Every year when I was younger, my family would throw a big 4th of July party to celebrate my brother’s birthday (he was born on the 3rd). I remember those days being filled with wiffle ball games with my cousins, lots of cake (LOTS of cake), and sparklers that would be the finale to a fireworks show perfectly executed by my dad and uncles. Something else that I always associate with those days? Savings bonds. I know, weird. You wouldn’t think an 8 year-old would know or care what those are. But every year my brother’s godmother would gift him with a $50 savings bond for his b-day, and every year I would be jealous. Why? Because even though it wasn’t a cool new pair of rollerblades or remote control car, our parents let us know that he would have a nice chunk of change once he decided to cash those in when he was older. And I wanted that nice chunk of change. Yes, I was a bitter 8 year-old. So be it.
While bonds are an unusual (yet awesome) gift for a kid still in grade school, they aren’t unusual to see in someone’s investment portfolio. Here’s the lowdown on the bond game:
Companies can raise money one of three ways: selling stock (see my previous post), taking out a loan from a bank, or issuing bonds. When the first two aren’t attractive options (hello, who wants to hand over part of their business if they don’t have to?), they turn to the third: Bonds. For this type of fundraiser, you, as the investor, are essentially acting as a bank and loaning your money to the company at a specified interest rate, known as the “coupon rate” in the bond world. Yes, they give it a different name to make it more difficult. Welcome to finance.
If you decide to purchase a bond, you will most likely do so in increments of $100 or $1,000, since this is the standard that most organizations use when issuing them. You will hold it until the maturity date, or the date the company says it will no longer need your money, and then all of that initial cash you threw at them for the bond will be returned to you. Best part? In between the time of purchase and that maturity date, you will receive interest payments, and these payments are made at intervals specified by the company (usually annual or semi-annual).
Because you know when to expect these interest payments and final return of your principal (aka the amount you “loaned” to the company), bonds are categorized as “fixed income” investments. Stocks, on the other hand? Not so much. You have no idea when (or IF) you’ll earn money with stocks, which is why they are the riskier investment. Ya follow?
Now, not only can corporations (think Kraft, Target and Nike) issue bonds, but governments can, too. Ever heard of a Treasury bond? Yep, that’s the old U, S, and A getting in on the bond action. Your state and local governments can issue these as well (to raise money, let’s say, for the construction of a new bridge or highway repairs), and these are known as municipal bonds. Bonus to investing in municipal bonds? Any interest you earn from them is tax free at the federal level (AKA Uncle Sam) and sometimes state level (Hoo – Hoo – Hoo – Hoosiers!) as well. Talk about an immediate benefit.
CHANGE IN THE GAME
Remember when I said that most bonds are issued in $100 or $1,000 increments? Well, I kind of lied. But only kind of. You see, when organizations initially set these, they base the interest rate based on a variety of factors at that time, including the credit quality of the issuer (i.e. how dependable they are in paying the bills) and the prevailing interest rates set by the government.
For instance, let’s say Victoria’s Secret wants to make some more moolah to do some research & development on a new swimsuit line. At the time, the market interest rate is 5%. They are a credible company, so they set their interest rate (or “coupon rate”) at the same 5%. People can invest in their money in the bond or an account offering the prevailing interest rate. Either way, they will make the same amount of money.
Now, let’s say that the market interest rate moves to 4%. All of a sudden, the Victoria Secret bond is more attractive – wouldn’t you rather get 5% on your money than 4%? Because of this, any bonds issued after this change will be bought at a premium, meaning that you’ll pay more than the $100/$1,000 bond value you initially would have. The opposite is also true: if the market went to 6%, the VS bond would be less attractive, and to get people to buy it, they would have to sell it for less than the $100/$1,000 original value. Who knew designing swimsuits could be so complicated?
PROS AND CONS
Like everything in life, bonds have their good and their bad. First, let’s start with the good.
Lower Risk – For the most part, because the organization issuing the bond is obligated to pay the coupon rate and return your principal at the maturity date, these represent lower risk than stocks (which guarantee no earnings or the return of principal – in fact, they can take it all and drive off into the sunset if they wanted. Stocks can be heartless devils).
Vehicle for income stability – As you near retirement, keeping your investments in a safe vehicle that almost guarantee payments can be a huge benefit. Even though it won’t be large sums, you’re still earning money and will have regular payments coming your way.
Lower return – Unfortunately with lower risk comes lower return. You won’t be able to design a retirement portfolio that will support you for all those years you are old and crotchety on bonds. They just don’t have the opportunity for large gains like stocks do. Period. End of story.
Higher tax rate – With stocks and bonds, any long-term gains you earn are taxed at what is known as the capital gains rain, and this is currently capped at 15% (but can be lower depending on your tax bracket). Any interest earned on bonds, however, is taxed at your normal tax rate. So, if you make $500 on stocks, you’ll only pay $75 in taxes. If you make $500 of interest income on bonds and are in the 25% tax bracket, you’ll pay $125. And I’m sure you, like me, could do so much with that extra $50 – like buy one of those new Victoria Secret swimsuits.
Bonds are a great investment option as you get closer to retirement age. However, as someone in her mid (ok, late) 20s, I really don’t put my money there – I’ve got a while until I say sayonara to the working world and would rather put my money in something with greater growth potential.
As always, I’m here to answer any and all questions you may have. Also, I’d love to hear what you dream your retirement is going to be like! Mine? Well, I envision winters spent somewhere warm, vacations to Italy/Thailand/etc., and many glasses of wine ;)
Congrats…Lesson 2 is done!