Step 49: The Difference between Shares and Bonds

Step 49 of the 100 steps to Financial Independence: The Difference between Shares and Bonds
Step 49: The Difference between Shares and Bonds

Stock markets have a vast selection of stocks and bonds that can be invested in and before deciding what to invest in, understanding the main differences between stocks and bonds well is absolutely key if you consider getting in the stock market. Investors can decide whether they want to invest in just shares, just bonds or whether to create their own mix of stocks and bonds. With time, many furthermore decide to slowly reallocate their investments, so even if you start with a certain percentage shares and bonds, this needn’t stay as such for the rest of your investment life.

Here we’ll look at the main differences between shares and bonds from an investor’s point of view and how they both offer different advantages and disadvantages.

Volatility

  • Share prices vary more day-to-day but also over long periods of time: their value can increase or decrease fast.
  • Bonds are generally more price solid and fluctuate less over time and at a much slower pace than shares.

Continue reading

Step 48: Understanding Bonds

Step 48 of the 100 steps to financial independence: Understanding Bonds
Step 48: Understanding Bonds

In step 47 we looked at an introduction of what shares are, but they are only part of the stock market, there is another major player to be found on the stock exchange, which are of course bonds. In this step we’ll look at bonds in greater detail and find out why they might be interesting to invest in.

What is a bond

A bond is in essence nothing more than an IOU that a government or company issues when they borrow money. In the case of a bond, the debtor (i.e the government or company that issued a bond and therefore borrows money) agrees to pay back the full amount of the original loan, along with interest.

A bond is traditionally an official paper to confirm the loan and when bonds are issued, they usually have the following information:

  • Value of the original loan, i.e. how much money the bond was for.
  • Interest rate that the company or government will pay back yearly.
  • Redemption date: this is the date when the issuer of the bond will pay back the original loan. This is usually anything between 5 and 30 years.

Like with stocks, companies and governments often issue many bonds at the time in order to raise a total amount of money they need for a new investment or expansion.

Why do bonds exist

So why do companies issues bonds and not just borrow money from the bank? The main reason to choose for bonds is that companies can often agree lower interest rates with investors than they can with banks. It also means that they don’t need to adhere to the restrictions that many banks impose on entities when they borrow money. By issuing bonds it guarantees that companies have more flexibility and freedom when it comes to chosing between reinvesting or loan repayments.

So why not issue shares then? A drawback of shares is that a company cannot just continue issuing more and more stocks without annoying their investors as the more shares are out, the more owners of the company there are, the more reduced the Earnings Per Share (EPS) are: the same profit has to be divided amongst more investors. With bonds, companies don’t have this problem as they can issue more so long they can find new investors willing to lend them money. Of course the disadvantage of bonds over stocks is that the full amount needs to pay back, which as we saw in step 47 is not the case when a company issues shares.

What do bonds give

Bonds give investors the possibility of making money in the following two ways:

  • Interest payment – as with any loan, a debtor agrees to pay interest on an outstanding loan, so if you lend somebody $100 at an interest rate of 5%, you can expect to get $5 every year until the redemption date, when the bond will be paid back in full.
  • Capital gains – similar to shares an investor can decide to sell their bond to somebody else, meaning the new investor takes over the loan. Since bonds are traded on the market, their prices can go up (or down). Bonds can be sold for more or less money than was originally lent to the company or than what the original investor paid, so as with shares, one can make and lose money on the buying and selling bonds.

What affects the price of bonds

The fluctuation of bonds prices is usually a result of the following three main factors:

1. Interest rates of the national and global economy

Investing in anything on the stock market always brings a risk as well as a cost with it. You pay fees somewhere along the line, be that to a stock broker or your brokerage account.. at some point you’ll pay. Added to that, bonds might cease to exist if the company or government goes bankrupt. So if you get 5% interest on a savings account with you bank, you’d be silly to buy bonds at 4%, as not only will you get less money on it, you will also run a higher risk of losing your money and you haven’t even paid for any costs at this stage. When interest rates of the economy go up, bonds have to offer more interest, otherwise people will invest their money in their own savings accounts. Add in inflation rates being high or low and you can imagine that it might be more interesting to put your money in stocks instead of in a low-interest bond.

2. Risks associated with the bonds

Every bond issuer is different and is either more or less likely to actually pay back the loan. If the entity goes bust, you simply won’t get any money back. Safer bond issuers might be more interesting as they are less likely to go bankrupt, although returns (i.e. interest rates) are generally lower than on bonds from more risky entities. To indicate how safe a bond is, there is a credit quality rating or bond rating, which ranges from AAA (highest level of safety) to AA, then A, BBB, BB and B and continues with CCC, CC and finally C, which indicates a low quality bond. During different economic times, people are willing to take more or less risk.

3. The remaining life span of the bond

Bonds that have a long life span have a higher risk of a payment default (the issuer not being able to pay) or a change in their credit rating. A company might be very healthy at the moment, but what will they look like in 30 years’ time? Because of the associated risk, longterm bonds usually have a higher interest rate to correct for the increased risk or insecurity. Bonds getting closer to their redemption date can go up in prices as they become more interesting to have as the chance of payment default or bankruptcy of the company goes down.

Two last warnings

  • Remember that if you bought a bond of $100 for $110 (thinking you’d either get enough interest on it to counter for the $10 difference, or would be able to re-sell at an even higher price), since the bond was originally issued for $100 at the end of the its date, you will only be given $100 by the issuer! If on the other hand you purchased it for $90, you will make $10 on the bond by its expiry date.
  • If a company has issued both bonds and stocks, then their bondholders must be paid interest before any profit can be given to the share holders. At the same time when you buy a bond, you won’t be given any part of the profit.

