There’s a lot of talk in the financial media about stocks, bonds, mutual funds, hedge funds, and other financial terms that everyone just seems to automatically understand - unless that everyone is you and you have no idea what they’re talking about!
The whole financial community seems to have this have this special language that involves jargon and lingo that only an insider can truly understand. I’m mean after all, if you’re not a member of this elite financial club, what good does talking about P/E ratios, book values, and earnings before interest taxes depreciation and amortization do for you?
Even if you’re just talking about general economic terms, like interest rates, trade tariffs, the value of the dollar against other currencies, and unemployment levels relative to inflation, it’s still very easy to get lost.
Let’s take this one step further.
What about the basic ingredients of financial markets, like stocks and bonds, mutual funds and annuities, cash value life insurance, and even CDs at the bank? You may be familiar with these terms but do you really understand them? Could you explain how they work and feel confident that what you’re saying is actually correct?
Your answer may be “yes” to a few of those financial instruments I just mentioned, but I would guess that if you’re like most people, you would much rather talk about something else. You know, like maybe something simple and straightforward - like parenting… (Yeah, right!)
Building your financial confidence If you’ve ever felt uncomfortable listening to financial people talk or trying to explain financial concepts to your spouse or to your kids or even to your friends and colleagues, I’m going to equip you with something that will empower you to feel confident the next time you find yourself in a financial conversation. But, in my typical style, I’m going to explain it to you in a way that has nothing at all to do with economics or finance.
Today I want to teach you about how bonds work. And, to help me teach this lesson, I’m going to use a comparison between this confusing financial vehicle and a simple dairy farmer. Now, if you just happened to be a dairy farmer and you’re reading this article, I do respect the fact that your business is far more than just a “simple dairy farm.” But beyond the complexities of your day-to-day operations, let me deconstruct dairy farming to its basic elements in the same way that I’ll deconstruct the mechanics of how bonds work. Okay?
Here we go.
Life on the farm When a dairy farmer buys a cow, what is it he’s hoping that cow will produce for him? Of course. The answer is milk and lots of it! That farmer wants to have the milk production from his herd be as high as possible.
In the world of bonds, the milk they produce is called “interest income.” You allow the government, an individual company, or a municipality to borrow money from you for a set period of time, and in exchange for your allowing them to use your money, they agree to pay you a set amount of income called interest. The dairy farmer gets his milk daily but the interest that comes from bonds is usually paid twice a year, six months apart. Just like the farmer, a person buying a bond wants to have that bond pay as much income as possible for as long as possible and the interest rate the bond has tells the person buying it exactly how much they can expect to receive. The bond also has a maturity date to let that person know how long that income will last.
Hanging on when prices moooove As a person owns the bond, the price of the bond can fluctuate in value, just like the price of beef fluctuates for the farmer while he’s managing his herd of dairy cows. If that farmer needs to buy or sell a cow for any reason, then the price of beef becomes much more important to him in that particular situation. But, assuming that he doesn’t have to buy or sell cows very often, he can live with the fluctuations in the price of beef and enjoy the level of milk production his cows produce stress-free.
For someone holding a bond in their investment portfolio, the price of that bond can fluctuate a lot while they own it too. Some of that fluctuation is determined by how much income it produces relative to the amount of time that’s left until the bond matures or comes due. And some of it is related to the quality of that individual bond relative to others that are available on the open market.
For example, if you have a 20-year bond that pays 3%/yr. in interest income and interest rates go up to 5%, the new bonds that come out will pay more than yours do. So, if someone was going to invest money and they could choose your 20-year bond at 3% or a brand-new bond at 5%, which one you think would be worth more? Of course - the one that pays more interest would be more valuable, just like dairy cow who produces more milk would be more valuable compared to another who doesn’t produce as much.
So, in this scenario, if you need to sell your bond at 3% and someone could go out on the open market and buy another one at 5%, you’d have to sell yours at a discount to make it more competitive. On the other hand, if your bond paid 5% and the interest rates dropped to 3%, then you’d have a premium level of income in your bond compared to what was available on the open market. That would allow you to charge a premium price if you needed to sell your bond before it came due.
Reducing volatility and adding safety Let me add one more twist to this scenario. If you have bond at 3% and interest rates rose to 5% - but you only had two years left on your 20 year bond – what impact would that have on the price?
Well, it wouldn’t have nearly as much impact as if you had 20 years left on your bond because when that bond comes due at maturity, you’re entitled to get your full investment back regardless of where interest rates are at that time. If you needed to sell your bond early, you would still be able to get a lot more of what it will be worth at maturity because that maturity date is not very far off.
In other words, owning bonds with shorter maturities can help reduce volatility in your overall portfolio. Bonds may be a part of your overall longer-term strategy, but you can fill that slot in your investment recipe with shorter bonds that provide income and more safety than their longer term counterparts.
And speaking of safety, one big risk of dairy farmer has is that is herd can get sick or die. And bonds can die too… Well, sort of.
If the company or municipality that’s backing the individual bond’s interest payments and repayment of the amount you invested goes bankrupt, the value of your bond can go to zero. To help eliminate this risk people can protect their bond investments by buying insured bonds. Even if the municipality or the company involved goes out of business before the bond comes due, a private insurance company will help make sure you don’t lose your investment.
Of course, government bonds don’t need to be insured because they’re backed by the full faith and credit of the US government. That may or may not make you feel confident these days, but as long as the government can print money, they should always be in a place to repay their bondholders.
So let’s review The interest income that a bond pays is a lot like the milk that a dairy farmer receives from his cows. While those cows are producing milk, the price of beef can and will fluctuate, just like the price of bonds do for people who own them. If you stick with high quality bonds, just like a farmer would want to have the highest quality cows in his herd, you can relax more knowing that your investment is safe and that your income is dependable.
I’m not sure if you can get life insurance on cows in case they die, but you can protect your bond from dying by purchasing government bonds or insured bonds. That gives you an advantage over the farmer and you don’t have to get up at 4 AM every day to collect your interest check! That’s definitely a major advantage over dairy farming.
Now you’re in the know Finances don’t have to be complicated. A little understanding of the basic mechanics can take you a long way toward improving your financial literacy. Hopefully my cow and bond comparison today helps you make sense of this commonly used financial vehicle. And, if you haven’t yet seen it, also check out my article where I talked about how mutual funds work. Since bonds can be held in mutual funds too, you’ll have both of these bases covered and you’ll be on your way to a better understanding of how your money works.
All of my articles are designed to help give you a fighting chance to improve your finances and understand what’s in your best interest when making investment decisions, and decisions on whom to trust as your financial advisor. Keep reading and keep learning. And, if I can help answer any questions or help you in any way, please let me know.