Friday, February 5, 2010

Stocks, Bonds, Markets

This article is a primer on stocks, bonds and their respective markets.  It's not necessary to understand all of this material to be a successful investor; this is intended for people who are interested in building up their knowledge of the fundamentals of investing.

Stocks and Bonds

Companies can raise capital (a fancy word for money used by a company to make investments to grow its business) in two ways: by selling an ownership interest in the company, or by borrowing the money.  They sell an ownership interest in the company by selling shares of stock to investors.  They borrow money by selling bonds, to investors.  Governments also raise money by selling bonds.

Bonds issued by a company are referred to as corporate bonds.  Corporate bondholders get paid before stockholders if a company goes bankrupt.  Also, bonds are easier to value than stocks, since the interest payments and principal of a bond are known (although with some uncertainty), whereas the future value of a stock and its dividends are difficult to estimate.  For these reasons, stocks are considered riskier than bonds, and investors demand a higher expected return from stocks.  This is known as the equity risk premium (stocks are also referred to as equities).

Stocks and Stock Markets

A company issues shares of stock and sells them in a public offering.  If it's the first time they've issued and sold stock, it's called an Initial Public offering (IPO).  This is something most of us don't have to worry about, because it's mainly large investors that participate in public offerings.

Each share of stock represents a fractional ownership interest in the company.  For example, if a company issues one million shares of stock representing 100% of the value of the company, then each share of stock is worth one one-millionth of the total value of the company.  If this company is valued at one million dollars, each share is worth one dollar (how companies are valued is the subject for another article).

Once shares of stock have been issued and sold to big investors in a public offering, they are available to be bought and sold by other investors.  Like other things that are bought and sold, the word market is used to describe the place where stocks are bought and sold.  In the modern era, a stock market may not necessarily be a physical place, but instead may be a network of computers and phones (just like you no longer have to go to the bookstore to buy a book, but can buy it over the internet).  The investorwords.com definition of stock market is "General term for the organized trading of stocks through exchanges and over-the-counter" (you can click on the links to see the investorwords.com definition of each of the terms used in the definition).

The New York Stock Exchange (NYSE) is the largest stock exchange in the world in terms of dollar volume.  Other large U.S. stock exchanges are the American Stock Exchange (AMEX) and the Nasdaq.  The NYSE and AMEX have actual physical locations where some of the trading is done, but the Nasdaq is a pure electronic exchange.

When you read or hear the phrase "the market was up (or down) today", the reference is usually to the stock market in your home country.  In the U.S., "the market" is usually referring to the Dow or S&P 500, which as I discussed in my previous article, are actually stock indices that are intended to be representative of the broad U.S. stock market.  Keep in mind though that there are many, many other markets that investors are interested in, including bond markets, foreign stock markets, and currency markets.  There are stock markets and stock exchanges in countries around the world.

Stock Dividends and Appreciation

A company may or may not pay a dividend on its stock.  A dividend payment is a way of distributing part of a company's profits to its shareholders.  Dividends are part of the total return an investor receives for investing in stocks.  The other part of the total return on a stock investment is the appreciation in the price of the stock, based on the perception of investors that the company's value has increased.  Of course the price of a company's stock may go down, and the company may reduce or stop paying dividends if their business is not doing well; these are risks of investing in stocks.

Bonds and Bond Markets

A company or a government borrows money from investors by selling them bonds.  Bonds then trade in a bond market.  Unlike stocks, it is common for individual investors to buy bonds directly from a company (or a government), so the term secondary market is used to refer to the marketplace where bonds are bought and sold after they have been originally issued and sold.

The U.S. government uses an auction process to sell Treasuries (bonds, notes and bills), so the term "at auction" is used for purchases directly from the U.S. government.  Treasury bills are short term debt obligations (maturing in 1 year or less), Treasury notes are intermediate term (maturing in 2-10 years), and Treasury bonds mature in more than 10 years.

Bond Interest and Price Changes

When a bond is sold to an investor by a company or a government, there is an agreement to pay the bondholder a stated rate of interest, and to return the original amount the investor paid for the bond (the principal) on a certain date.  The bond is said to mature on the date the principal is repaid, and the length of time between when the bond is sold and when it matures is known as the bond's maturity.

Two of the main risks of investing in bonds are credit risk and interest rate risk.  Credit risk is the risk that the issuer (company or government) will reduce or stop its interest payments, or that it will declare bankruptcy, in which case some or all of the principal may not be returned to the bondholder.  Interest rate risk is the risk that interest rates will rise, causing the value of the bond to fall (more on this below).  For individual bonds, Interest rate risk is only a concern if a bond is sold before it matures, since the entire principal will be repaid at maturity (assuming the issuer doesn't declare bankruptcy before then).

