Understanding Corporate Bonds
This post is a bit out of order, but I just wrote my son this morning explaining some very current situations involving corporate bonds. I thought it would be good to share that email with you here.
I know you remember I told you a couple of weeks ago that now is definitely NOT the time to be getting into the stock market for investing.
The essay I just sent you does a good job of explaining why that is for one sector (oil and gas) and a bit for another (banking).
One of the big things the Stansberry company is pushing right now is their service to tell us which corporate bonds to buy.
It seems like an excellent service, but I’m not ready to shell out $5000 for it.
However, I will probably at least do some studying on my own to learn more about it. Here’s the essence of what I’ve found out so far:
- Corporate bonds are legal debt. Money a company borrows from the bond buyers. If the company ever goes bankrupt, bondholders have a superior claim on company assets, above both stockholders and preferred stockholders.In other words, the legal proceedings of a bankrupt company require it to pay bondholders before the owners get anything.If the company does not go bankrupt, it must pay the bondholder the face value of the bond (usually $1,000, occasionally $5k) at bond maturity.Each bond has a maturity date, the date at which the company must pay the bond holder the face value, also called par value.
- In addition, as long as a company is in business, it must periodically pay bond interest to bondholders.For example, if you held a $1,000 bond at a 4% coupon rate (think of it as interest), the company is required to pay $40 a year to the bondholder. Typically, they will do this quarterly ($10/quarter in the example), although it can be done monthly, semi-annually, or annually.
- Person-to-person corporate bond sales is a huge market, and they frequently happen at values other than the par value.For example, if a company is soaring in profits and reputation, or if it has an exceptionally high coupon rate, like 8% or 10%, someone might be willing to pay $1,200 for a $1,000 bond from that company.If the company seems to be in trouble, bondholders might get skittish and be willing to sell the bonds at below par value.Of course, if you bought a 4% coupon rate bond for $1,200 instead of $1,000, your actual return on your investment (ROI) would be less than 4%, because you’d be getting 4% of the $1,000 par value of the bond. Conversely, if you bought that same bond for $750, your ROI would be significantly higher.
- In a dramatic economic slump, such as I believe we are about to have within the next few months, many corporations find themselves in trouble, as indicated in the essay I sent, even huge world-dominating corporations.One of the curious things about seasons such as this is the public perception that “if the economy is in trouble, everyone’s in trouble” and the emotional knee-jerk tendency to paint all corporations with the same “you’re in trouble!” brush.The result of this perception and knee-jerk reaction is that even companies that are having a hard time but are not truly in trouble see their bond prices tumble along with everyone else’s.It is during times like this that we can pick up corporate bonds at a huge discount to their par value.For example, during the 2008 slump, bonds for a drugstore giant were selling as low as $460, I think. I don’t know what their coupon rate was at the time, but whatever it was, if you bought their bonds at that price, you literally doubled your ROI.
- The only risk in purchasing corporate bonds is that the company will go out of business, AND will not have enough assets to cover its debt (outstanding bonds).Buying distressed (low price) corporate bonds during this time can be a superb investment, providing you check out the company issuing the bonds and can be reasonably certain they will not go bankrupt.
Of course, there’s a lot involved in (a) just finding the bonds that are being sold at a huge discount to their par value, and (b) doing the research to be sure the company won’t go out of business.
That’s the service Stansberry wants to sell me for $5,000, and I’m not buying.
Anyway, this, I think, is a pretty good overview of what’s meant by bonds when someone says “stocks and bonds.” Now take a look at the essay below, and you’ll see some of the indicators of the coming economic downturn, and why there might be some corporate bonds from exceedingly strong companies available soon at bargain prices.
After reading this letter, I hope you, too, have a better understanding of what corporate bonds are, and why people trade them.