Warning: Keep in mind, this discussion is insufficient and its not in depth to provide a clear, decision-making process in investing in bonds and stocks. It is merely a discussion on the general characteristics of bonds and stocks.
*I can't be bothered to highlight important words..just for this article..sorry readers..
I should have started with this article in my 'Lessons in Value Investing' as it discusses the differences in share and bond. Anyhow, I do not plan to have a structure in my lessons. But it was a bad start..
Today's discussion is rather straightforward and simple. At this time, I am not mentally prepared to discuss on critical issues...Exam season..
Let's begin!
Many of you (all I hope) knows what is a Share. It is also referred as ordinary shares, common stocks, or stocks By purchasing a share, you are buying a partial ownership in a company. You own a piece of it. You are entitled to its earnings, assets, liabilities etc. Say, Company X issued 100 shares. I bought 10 shares - I own 10% of the company. However, I am not entitled to effective control of the company's resources. In another words, although I own 10%, I can't sell 10% of the company's asset and pocket it or take 10% of the company's cash and spend it. This issue is known as the separation of ownership and management which, isn't our topic of our discussion.
By having a partial ownership in a company, you are able to vote during the Annual General Meeting (AGM) - selecting directors, approving certain company policies etc. Also, why people buy shares because they are entitled to dividends. However, the company is not obliged to payout any dividends. Of course, shares are purchased to earn capital gains as well. You buy $10 today and hope to sell it for more sometime in the future.
Being a shareholder is not all that good. Before a company makes any payout to its shareholders, it has many other obligations that has to be settled. Firstly, if a company has loans/debts, it has to pay the interests and capital repayments before distributing dividends to its shareholders. In a worse case when a company is about to go bust, the creditors have prior claim to all of the company's assets to settle the obligations by the company. Residual assets after all obligations are settled, if any, will then only be distributed to shareholders. In simple words, when a company is in an adverse financial position, shareholders are the last in line for any claims.
Moving on, what are Bonds? Bonds is a form of debt/loan. Instead of the company obtaining debt or financing from a bank, it issues bonds directly to raise money. Company A needs $100 and issues bonds with par value of $1.00 and coupon of 5% annually for 5 years and redeemable at the end. With a par value (or face value) of $1.00, this means there are 100 bonds issued. 5% simply means the interest rate the company has to pay as the costs of bond financing. The company pays 5% of the face value annually to its bondholders or 5cents a bond for 5 years and at the end of 5th year, you will receive your final interests and also your principal value of $1.00 invested initially. 'Redeemable' option is just one of the few examples what a company can do at the end of the bond's life. Other options are converting it to ordinary shares or a combination of both redeemable and convertible feature.
One can see that bond to investors is like a savings account. I put my money into the bank (I buy the bond), and I receive interest from the bank for keeping it there ( I receive interest from the company as a return for using my money). Bond is more interesting than that. On the surface, it looks the same. What is left out from the picture is there are risks inherent when investing in bond and also, you can earn capital gains from it.
Risks in this case refers to the financial position of the company or the company's operating environment. A financially distressed company will have difficulty in meeting obligations and therefore will have a hard time paying you interests. Worse still, you might not be able to recover your principal. A cash-rich company is seen as low-risk as they have sufficient funds to meet obligations. Credit Rating Agencies are institutions responsible for rating the credit/risk position of companies having debt/bonds/loans in their capital structure. Perhaps you might have heard of few of these institutions - Moody's, Fitch etc.
If a company is in an adverse position, its bond price will fall below its face value. Bonds are like stocks. You can trade it (sell and buy) so you are not lock into it until its maturity. Note that bonds do not usually trade at its face value. A distressed company will find its bond trading below par value. Bonds worth investing, with high credit rating is known as 'Investment Grade' bonds. Bonds by distressed companies are known simply as 'distressed' bonds or 'junk' bonds.
When a price of a bond fall, will it be a good decision to invest in it? Again, it is a case-by-case basis. You only invest when you know the probabilities and certainty of the outcome and the situation. A market will undervalue solid bonds for no apparent reasons. When its price falls, your interest yield is higher. 5cents interest on par value translates into 5% yield. What if the bond trades at 80cents instead of its face value of $1.00? In this case, you yield 6.25%! But if it trades higher than its face value, then your yield will fall.
If you buy lower today, and the company manage to survive to redeem the bond, you will earn capital gains. You buy at 80cents and at maturity, the company will pay you back $1.00. Effectively, you earn capital gains and also higher yield. However, always compare your return to time-value of money.
For a better discussion on bonds, check out the link below.
http://www.btimes.com.my/articles/georgy2/Article/
The above article was contributed by the Funds Management Division of Aminvestment Bank Group.
That's all for now folks.
Cheers.
Aaron.Hee.Wy