One of the most important things to understand about bonds is bond prices and interest rates move in opposite directions. Let's look at an example to help understand this. Say you buy a $1,000 bond paying 5% interest maturing in one year, and assume the $50 in interest is paid at the end of the year (5% x $1,000 = $50). When your bond matures at the end of one year, your $1,000 principal will be returned to you along with $50 in interest, for a total of $1,050. Say that the day after you buy your bond interest rates on 1-year bonds rise to 6%. Since a buyer of the new $1,000 bond yielding 6% will receive $1,060 at the end of one year, no one would pay you $1,000 for your bond for which they would receive only $1,050 at the end of the year. The market price of your bond will fall to a value that will give an investor a total return of 6% (so they will earn $60 of interest in one year). Since the buyer of your bond would receive $1,050 at the end of one year, just as you would have, the price of the bond will fall to about $990, since $1,050 – $990 = $1,060, giving the buyer the the same return as a new bond yielding 6%. So if for some reason you need to sell the bond the day after you buy it, you will lose $10. Holding the bond to maturity is no better, since you have given up the opportunity to make an extra $10 in interest on the new bond yielding 6% (this is referred to as “opportunity cost”). Either way, you lose $10 (1%) relative to someone who bought a bond after rates rose from 5% to 6%.

Of course the opposite happens if interest rates were to fall to 4% shortly after you purchase your 5% 1-year bond. Investors will now pay you about $1,010 for your 5% bond, since that will give them about the same return as paying $1,000 for a 1-year bond yielding 4%. Either way they earn about $40 interest in one year.

Interest Rate Sensitivity: Bond Duration

The longer the maturity of a bond, the more it's value changes with a change in interest rates.  A bond maturing soon won't change much with a change in interest rates, since the principal will be repaid soon, along with the final interest payment; i.e. there's not much time for a change in interest rates to have any impact on the remaining value of the bond (the principal and the final interest payment).  At the other extreme, a change in interest rates will have a significant impact on the value of a bond maturing many years in the future, since there are many remaining interest payments still to be paid at the bond's original interest rate; e.g., if rates fall, the many remaining payments at the bond's higher rate of interest add up to a lot more money over the years until the bond matures (when compared to the lower interest payments received from a new bond paying the lower interest rate).

Duration is an attribute commonly used to estimate the amount the price of a bond (or bond fund) will change given a 1% change in interest rates.  Duration is expressed in years, and is related to the maturity of the bond or bond fund; i.e., the longer the maturity of a bond, the higher the duration.  Since most of us will invest in bond funds (mutual funds that own bonds) rather than individual bonds, it's important that the duration of our bond fund not exceed the timeframe when we're likely to be withdrawing money from the fund.  That's because the duration is approximately the amount of time it will take for a bond fund to recover any value lost to an increase in interest rates.  Let's consider a simplified example to clarify this.

Say you invest $1,000 in a short term bond fund paying 3% interest with a duration of 2 years, and a few days later, the interest rate increases 1%; i.e., from 3% to 4%.  Remembering that bond price moves in the opposite direction of interest rate change, and that duration is an indicator of how much, the value of your bond fund is likely to drop about 2% (1% rise in rate times 2 year duration), or $20.  So, your fund shares are now worth $980 instead of $1,000.  That's the bad news.  The good news is that you're now getting 4% interest instead of 3%, so instead of earning about $30 per year (ignoring compounding), you'll earn about $39.20 per year, or $9.20 more in interest than you would've earned if rates hadn't risen.  In two years, you will have earned about $18.40 more in interest ($78.40 total interest instead of $60), almost making up for the $20 loss due to the rise in rates two years previously.

Summary

When you own a stock, you own a small part of a company.  When you own a bond, you own a loan to a company or government.  Stocks and bonds trade on various exchanges in various markets around the world.  Stocks are generally riskier than bonds, although bonds also carry risk.  Two main risks of bonds are credit risk and interest rate risk.  Bond prices move in the opposite direction of interest rates, and the longer the maturity (or duration) of a bond, the larger the change in price for a given change in interest rates.

I don't recommend that most investors own individual stocks or bonds (although treasuries may be an exception, if you're willing to learn how to buy them), but instead own low cost index mutual funds.  As discussed in other articles, you can buy a single index fund that essentially owns all the stocks in the U.S., one that owns all the stocks outside the U.S., and one that owns all the bonds in the U.S.  This is a very simple way to own a diversified investment portfolio, and by doing so, you are likely to outperform the vast majority of investors over a 20-50 year timeframe.  Even though I recommend low cost index funds, and you can be a successful investor using them without understanding much about stocks and bonds, knowing more about the basics may help you be a more confident investor.

