One of the reasons I think talking about investing is important is because there are more ways to get engaged in the investing process than you would think. Earlier in the Stock Market Basics series I talked a lot about how to know what a share of a company is, how to research the price and other basic metrics when assessing whether to buy a piece of the company. But what I haven’t discussed before is how you can actually buy a piece of a company’s debt in similar fashion. You’re probably asking why would I ever want to buy into a company’s debt? Great question. Hopefully I answer it by the end of this post.
When a company, government or municipality (i.e. city, state, county) issues debt publically, they are essentially borrowing money from the investors with intent to repay. Essentially a bond is a loan that a company, government or municipality issues in order to generate the necessary cash. For example, Microsoft recently announced the purchase of LinkedIn for $26.2 billion dollars. Looking at Microsoft’s balance sheet, you will realize they could pay that bill with cash on hand and cash equivalents if they really wanted. However, Microsoft is going to be offering a new corporate bond to cover the bill.
*Side Note: This particular thing about Microsoft taking the debt route instead of paying with cash is a little too deep for this post, but all in all just know they probably did it for tax purposes. Like your student loan interest or mortgage interest is tax deductible, interest payments made from corporate bonds are also tax deductible.*
By purchasing a bond offered by Microsoft or any other issuer, you are trusting that they will pay you back the full amount you gave them, at the time they said they would. This is where you need to start asking for proof of creditworthiness from a corporation. Just like you have a credit score, there are rating systems designed to provide issuer ratings for bond issuers. The Standard & Poor’s and Moody’s ratings are the most popular.
Last thing I want to cover is that bonds are also a part of the fixed income family. Bond issuers generally pay out a interest payment based on the issuers creditworthiness. The general rule for bonds is that the better the issuer rating, the lower the interest rates will be. US Treasury bonds are some of the highest rated bonds and sometimes pay out no interest depending on the term of the bond. Bonds with the lower ratings normally pay higher interest rates simply because they want to appeal to investors despite not having a investment grade issuer rating. It’s a form of compensation for default risk, or the risk you take on for the person you loaned money to not actually paying you back.
There are loads of details about bonds that make them appealing to folks on the more conservative side of investing especially as generating income from investments becomes necessary in a portfolio. I personally don’t own any bonds in my personal brokerage account, but my 401K definitely has some bonds to generate fixed income. I may get a few in my personal brokerage soon…maybe.
Until next post…