A couple months ago I wrote about the capital markets in reference to stocks. As a way to raise money for a business, you can issue out stock in return for an investment into your company. The shares of stock represent partial ownership of the company, and as a shareholder, you can benefit from the profits of the company. (please see my blog “Capital Markets (Stock)” on 2/28/2017)
Now, as I mentioned in that blog, there is another way to raise money for a company: borrowing the money. Let’s take a look at that.
In the world of capital markets, borrowing money is achieved by issuing out bonds. Bonds are debt instruments issued by an organization (a company or a government). When someone invests in a bond, they are loaning money to the issuer. The issuer, in turn, agrees to pay a certain interest payment for a defined period of time and then at the end of that period, to pay back the principle.
Let’s go back to the startup company, PB&J’s, that needs $100,000 to open. You have $50,000, but this time you decide to borrow the other $50,000. To do this, you issue out 50 bonds with a face value of $1,000 each. In this case, the bonds have a 6% coupon and a ten year maturity^. This means that you agree to pay $60 in interest per bond, per year ($1,000 x 6%) and then at maturity, in ten years, you will pay back the $1,000.
You find five people who each buy ten bonds to raise the $50,000 you need. The big difference between issuing out bonds v. stocks is that when you issue out debt, you are not giving up any of the ownership of the company. So, in this example, you still own 100% of PB&J’s, and the five bondholders are your creditors. On the plus side, this means you get to keep all the profits of the company. On the downside, different than dividends, you must make the bond interest payments regardless of how the company does. (remember that dividend payments are at the discretion of the company)
If Pb&J’s makes $20,000 in profits, you, as the sole owner will net the entire amount minus the bond interest, or $17,000. However, if the company just breaks even, you still need to pay out the $3,000 in bond interest. As a bondholder of the company, you do not participate in its earnings. No matter how well or poorly PB&J’s does, you will only get your $60 per bond, per year.
A few things to know about bonds:
- Bonds are issued by corporations, state and local governments (municipals), and the Federal Government (Treasuries). They are all slightly different in makeup, but all represent debt of the entity which issues it.
- While getting much less press than stocks, the US bond market is much larger than the US stock market, with about $37 trillion in outstanding bond debt v. about $21 trillion in total stock market capitalization (2012).**
- In the capital structure of a company, bonds rank higher than stocks. Therefore, bond interest payments must be made before any dividends can be paid. Also, in the case of liquidation of the company, bonds have a higher priority for any claims on assets.
As with investing in stocks, it is important to know what bonds you are buying and why. And, that bond prices can and will fluctuate over time. There are many reasons why a bond’s price may fluctuate, including, the financial health of the company, prevailing interest rates, and the length of time to maturity. Bonds are an important asset class in portfolio management and can play a significant role in your long term financial plan.
^This is for illustrative purposes only and does not represent an actual investment.
*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. Verity Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.
Check the background of this investment professional on FINRA’s BrokerCheck.
A Financial Advisor registered through CUSO Financial Services, L.P., Gavin has 25 years of experience as an advisor in the Puget Sound area.
“I believe every client is unique and deserving of a personalized financial plan that will help them reach their individual financial goals. Before I make any recommendations, I like to get to know my clients. By asking the right questions, and developing an honest, trusting relationship, I can really get a sense of what’s going to work best for them.”
Gavin graduated from the University of Washington with a BA in Business Administration and started his financial career with US Bank in the Investment Department. Prior to joining Verity in 2006, he spent eight years with Piper Jaffray.
So what is Gavin’s vision for his dream retirement?
“My dream retirement would be absolutely worry free: financially, emotionally, and in every aspect of life. My finances would be in order so expenses for travel, luxuries, and gifts for the kids, grandkids, and great-grandkids would be taken care of. My kids would be financially sound, so I would be confident in their prosperity. This would give me the freedom to travel and play and do whatever it is I want to do.”
When Gavin’s not working, he enjoys spending time with friends and family, watching Husky football and taking weekend trips around the Northwest.
Gavin is registered to transact securities business in the states of AZ, CA, CO, FL, HI, ID, IL, KS, MN, NV, NY, OR, UT, VA and WA.
*Non-deposit investment products and services are offered through CUSO Financial Services, LP (“CUSO Financial”) (“CFS”), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CUSO Financial. Verity Credit Union has contracted with CUSO Financial to make non-deposit investment products and services available to credit union members. Atria Wealth Solutions, Inc. (“Atria”) is not a broker-dealer or Registered Investment Advisor and does not provide advice. CUSO Financial is a subsidiary of Atria.
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