6 comments:

  1. I received this question in an email: what affects the fluctuation of bond interest rates -- is it the same thing that affects stock fluctuation?

    First, perhaps the most important thing to understand as an investor is that all evidence indicates that consistently and accurately predicting changes in interest rates is pretty much impossible, no matter how much expertise one has. So, even if we understand what influences changes in interest rates, it's difficult if not impossible to use this knowledge to make investment decisions. This has been demonstrated by studies that show that actively managed bond funds, where the manager may be trying to adapt the fund's bond allocation based on his or her prediction of future interest rates, generally underperform bond index (passively managed) funds in the long run. We're better off basing our bond asset allocations on other factors than our guesses about future interest rates.

    Having said that, as with all things economic and financial, there are numerous factors that affect changes in bond prices and rates, but I'll post a few of the big ones in the next comment (there's a limit on how big a comment can be).

    ReplyDelete
  2. Very short term fixed income (a generic term for bonds, commercial paper, money market funds, etc.) rates are influenced by the interest rates set by the Federal Reserve Board ("the Fed")-- i.e., the rates banks pay to borrow from each other, and the rate the Fed charges to loan money to banks. That's why money market funds (which only buy commercial paper of the shortest maturities) are paying close to 0% interest now. If a bank can borrow money at close to 0%, it doesn't have to pay much interest to make a profit.

    Other major factors that influence interest rates are inflation and the expectation of future inflation. Since investors are concerned with real (after inflation) returns, low current inflation will tend to result in low short term bond rates. Long term bond rates will be influenced more by future inflation expectations, since the bondholder won't get the principal (original investment) back for many years, and the interest rate must compensate the investor for the likelihood of higher inflation in the future.

    Another factor: fears about financial crises will cause interest rates on U.S. government bonds to fall, but rates on corporate debt to rise. Because they are considered the safest investment in the world in terms of credit risk (the risk of not getting your money back), demand for U.S treasuries (bonds, notes and bills) will rise during financial crises, pushing prices up and rates down. These same fears will cause corporate bond rates to rise (the lower the credit rating, the larger the rate increase), since people will be worried more about corporate failures, decreasing demand for corporate debt, and pushing rates up. We saw this big time during the recent financial crisis (government rates way down, corporate rates way up).

    This factor is one that influences both corporate bond prices and stock prices in a similar manner, but government bond prices in an opposite manner. This is one reason why many financial gurus (but not all) recommend holding only government debt in the bond portion of your portfolio. Others recommend considering the spread between government and corporate rates, factoring in historical default rates for corporate debt of a given credit quality, and investing more in corporate debt if the additional interest outweighs the probable default rate.

    The former group is basing their recommendation on the fact that government bonds move in the opposite direction of stocks when it matters most: in times of financial crises or panic. However, rates on U.S. government debt were pushed so low during the recent panic that many (including Warren Buffet) saw this as a bubble in government debt. I was in this camp, which is why I've been adding to my investment grade bond funds (which hold some government debt, but more corporate debt) throughout this period.

    There's a lot more to this complex topic, but that's probably enough to chew on for now.

    ReplyDelete
  3. I really appreciate this blog -- I know you have told me multiple times about the differences between stocks and bonds, but sometimes it's easier to read. Your examples really helped clarify things although I think I need to understand a bit more about interest rates fluctuating and returns. I am also curious then, why do companies offer bonds if they are lower-risk to investors? How do they help the company? I know this is probably a naive question--- but being a new investor it may help me understand a bit more.

    I understand that stocks helps give the company money to make more investments (am I right?). I do appreciate the advice of owning more of the global markets vs. trying to diversify your portfolio by buying individual stocks/bonds here and there. Thanks also for the definitions! Really helpful to take a break and check that out with the links attached before reading further!

    ReplyDelete
  4. Also, you mentioned a separate article for how we determine "value of a company" -- can you go into detail on that?

    ReplyDelete
  5. Kristen asked: why do companies offer bonds if they are lower-risk to investors? How do they help the company?

    I'm not an expert on this, but I don't think a company thinks about the risk to investors in raising money (issuing bonds or stock), but rather what is the lowest cost way to raise the money. In selling stock, the current stockholders are giving up some of their ownership, and sharing the future profits of the company with the new stockholders. In selling bonds, the current stockholders are borrowing money and paying a fixed interest rate to the bondholders, and eventually paying them back what they borrowed (the principal). The management of the company decides how much of each way (stocks or bonds) makes the most sense at the time. Each brings cash into the company, which they can use to invest in their operations, and hopefully increase their revenue and profits.

    ReplyDelete