When it comes to creating your diversified financial portfolio, you know it’s important to figure out how stocks and bonds fit into your overall investment plans. But honestly, do you know the difference between a stock and a bond? And specifically, are you aware of the various types of bonds that exist, and how they can help or hinder your overall portfolio growth?
You’re probably more familiar with stocks–shares or equity in a corporation. Even if you don’t invest in stocks, you probably read and hear news regularly from Wall Street about the rising or falling stock market on any given day.
Stocks even have an impact on our culture–they are often influenced by societal trends and they even have starring roles in the storylines of many great films, including Wall Street, The Wolf of Wall Street, and Trading Places.
Bonds, on the other hand, represent debt obligations, allowing corporations and governments (at the local, state, and federal levels) to borrow money. They are less ingrained in our day-to-day culture.
The truth is, most people don’t understand bond markets like they do stock markets. We’re going to help right now to get you up-to-speed on some important bond basics, or maybe refresh your memory if you’re already familiar with them.
Before we get started, we promise not to overwhelm you with too many details filled with financial jargon. Instead, we’ll provide you with just enough information to help you determine if bonds may be a good choice for your investment needs.
What are Bonds, and Can an Analogy About Pizza Help Me to Understand Them?
Bonds are loans that corporations use to raise money from investors, upfront. Bonds are used most often to grow a business.
Corporations hire banks or investment banks to issue bonds to the public. By issuing bonds, the corporation is actually borrowing money from investors, which is different than buying the stock of a company where you own a “piece-of-the-pie.”
Speaking of pie, at Reliance Trading Co. Limited, we use what we call the Pizza Analogy to put some clarity around bonds:
Imagine that you own a small pizza shop in your town. You’ve established your business and of course, you have the best pizza around.
You’ve reached the point where you want to–or actually need to–expand your business, whether it’s adding more seating, moving to larger space, or opening more locations. There’s no doubt that you’ll need financing for your growth and you know you have a few options, but you are unsure of which one is best.
First, you could simply save your cash. Not the best option since you need the cash to grow immediately.
Second, you could bring in a partner to work with you. By doing this, you’ll most likely need to give up some ownership (read-equity) in your business. You probably opened your shop to be your own boss, so it’s a big decision whether you’re willing to give away some of your ownership.
Third, you can go to your banker for a loan. This option would allow you to keep your equity ownership but would increase your overall debt burden.
Any of these three options can work for a small, growing business. Even after you decide on which works best for your needs, these options continue to be available to you as you to expand.
Now let’s say you have really grown and you are thinking of franchising or going public. Down the road, you may consider issuing stock to the public in the form of shares. Like taking on a partner, this would decrease your overall ownership. However, you’d be able to infuse your business with the cash you need to accelerate your growth today.
Once your company reaches a large enough size (for example, Domino’s pizza valued at $12.4 billion) you may decide to issue your own debt rather than going to a bank for a loan.
In this scenario, you would issue a bond with an interest rate that is required to be paid to the bondholders over a specific amount of time. The interest rate required would be determined by a number of factors. Some of these include:
- Current interest rate environment when issuing the bonds
- The size of your company
- The size of outstanding loans/debt on your company’s balance sheet
- The amount of cash flow generated from your company to service the annual interest expense and pay back the bondholders
- The rating received by the third-party agencies (Moody’s and S&P)
Traditionally, large companies with strong balance sheets pay less in interest than weaker competitors. As your pizza business grows and improves its financial footing, your borrowing cost decreases.
Think of it this way, when an individual is looking to borrow, a bank looks at their credit score. Typically, a higher credit score and income coincides with a bank lending more money at better (lower) rates. The same holds true with corporations in the public markets.
Using the analogy of a pizza shop to explain how bonds work focuses on the benefit to the business while looking at various options to ensure growth.
But how does this work if you’ve been a long-time fan of this fast-growing pizza shop and you want to invest in their future by purchasing the bonds they decide to issue? By purchasing the pizza shop’s bond, you need to realize that they are actually borrowing money from you and other bondholders. Since you’ve purchased a bond, you receive no equity in the business. However, there is a legal obligation for the pizza shop to pay you back at the end of the bond term, along with interest owed to you that was paid along the way.