Nov 17, 2020
Bonds
A Guide to Debt Markets
What are bonds?
A bond represents a loan you are making to a borrower with interest.
The borrower is typically a corporation or government.
Bonds are used to raise money for projects and operations.
When you buy a bond, you are buying corporate/government debt.
Why buy bonds?
Purchasing debt at a discount is the main appeal of bonds. If someone offered you a contract saying, “If you give me $80 now, I’ll give you $100 in two weeks — and I’ll pay you $1 a day until then,” you’d be pretty crazy to pass it up, right? However, there are some key considerations that must be made before we jump in with both feet.
A real example:
The following is a real bond issued by Royal Caribbean Cruise Lines (RCL), retrieved on April 30, 2020.
Let’s cut out the noise and look at the important information in a way that will make sense!
In the top left, you can see the Bond Offering Detail.
CUSIP/ISIN: The serial number of the bond. This can be retrieved by any brokerage firm to verify the authenticity and details of the bond.
Credit rating: A risk assessment of the bond: How likely are you to get your money back?
*Moody’s, S&P, and Fitch are three companies that handle about 95% of credit ratings. Their ratings may differ slightly, but all are considered reputable. Here you can see ratings by Moody’s and S&P.
The credit ratings in this case are “Baa3” for Moody’s and “BB” for S&P. We’ll look at what that means in a second.
Credit ratings are wildly important. The higher the credit rating, the more likely you are to receive your money. However, a lower credit rating (and therefore riskier investment) often issues higher payouts.
We’re going to look at a table of credit ratings but don’t freak out. It’s actually very easy to divide into just two sections.
There’s a lot of jargon associated with ratings, but the most black and white terminology is in the circles on the right. It’s fairly self-explanatory: bonds are either “investment grade” or “non-investment grade.” You can think of this as meaning “mostly safe” or “mostly unsafe.”
Other terms used are things like prime/sub-prime and high grade/low grade. They all mean the same thing.
Our RCL bond was rated by Moody’s a Baa3 and by S&P a BB. What does that tell us?
The ratings are close, but this is definitely toward the lower end of the investment-grade scale if you’re a pessimist, or the higher end of the non-investment grade if you’re an optimist. We should consider the lower grade as a safety measure and think of this as a “Non-investment grade speculative bond.”
Speculative investments are those which have uncertain futures. Essentially, you’re gambling on everything working out for a company in the long run if it’s not investment grade. We don’t want to be gamblers, we want to be investors. So this bond, just based on credit rating, is probably not a good beginning investment for most people.
Let’s look at credit ratings in a different way and think of them in terms of credit worthiness, or a company’s worthiness to receive our loan.
Again, don’t be intimidated: we can divide this entire table into just two sections.
Credit worthiness is a measure of how capable an institution is of paying you back. Can they pay you back in both the short term and long term, no matter what? At the time of writing, only two companies in the entire U.S. have AAA ratings — Microsoft, and Johnson and Johnson.
As you go down the list, you can see that lower grade investment bonds in the triple-B range are considered able to meet all of their obligations to you unless there is some unforeseen national/global event.
Moving down the scale, B and BB bonds might be able to survive for the short term, but have uncertain futures. C-tier bonds don’t even have a sure short term future, and may have already failed to make payments or entered into a petition for bankruptcy. There’s almost no situation you’d ever want to invest in something below a B-tier.
Now that you have an idea of the scale of credit ratings, let’s go back to our RCL bond.
This section lists the issuer, coupon, and maturity.
Issue Description: Tells us who issued the bond, as well as some optional supplementary information we can click through, like the long-form credit evaluation.
Coupon: The percentage interest per year you should earn on the investment. Most corporate debt pays interest semiannually (twice a year). In this case, a coupon of 7.5% annually means you will receive 3.75% interest every six months.
Maturity: The date upon which you should receive the full face value of the bond (we haven’t gone over what that is yet).
The bond has some very basic information on the left side as well:
Under the Issuer Information, you can see when the bond was created, when it first paid interest, how often it pays interest, and when it’s expected to pay next. If you’re lucky, maybe you can buy a bond right before an interest payment and get six months of interest without having to hold it that entire time.
What does this tell us?
At the time of writing, it was 2020. Therefore, we can see by the issue date (1997) that this was not a new bond. That means it’s a secondary market bond: another person or institution other than the issuer is selling this debt to you.
The frequency tells us this is a regular bond paying semiannually, so we should expect a coupon (interest payment) every six months. The first coupon was made, as expected, six months after issue.
