What is a bond?
A bond is basically a loan that you are giving a company or government.
A company or government sells bonds to raise money to finance whatever they want to get done. Maybe a business wants to build a factory or maybe a government wants to build a bridge.
The bond has terms that determine the rate and duration for the amount of money borrowed. So, the investor will get a predetermined return with a predetermined expiration date. Just like a home loan – but imagine you’re the bank.
As an investor, bonds are very good investments because you know exactly what you are getting into. Furthermore, the company or government must pay back the money owed to you unless they go bankrupt.
This is important to understand because if you hold a bond from a company versus a stock, the bond principal must be paid back to you, while the stock price could fluctuate all over the place.
If a company’s stock price crashes, the bond holders still get paid. (This is why investors hold bonds instead of stocks.)
If a company’s stock price skyrockets, the bond holders still get paid the same – no more, no less. (This is why traders hold stocks instead of bonds.)
Bonds are a bit harder to invest in because they don’t trade like a stock. This means you can’t just go online and buy bonds with a click of a mouse. Usually, you need to make phone calls and be aware of what bonds are for sale.
Because they are more difficult to purchase, regular consumer investors don’t usually purchase many bonds – they by stocks, which is often why stock prices get bid up so quickly.
Now we know what a bond is…
So how can we make big money from bonds?
We first need to identify what the general opinion is of bonds. This is extremely important to understand, because investor’s opinion towards a particular investment usually determines the direction it goes.
So, in general, investors view bonds as a very safe investment.
In order for an investor to not get their investment in a bond paid back, the company or government has to go bankrupt.
If we looked at most companies and governments, we can confidently say that they will not go bankrupt. At least, that’s what most investors think.
Now, I’m not purposing that we are going to have a massive wave of bankruptcies.
But, there is an area in the bond market where we could see a huge problem.
If we were to look at all the bonds in existence we’d see bonds for technology companies, food companies, city governments, country governments, and numerous other entities from around the world.
Because there are so many entities issuing bonds, there is obviously a wide variety of quality.
Traditionally the bond issuer with the best reputation has been the United States government – these are high quality bonds. Investors who buy US bonds feel very confident that they will get their money back because the US will not go bankrupt.
Because these bonds are considered to be very low risk, the yield paid is not very high. The idea is basically low risk, so low reward.
Now, let’s look at bonds that are high risk, or low quality. There are many countries throughout the world who a have history of going bankrupt. That means that they weren’t required to pay back their bond holders. A famous example of this is Argentina.
Well, Argentina just issued bonds this year (2016) for the first time in 15 years. But, because not everyone is confident in Argentina, the yields on these bonds must be higher than say, US bonds. Higher risk bonds need to have higher returns, otherwise investors wouldn’t take the risk.
We can apply these same ideas to different businesses, assuming that risky businesses will pay more to borrow money, while businesses that have less risk don’t have to pay as much.
The businesses that are paying high yields on their bonds could be in danger of going bankrupt – investors understand this risk, but accept the risk because they want the high return.
These high yielding bonds are known as ‘junk bonds.’ Junk bonds carry a rating of BB or lower according to Standard & Poor’s rating system.
Ok, now we understand that there are different qualities of bonds… but you still want to know how we’re going to make big money.
And here is where the problem starts to surface…
An investor who is looking for the least amount of risk will invest in the least risky bonds. However, these bonds yield very low returns and in some countries they are yielding negative returns.
Essentially, this means that an investor loans money to a business or government for a predetermined amount of time. The borrower will pay back the investor over that time, and the total amount of money paid back to the investor is less than what the investor originally loaned.
Think about that. A negative yielding bond guarantees that the investor will lose money. That’s crazy.
So, investors have begun to look in other places to put their money. Some are buying stocks, some are buying gold, some are buying real estate, and some are buying bonds with higher yields (junk bonds).
Because interest rates are so low today, investors have become desperate for yield, so many are buying more and more risky bonds.
Investors are willing to take the risk of buying junk bonds because they feel they have no other option.
And when I say ‘investors,’ I’m not just talking about your regular Joe down the street. Many major funds, like pension funds, that rely on predictable returns are buying up these junk bonds.
As this trend continues and junk bonds continue to provide returns, the idea that these bonds are risky is forgotten.
Just like the housing market in 2007, investors are not realizing that things can go wrong.
To put bonds into perspective:
In 2000, the US stock market was valued at $15 trillion and the US bond market at $17.3 trillion, according to the Wall Street Journal. By this year, US stock market capitalization has jumped 76% to $26.3 trillion. But bond market capitalization has soared 125% to $39.5 trillion.
The bond market in the US is almost twice as big as the stock market.
At the same time, we recognized earlier that investors feel safe with bonds in comparison to stocks. Stocks could crash, but bonds will be repaid as long as the borrower doesn’t go bankrupt.
Again, I want to point out the housing market in 2007. Real estate owners didn’t see the crash coming. They felt that real estate was safe and that prices would never go down.
Behind the curtain, real estate investors had no idea about Mortgage Backed Securities (MBS), Collateralized Debt Obligations (CDO), or how the rating agencies were falsely giving good ratings.
Now, the US and financial world in general has come a long way since 2008. There have been complete overhauls of many rules and regulations. There have been massive changes in the banking and mortgage world. And investors aren’t throwing their money around recklessly.
So, we’re completely safe then… right?
The fact that 2008 resulted in massive overhauls gives investors a false sense of safety. In addition, investors seeking yield have been forced to invest in higher risk investments.
Still, the idea of investing in bonds seems secure.
What happens when bond issuers stop paying back their investors? And what would cause the bonds to be not paid?
I’ll share that with you soon and give you some ideas to act on this massive opportunity.