 10 year treasury bond, it cannot be redeemed before 10 years have passed from its issue. But there has been an emergency and you need the money, what should one do then? In such a case, one can sell the bond in the markets and get his/her money back. Bonds once issued are listed in the market and can be bought and sold like shares.
How is pricing for a bond determined? Bond prices are sensitive to interest rates in the economy. The interest rates are determined and dictated by the Federal Reserve. A rise or fall in interest rates affects the prices of bond which falls and rises respectively. Yield as we had discussed is based on the price of the bond. This will become clear from an example.
Say a bond is issued at a Face Value of $1,000 and paying an annual coupon of 5% or $50. Your return on the bond is 5% per annum. The bonds begin trading at $1000 and the interest rate at that time is also 5%. Now the Federal Reserve decides that the economy is moving too slowly and it needs to grow faster in which case it will lower the interest rates to say 4% and flood the markets with money to encourage borrowing. Now the interest rates in the market are 4% but your bond is yielding 5% so there will be a rush to buy that bond in order to get that 1% extra return. This increase in demand will cause the bond prices to go up. Now the bond is trading at $1,250, but the coupon is still only $50. In this case the return on the bond for someone who paid $1,250 will be only 4% ($50/$1250). This is his/her Yield on the bond.
Similarly, considering the same example, now the Federal Reserve decides that the economy is facing inflation and it needs to be controlled in which case it will try to remove money from the economy and make borrowing difficult by increasing interest rates to say 6%. Now while the market interest rates are 6%, your bond is yielding only 5% in which case there will be selling in the bonds as people want to free up their money and invest in the higher interest rates. The bond would fall till $833 at which point its yield will become 6% ($50/$833).
This is a simplistic representation of the complex maneuvers that determine bond prices but in essence interest rates and time to maturity affect bond prices. Longer duration bonds will be affected more by interest rate movements as compared to shorter duration bonds as shorter duration bonds are closer to maturity.
Exact pricing of bonds is determined by summing all future cash flows and discounting them to present value. Remember inflation and the price of movie tickets? The value of money today is not the same it was years ago, it has reduced. So $100 that we have today is worth less than $100 years ago and $100 in the future will be worth less than the $100 today due to inflation. So while you will receive future coupon payments worth $100, they won’t have the same value they have today. In order to estimate their current value, we use a method where a specific estimated inflation rate is used to discount that $100 to current value. For e.g. if 5% inflation is assumed, then $100 a year later is actually worth only $95. It can be a bit confusing but you will get the hang of it. Simply imagine that the things you can buy for $100 today will be available for more than this the next year. This method also known as Discounted Cash Flow method is used to determine fair price of bond which is then subject to supply and demand fluctuations of the market.
The next thing that affects yield and bond pricing and an issue that often crops up in one’s mind is the reliability of the borrower and its ability to pay back the borrowed money. That is where credit ratings come in the picture. Based on the quality of the business, company’s financial status and its ability to service debt, a company and its bonds are awarded certain credit ratings. Treasury is the top most rated bonds and this rating is awarded to sovereign government bonds only. AAA is the top rating for other non-government bonds. The ratings go down from there to AA, A, BBB, BB etc. until the bottom most rating which is Junk rating. A bond rated junk has a high chance of default on interest and principal and is best avoided by common investors.
A final thing that affects yield and bond pricing is seniority of debt. Debt comes in two types, senior debt and subordinated debt. These are priority levels for payment in case of default in company. In case of a default by a company, secured creditors are paid first followed by unsecured creditors. Debt which has been marked as senior will be paid first followed by that which is subordinated. As a result, subordinated debt has a higher yield as compared to senior debt.
Now that we are thorough with our understanding of bonds, let’s get back to various types of bonds which are classified as per yields, borrowing organizations, convertibility, credit ratings etc. The list is as follows:
There are two styles of options traded in the world today based by their exercise methodology. European options which are traded around the world can only be exercised at expiry. You can trade freely in them, buying and selling them and closing out your contracts at any time until expiry and on expiry ITM options are exercised. This is the most widely used option style across the world.
American options are those which can be exercised anytime they are ITM. One need not wait till expiry to do so. American options are primarily used only in USA.
Other types of bonds include War Bonds (Issued at the time of war for money), Social Impact Bonds, Revenue bonds etc. Investors can also invest in bonds of other countries issued in their local currency and some of the examples are Kangaroo bonds (Non Australian bonds for Australian citizens), Masala bonds (Indian rupee denominated bonds outside India) etc.
Advantages and disadvantages of Bonds
Bonds in general are safe and reliable investments and thus quite stable. While the prices fluctuate wildly subject to vagaries of interest rates, supply and demands and duration, for a simple investor like you and me, one simply needs to buy when issued and hold till maturity, enjoying the coupon payments along the way. A common investor simply need not concern himself/herself with these price movements at all. Bonds provide a stability effect in a portfolio, looking to calm down and protect the portfolio from the wild swings that are a part of equities and gold.
The returns however can be unsatisfying for those seeking better performance. Also debt has a particularly bad rep for poor performance during high inflation periods. While USA has not had a high inflation period in the last three decades, it cannot be said with utmost certainty that this will continue in the future. Nonetheless the pros outweigh the cons and it is always advisable to hold debt in the portfolio. In fact in your senior years, the debt portion will be significantly larger than any other in your portfolio as it is the only asset that can guarantee regular income.