A note on the secondary market: When you buy a bond on the secondary market you are not giving your money to the institution/corporation. The institution received its money from the initial bond sale. You are paying some other party (usually an exchange or brokerage) for the share of the debt they purchased. The institution (in our example, Royal Caribbean) made all of its money from the initial bond sale and makes no money from the buying/selling/exchange of debt bonds.
What’s it cost? How much am I actually investing?
You can find this information under the “Offering” information.
Here it’s listed as price. You can also think of this Offer (sometimes called the “Ask”) as a percentage in the following way: How many pennies on the dollar am I spending? In this case, for every one dollar of the bond, we’re paying under 80 cents (79.744) for each $1 the bond is worth. We’re getting just over 20% off of the actual face value of the bond.
Face Value
So can we finally know what this thing is actually worth?
Bonds are typically traded in even $1,000 increments and this bond is no exception. We can see this information under the “Original Issuance” section.
Minimum denomination/increment: The smallest face value of an issued bond in dollars. This is often written in a purposely confusing manner, but what you see below (1,000x1,000) means the smallest available face value of the bond is $1,000 and the number of bonds you purchase must be divisible by increments of $1,000.
In our case, the bond’s face value is $1,000 but the price is 79.744 cents on the dollar. We can buy this $1,000 bond for $797.44.
Now we can figure out what we really care about: how much are we going to make?
The $1,000 face value is what we should receive in full on the maturity date of the bond. Therefore, if you bought this bond in 2020 for $797.44 and held it until its maturity date, you would receive:
$1,000 on Oct. 15, 2027
7.5% interest on $1,000 per year from 2020 to 2027
How much would we make?
The spoiler for those who hate math and want to skip to the next heading: we outperform the stock market quite handily.
Our $1,000 bond is purchased at $797.44.
We held it for 7 years (2020 to 2027) at 7.5% interest (on $1,000) per year.
Therefore:
Interest per year:
$1,000 face value * 7.5% = $75/year
Total interest:
$75/year * 7 years = $525 total interest
Face value + total interest:
$1,000 face value + $525 total interest = $1,525 final cash amount.
Minus the price of the bond:
$1,525 final cash amount minus $797.44 initial amount paid =
$727.56 profit*
*Your actual profit could be a little less due to things like brokerage fees.
Is that good?
The overall stock market averages about 6-8% return on investment a year.
If we divide our profit by our cost ($727.56 / $797.44) we get a total gain of ~91.24% over the course of 7 years.
91.24% total return divided by 7 years of holding means our average yearly gain was around 13%. If everything went according to plan, we beat the stock market by 5 to 7%.
Understanding Profit Yield
If you’re not aware, a traditional investment is considered pretty great if it returns about 5% a year. That’s why this kind of bond can be attractive. It’s a higher risk since its credit rating is only BB, but it’s also returning 7.5% a year. It’s a 50% better investment (5% * 1.50) than even a “pretty great” one.
But actually, since we’re getting it on a discount for less than the $1,000 face value, our return is even better.
The bond will pay the full amount of interest no matter how much we actually paid for it. Therefore, the lower the amount you actually paid, the higher your return on that cost (and vice versa).
The “current yield” and “yield to maturity” reflect this.
Current Yield: Your profit for holding the bond for one year.
Yield to Maturity: Your profit for holding the bond until maturity (and reinvesting coupons).
This is our Current Yield for the RCL bond:
Yield to Maturity (or YTM) is sometimes called other things like “Yield to Worst/YTW” or “Internal Rate of Return/IRR.” It’s how much you make if you hold the bond until it matures and reinvest the coupon interest as you go.
YTM is calculated with regard for the inverse of the ask/offer and coupon. The math isn’t really that important.
It’s easy to explain with common sense instead of a formula: If you pay less and get more interest, you make more money!
To drastically oversimplify things, YTM is basically a representation of the imbalance between how much/little you pay and how much/little interest you get.
Intermission: Why Rich People Love Bonds:
At this point you know enough basics to start evaluating a bond! You actually probably already know more than anyone you’re going to talk to at your local bank. A bank investor will probably just tell you to buy a mutual fund and go away.
But if you’ll recall the quote at the beginning from a former broker-turned-entrepreneur…
This is because most people are not investing in bonds until they’re dealing with bank accounts in the $1M range.
Typical bond purchases are done by accounts with $10M+.
It’s important to ask yourself what these rich people understand that most people don’t. And, well, that’s easy to answer — it’s bonds.
