Even Your Alma Matter Issues Bonds

What is a Bond?

A bond is basically an I.O.U.

When a company, or government or your Alma Matter needs to borrow money- they typically do so through the bond market.

But what exactly is a bond?

A bond is the obligation of the borrower (i.e. the corporations, government, alma matter) to pay you a certain rate of interest on your money for a certain period of time– and then pay back all the money you leant them.

Why would these entities ever need to borrow money?

You can bring in money one of three ways:

1) Make more money the old fashioned way.

2) Sell parts of your company – diluting what the existing owners hold. This is called a stock offering.

3) Issue debt- also known as bonds.

If you don’t have the money- is it really wise to borrow?

The American Consumer is a bad example- because on average they spend and borrow more than they make. But sometimes- prudently- you have to spend money to make money. Sometimes it is cheaper to borrow money than spend the money that is already invested in your business. These are decisions businesses, cities and Federal Governments make regularly.

What to Consider Before Investing in Bonds?

Credit Risk: How much do you trust the borrower to pay you back? It’s as simple as that. Unfortunately, with many companies, it takes a lot more than trust. It also takes a good amount of research on their ability to pay you back.

There are people who will do this for you. They are called credit rating agencies. They look at the health of different companies and nations. While it is their job to provide you with an accurate summary of the risks involved- they don’t always get it right. In fact they were highly criticized in the 2008 financial crisis as many bonds that were rated very highly (i.e. the credit ratings agency deemed them to be safe) lost tremendous value. Lesson- where there is money to be made- there is risk to be taken.

Why would you ever invest in a lower credit quality bond? Simple answer- they pay you more interest.

Interest Rate Risk: The rate of interest that bonds pay you depends upon two things 1) the credit risk (ability of the borrower to repay) 2) the general level of interest rates in the market.

Let’s focus now on interest rates. When you buy a bond there is always the risk that 2 months or 2 years down the road, interest rates in the market will have gone up and you would have been better off waiting. This is very much tied into the Fed Funds Rate and the level of Inflation within the economy. When both of those things move up, interest rates move up as well.

Because, to our knowledge, no one has a crystal ball, there are always people willing to take bets on either side of the coin. However there are certain times when it is better to buy bonds (save) and times when it is better to take them out yourself (borrow). For more read: The Fed Funds Rate: To Save or Borrow.

Related Articles: Investing In Bonds: Part 1