Brian Dress explains corporate bonds as loans to companies with fixed interest payments and repayment dates. A Royal Caribbean bond paying 5.25% annually on $1,000 shows how interest works. Bonds offer lower, more predictable returns than stocks and rank higher in bankruptcy.
Hello, investors, and welcome to Fundamentals of Investing from Left Brain Investment Research. I'm Brian Dress, Director of Research here at Left Brain Investment Research. This video is part of Left Brain's series helping you understand key investment terms. Today we'll look at one of the basics: what is a bond? We'll focus on corporate bonds, where Left Brain concentrates its study. Here's a little-known fact: the bond market is actually significantly bigger than the stock market. Well-rounded investors are sure to have bonds as some percentage of their portfolios. Companies sell bonds for the same reason they sell stocks: to fund their operations. At the most basic level, a corporate bond is a loan from an investor to an established company with a guaranteed interest rate and a set amount of time for it to be repaid. A large loan is divided into small pieces, or individual bonds, and made available to investors both large and small. The company uses the loan to grow its business. Their goal is to grow the profits of the business at a higher rate than the interest of the bonds they sold. When the loan is repaid, investors receive their initial investment back, plus the final interest payment. To understand bonds and their role in the investment world, let's demystify 3 terms that you will see in most bond analysis. Term 1 is coupon. Coupon is an old-timey bond term you often see, which is just another term for the interest payments associated with the bond. Simple as that. Term 2, principal. Principal is the money loaned by the investor on which interest is calculated. Bonds are priced in units of $1,000, which correspond to the principal amount. The principal payment is returned to investors, along with interest, when the loan is repaid. Term 3: Yield to maturity. This is the annual total return implied by a bond's price if that bond is held by the investor until the agreed due date, referred to as maturity. Here's how the interest payments work for an investor. This example uses a bond we cover, Royal Caribbean. It has a coupon rate of 5.25% and a principal investment of $1,000. Investors receive interest payments of $2,750 twice per year. The last interest payment and the lump sum loan amount are repaid on the maturity date. After the holding period of 2 years, the investor's principal of $1,000 is returned along with the interest of $137.50 for a total of $1,137.50. So you can see, in contrast to stocks, which have an uncertain payout structure, Bonds offer investors predictable income streams. In general, a company's bonds provide investors with a smaller total return relative to a company's stock return. That's because bonds carry a lower risk profile than do the company's shares. This has to do with the fourth term, capital structure. Capital structure refers to the distribution of debt and equity that make up the finances of a company. If a company files bankruptcy, its capital structure defines a pecking order for investors to be repaid. Holders of bank loans are paid first, then bondholders, and if anything is left over, shareholders receive repayment. This means the risk of loss is lower for bondholders than it is for stockholders. Because of the unique risk and return characteristics of bonds, they should play a key role in any balanced portfolio. Bonds offer steady, predictable income, and defaults are relatively rare. Because of the predictability of cash flows, bonds give investors the opportunity to match their maturities of those bonds to the time when they'll need the money. Say you have a child entering college in 10 years. Placing funds in bonds maturing in 10, 11, 12, and 13 years can match the expected tuition payments. So now you know. The term bond refers to principal loaned to a corporation with a set coupon rate and an anticipated yield to maturity. If this video helped you understand the concept of bonds, click the subscribe button below. You'll get the latest from LBIR and the chance to join our growing community of left brainers. You can always learn more at our website, www.leftbrainir.com. This is Brian Dress of Left Brain Investment Research for Fundamentals of Investing. Thank you and see you next time.