To answer less facetiously, they understand the security and high rates of return bonds can offer if you can afford to divorce yourself from your money for a long period of time. While you can buy a stock today and sell it at any point (even later today!) that would defeat the purpose of a bond.
Bonds offer fairly safe, fairly consistent rewards — as long as they aren’t sub-prime — but have a higher buy-in cost. You need around $1,000 to buy into bonds, whereas many stocks are available for less than what some of us might have in loose change in a jar at home.
But as long as you can afford to meet the minimum Ask/Offer for a bond, you can play in the rich kids’ playground!
Investment grade bonds are not an issue of high risk and high reward like many stocks. Good bonds are a low risk, high reward scenario. That’s attractive to people trying to preserve and grow wealth and who can also afford the high buy-in price.
Since the buy-in price is so high, this is, in many ways, a rich get richer system. Bonds won’t likely make you a millionaire overnight if you’re starting with a thousand dollars, but they’ll help make sure you walk away with more than that thousand dollars. It’s not a guarantee, but it’s generally a much safer bet than anything you’ll find on the stock market.
You’ll never wake up to your bond being worth three times more than you paid for it like you could with a stock, but you don’t blindly risk losing 2/3 of your money, either. Bonds are not a get-rich-quick scheme, they’re a build-wealth-slowly plan. No one is going to be inviting you to crazy parties because they hear you’re really into bonds. But they might wish they had twenty years from now.
Back to the Show: To Buy or Not to Buy?
Let’s say you have your $1,000 in hand and you’re ready to invest. We’ve been looking at this RCL bond. Take a moment to consider what you’ve learned. Do we invest?
There’s a catch. We need to revisit that credit rating and take a look at just a couple more things before we make a final decision.
If, at any time, the institution fails to make their coupon payment (what you might hear described as “servicing their debt”) their rating will instantly fall to “In Default” status. You may hear this called “conditional default” or some other name, but the outcome is the same regardless of the terminology.
How Corporations Avoid Defaulting : A Case Against Stocks
There are a few different ways a corporation can finance its debt. Stock doesn’t come with a coupon price to worry about, so one of the most common ways corporations avoid defaulting on bonds is by issuing more stock. This is called “equity dilution.”
This is great for bond holders because it means the company can keep funneling money into paying us our coupons and maturity values. It’s terrible for stock holders who will see their value per share diminish.
Another option is issuing new bonds to ensure payments on older ones. This is more or less a legal Ponzi scheme.
There are other, less common scenarios (like government bailouts) that can also occur.
Spotting Risk of Default:
We now understand the Moody’s and S&P credit ratings, but there’s one more thing we want to check on our bond sheet: the Creditwatch status.
This bond’s credit rating can only stay the same or be lowered due to its negative Creditwatch status. It is thus at risk of falling below investment grade and becoming a “junk bond.”
Negative creditwatch renders the current credit rating useless because you have no idea how far it could drop. Our Baa3 bond could become a Ba1, or it could plummet to a Caa2. We have no way to know.
Let’s Invest Anyway!
If you understand the risks and want to buy the bond anyway, you’ll end up at an order screen.
In the top left, you can see the CUSIP.
Below this is the name of the issuer (the company whose debt you’re buying).
Further down, you can see a blank area with a few zeroes after it. This tells you the minimum number of $1,000 bonds you can buy is 1, and there are 497 available.
This can be an indirect indicator of supply and demand. We know from the bond summary page (under “Original Issuance”) that Royal Caribbean was initially trying to raise $300M. $300M divided by $1,000 for each bond means there were 300,000 bonds issued. If only 497 are on the market, that means less than 0.17% of bond holders are interested in selling. That’s probably a good sign for you as a buyer — people don’t want to give up this asset.
The “Price” listed below this as $79.45 is a bit misleading. This is the price per $100 of face value, but of course the bond has a minimum increment of $1,000. Even though the price says $79.45, what we’re actually paying for one bond will be $794.50.
“Execution Type” is just what kind of order you’re placing. “Fill or Kill” means the system will either accept or reject your order. If bonds are available and you have the funding to meet the price for the number of bonds you’re purchasing, your order will be filled. Otherwise, it will be canceled and nothing will happen.
In the bottom right, you can see a summary of the bond’s details to check for the finally-final time before you submit your purchase. This includes the Settlement Date, which is the day you’re taking ownership of the bond and “settling” your contract to buy it.
You can also click on “Expand Trade History” to open a new screen that helps you get a feel for the recent life cycle of the bond.
