Lesson Three, Bond (fixed income) Basics

Hello,

Welcome to Lesson #5: Bonds, I’ll Take One, Thanks!

This course has been running for over two weeks, and I want to commend you for making it this far! I know this topic does not have a reputation for being super interesting (and yah, the math!) But it’s all good—keep at it, you are officially past the halfway mark!

OK, onto bonds, also referred to as fixed income.

Bond Definition: A debt instrument issued by a company or a government (the issuer) for a set period (the term). The term can be anywhere from a year or less to as long as 30 years. In return for you providing the issuer capital for 1-30 years, the issuer pays you interest, most often semi-annually. On the date the bond is due (the maturity date), the issuer is supposed to pay back the face value of the bond to you in full.

Ok, but let’s see if we can make it less dull…

You and I start a company. Running with the theme of this course, let’s make it a lipstick company. We have to compete with MAC, but that’s cool—competition in our space just proves there is a market.

I am not sure what the main ingredient is in lipstick, and I don’t want to know (knowing might make me not want to wear lipstick anymore, and I’m not ready for that kind of change in my life).

Let’s say hypothetically that it is avocado oil.

Sephora has sampled our product, loves it (of course!) and has offered to sell the lipstick to our adoring public, but only if we can supply them with 50,000 tubes ASAP.

Woah, Nellie! That is a ton (maybe even literally) of avocado oil. Unless we have an avocado farm in the family, we are going to need money.

Where can companies get money? Banks. Yes, banks lend money. But not in all circumstances and even the banks do not have enough money to lend to all of the companies in the world that require money each and every day.

To finance projects and their operations, large firms will most often issue stocks or bonds.

(And what happens to those stocks and bonds after they are issued? Well, they are bumped over to trade in the bond market or on the stock market. …it’s all starting to make sense isn’t it?!)

OK, back to you and I, and our awesome lipstick company.

We determine that we need $10,000,000 to purchase enough avocado oil to manufacture 50,000 units of our lipstick (I think this might be some expensive lipstick!). As such, we visit our friendly neighbourhood investment banker who agrees to create and market a bond for us:

The Awesome Lipstick Company 8.9% Feb09/2020

What does this mean?

Bond Issuer: The Awesome Lipstick Company

Coupon: 8.9%

Maturity Date: February 9, 2020

Unpacking this: When an investor buys this $10,000 of this bond, she is buying a fixed income security issued by the Awesome Lipstick Company. The bond security pays 8.9% per annum with payments at $445.00 each August 9 and February 9. (Bonds pay interest semi-annually; the maturity date of February tell us the alternate month is July). The final interest payment and face-value amount ($10,000) is due on February 9, 2020.

And that, my investing friends, is a bond.

A couple of notes:

The safest bonds are government bonds, and like, bonds issued by Canada, Germany and the U.S. (maybe not Burma). The riskiest bonds are called high-yield or junk bonds. You can buy them cheap because investors have decided there is probably little or no chance they will continue their interest payment or repay their principal at maturity. All other bonds, such as those issued by healthy companies like Manulife or TD Bank, are priced and pay an interest rate, somewhere between government and junk securities.

Does anyone remember Kodak? The global leader in camera and photography until their CEO decided that digital cameras were “a fad”? In the final year of Kodak’s existence, their millions of dollars in issued bonds were most likely trading as “junk”. And for good reason-—the Kodak Company’s bonds were eventually proven to be worthless.

As with any asset class, you are going to want to diversify. And as we learned in the Day #12 lesson on fees, your best option is probably not a mutual fund. There are several diversified bond ETFs and index funds that hold government and corporate bond in a single investment.

Final note: I have not taken a deep dive into how the economy and changing interest rates have a huge impact on bond prices. In this e-course, I wanted to introduce the basics of fixed income as an asset class.

And the idea that owning a diversified bond ETF or index fund is the most effective method to include bonds in your portfolio.

If you are looking for a more comprehensive lesson on bonds that explains the oft misunderstood, “when yields go up, prices go down,” fixed income concept, you can click here to learn more about Zero to Portfolio, An Investing MasterClass.

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The Fine Print:

Investing Bootcamp is provided as an educational resource and should not be construed as individualized investment advice, nor as a recommendation to buy or sell specific securities. The investments and scenarios discussed in the course are examples only and may not be appropriate for your individual circumstances.

The investing strategies presented in Investing Bootcamp will result in losses during any period of decline in the broad stock and bond markets. All investments carry the risk of loss. It is the responsibility of individuals to do their own due diligence before investing in any index fund or ETF mentioned in this course.