Step 48 – Understanding bonds – in detail

Like in the previous step, we are for now just finding out about bonds and how they behave on the market.

  • Type in bond prices + a company to find out more about the characteristics of bonds, such as their interest rates, maturity date / redemption date, and current prices. See how this evolves over time. Don’t worry about the actual details or number, just try to get an idea of how bonds trade on the market.
  • It’s harder to find information on bonds in the news, as news items tend to focus more on shares since they sound more exciting due to their prices fluctuating more. Try and see if you can find some information on bond prices, defaults and other information on bonds.

And that ladies and gentlemen is the introduction to bonds. Does the whole stocks-and-bonds-story still sound little confusing? Good, as the next step is completely focussed on comparing the two in greater detail.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.

Step 46: On Inflation and Interest Rates

Step 46 of the 100 steps mission to financial independence: On Inflation and Interest Rates
Step 46: On Inflation and Interest Rates

We’ve mentioned inflation in several earlier steps, so it’s time to have a closer look at this economical phenomenon, how it works and what effect it has on the economy and your personal finances specifically.

Inflation

Inflation is an increase in the prices of goods and services over a period of time, leading to a  loss of the relative value of our money. If you have $1,000, you can buy 10 items that cost $100 each today, but when the item price goes up to $110, the $1,000 will only buy you 9 items in the future. Inflation leads to us being able to buy less for the same amount of money.

Deflation

The opposite of inflation is deflation, with prices dropping and therefore our money increasing in value. Although this might initially sound like a fantastic situation, a period of deflation is normally a sign of economic recession. When customers know that prices will go down with time and that their money will be worth more tomorrow than today, they hold off making new purchases or investments. Often times this is a vicious circle, as interest rates on loans drop (see further down as to why) so holding off bigger purchasing such as a house means not only that it will be cheaper if one waits a little, but also that the interest on a mortgage will be lower. The more people do this, the more prices drop further, the more interesting it becomes to wait even longer. Less money is spent, the government needs to make cuts as less taxes are coming in, more businesses struggle to survive, people lose their jobs and money is no longer flowing, meaning the economy is becoming unhealthy and in no time the economy is affected negatively tremendously. So in reality a situation of deflation is not generally a desirable one. Continue reading

Step 35: Income stream 3: Interest Income

Step 35 of the 100 steps mission to financial independence: Income stream 3: Interest Income
Step 35: Income stream 3: Interest Income

So we have thought about our first income stream, which was a wage coming from a paid job, as well as the possibilities of a second income stream in the form of profit income. For most people either of these might be their main and only income stream and they might have never thought of other sources of income. Yet there are five more possibilities and even though that doesn’t mean you need to pursue them all, it is always good to at least find out more..

Let’s have a closer look at a third income stream: interest income from money lent out. Money lending and borrowing isn’t usually free, as the lender runs a risk (they might never see their money again), so the person who borrows money is required to pay interest on the loan in return, to make lending money more attractive.

Continue reading

Step 21: Stop accumulating debt

Step 21 of the 100 steps mission to financial independence: Stop accumulating debt
Step 21: Stop accumulating debt

It’s time to start looking at an area of your finances that makes many people nervous, scared and / or depressed, leaving them ignoring rather than analyzing and planning how to deal with that very same area: debts.

Yet in order to become financially independent and in total control of your finances, it is important to understand how debts work and how even seemingly small debts or amounts can make a tremendous difference to your long-term finances.

In step 4, you listed all of your debts, so you should have a good idea of how much debt you have and how much you are paying towards amortizing these loans. In this current step we are going to look at the effects of debt and how much extra you end up paying on any long-term debts. Continue reading

Step 20: Learn about Compound interest

Step 20 of the 100 steps mission to financial independence: Learn about Compound Interest
Step 20: Learn about Compound Interest

You have probably heard about compound interest, and might even feel you understand the notion of compound interest quite well, but since it is the key concept in some of the next steps and because the impact of compound interest over time might be far bigger than you realize, this entire step is dedicated to looking at how compound interest works.

In finance compound interest is one of the most powerful factors at work that by using time as it catalyst, can do one of two things:

  • keeping you poor by losing money on outstanding debts
  • making you richer by making more money with the money you already have

Let’s look at how compound interest works and how it generates this power over time. Continue reading

Step 4: List your Debts

Step 4 of our 100 steps to Financial independence: List your Debts
Step 4: List your Debts

Now that you’re happily (?) tracking away your expenses, which we know will take a while to keep doing before we have a solid, reliable list, we are going to continue with other steps we can take in the meantime. To start with, we are going to pull up an overview of any outstanding debts – also known as liabilities – you have. Sounds like fun? No I didn’t think so, thinking about your debts is usually not a lot of fun, but since your debts are probably also one of your biggest worries or financial strains anyway, we need to find out how bad (or not) the situation is to begin with.

Borrowing money is a relatively common thing in our current society and although it might sound like a great way to finance big purchases, the problem is that as long as you have debts, you are not only tied to paying back money all the time, you are furthermore consistently losing money. Borrowing money comes at a high price: the interest that you are charged can been enormous and in later steps we’ll look at how quickly this interest can add up to massive extra charges. Yet we seem to always be borrowing money these days, first to get through college, then to buy a car, a house, that fancy holiday and it becomes more and more of a habit to buy first and finance later. And kid yourself not: unless you are paying off your credit cards in full at the end of each month, the overdraft on any of these cards are loans too! Continue reading