Trade History
If you look in the bottom left, you can see that the total number of trades made so far on this day is 18. In the “Trade Time” column, we can see the time the each transaction happened. To the right of that, we can see the quantity of bonds bought or sold in each transaction.
So at 8:59 AM, there’s a small fish like us doing a customer buy for a single bond.
But if you look toward the top of the list, at 10:45 we have two identical transactions going through for 1,000 bonds each. This happening at the exact same time and for $1M each as a customer sell tells us it’s probably a broker dumping some bonds for a wealthy client.
If there are a lot of transactions like this, you might want to worry what the rich folks know that you don’t. But for the most part, you simply can’t know why anyone else might be selling assets, so that’s just guesswork and speculation (or “market noise”). But if you want to browse that kind of data, it can be interesting to see someone waking up and deciding to liquidate $2M at 10:45 on a random Thursday!
No matter what the asset type is, there are a billion reasons someone might be selling, but only ONE reason to buy: you believe you will make money.
That’s the end of the official article! I’m going to add some supplementary notes onto the end for the extra-curious, but if you’re already exhausted, you’re good to go!
For more finance, TA, and all things Japan, visit me on twitter @Nikadesh
Supplementary notes:
Brokers:
It’s worth noting that all bond transactions are done digitally now. When you buy and sell stocks or bonds, you aren’t getting a piece of physical paper in the mail like your grandfather might have. For that reason, it’s important to have a reputable broker. Examples are E-Trade and Vanguard. You don’t want to go through the nightmare of trying to lay claim to your bonds if some small-town two man brokerage you’re buying through goes bankrupt.
Prices:
Our example came at a discounted price due to its poor credit rating. This discounted price won’t always be the case. If you’re buying a high end bond from a company with fantastic credit rating (e.g. Microsoft) the Offer/Ask price could be 99.99% or even the full 100%. In some cases, there might even be a premium you pay for the security of a stellar credit rating. You might have to pay an ask price of 103 (i.e. pay $1,030 for a $1,000 bond) and take a small loss on the face value because the assurance you’ll receive the interest payments is so high. That guaranteed interest should cover the premium you pay to own the bond in the long term.
This happens a lot with AA rated companies. Especially in turbulent economic times, there can be what’s called a “flight to safety.” That’s when people are willing to pay high premiums in a tumultuous time in order to guarantee their longer-term financial security.
But for our example (and any others with less wonderful credit ratings), we shouldn’t expect to pay the full price for the bond.
Timing:
Consider the economic climate when investing in such a long-term commitment. What kind of time period will the bond be maturing in?
Generally speaking, you want to buy in times of turbulence and sell in times of peace. Turbulence creates desperation and leads to lower prices (and thus higher yields for buyers). Peaceful times ensure the company can “make good” on the face value instead of defaulting or rolling over into new bonds.
YTM:
YTM is a little complicated to dig into because it makes a few assumptions: namely, that you’ll be holding the bond all the way until maturity, and also that you’ll be reinvesting the interest you gain. Neither of those things are necessarily true. However, it’s a nice statistic you can look at as an at-a-glance measure if you intend to hold your investments long term.
What Institutions Gain:
Why would a cruise line issue a bond offering for $300M? Probably to build a ship. It’s not always that easy to figure out why a company needs the money it’s seeking, but in this case, that seems our most likely candidate.
We can see why this makes sense. It costs them 7.5% for the coupon on $300M for 30 years. That’s $22.5M a year in coupons, which is $675M at the end of 30 years.
That’s just the interest! You also have to add on the $300M face value. In the end, this ship is going to cost them $975M. Why would they pay almost a billion-with-a-B dollars for a single ship?
If they’re making (hypothetically) $50M/year on the ship, the debt is no detriment whatsoever. In the meantime, they have to have a cash buffer for slow seasons, ship upkeep, entertainment, food, crew, and all that stuff. It’s safer for them to take on some debt than it is to liquidate their cash supply, even if they have enough cash to buy the ships outright. The company can preserve its cash stores for emergencies and let the ship pay for itself (and more) over its lifespan.
This is the same idea in many ways as going into debt to buy an apartment building under the assumption the tenants will be taking care of the debt for you over the lifespan of the mortgage. You still need cash set aside for things like water leaks, lawn care, faulty appliances, and so on.
Other institutions might build factories, retail space, et cetera, which they expect to out-earn the bond’s debt payments.
Okay! That’s it for real! Stop reading and go get rich!
