You and I pretty much run JKL Corporation, and have decided after talking to our trusted financial advisers that we need to raise $100 million to expand our operations. We don't want to sell additional shares of stock to the public, and interest rates are low.
We want to borrow this money and not pay it back for a long time, so we decide to issue bonds ... long-term IOUs. Now we need to get down to specifics. We are going to sell a bond issue to the public. What should we offer the new investors who will be creditors of JKL?
Each bond will be priced at $1000 and will have a coupon interest rate of 7%. These securities will mature in 25 years, at which time the owners will get their $1000 back. Those are the bond basics.
Now let's look at this offering from the point of view of a potential investor. JKL has a good credit rating, but there are other things to consider.
Each $1000 bond will pay 7%, or $70 per year in interest, and this will never change for the 25-year life of the investment. An investor does NOT need to own or hold these IOUs for 25 years. Once they are initially issued and sold to the public, they will trade in the bond market ... where they can be bought or sold by the investing public.
The $70 per year in interest and the 25-year maturity date are carved in stone, but the bond price or value is not. When they are issued the bond price is $1000, and at maturity they will be worth $1000, as long as JKL is still alive and well. But for the next 25 years, the price will fluctuate as the bond trades in the market. Hence there is a risk factor.
At the same time, the 7% interest rate looks quite attractive to investors in search of interest income when compared to other alternatives. Most bank CDs are paying less than 2%, and money market accounts & money market funds are paying below ½%. U.S. treasury securities (the safest IOUs in the world) have yields of: less than ¼% for T-bills, less than 4% for 10-year notes, less than 5% for 30-year T-bonds.
The reason JKL is paying 7% is that the bond investors who hold them are accepting risk, even if JKL remains financially strong. Of course, if JKL gets into deep financial trouble they may quit paying interest to their bond investors and may never pay the $1000 back.
Two other major factors can eat away at bond prices or values. These are inflation and rising interest rates.
Simply put, if inflation heats up, the cost of things you buy in the future will get pricey. The purchasing power of $1000 to be received years down the road (when JKL bonds mature) will be cut in half if the cost of cars, homes, and everyday necessities double.
Rising interest rates in the future would make these 7% IOUs less attractive as well. Remember, this 7% interest rate never changes. As interest rates in the economy go up, new bond issues could offer bond investors 8%, 10%, 12% or more.
Both of the above scenarios spell trouble for bond investors. In both cases, the price of existing bond issues will fall as bond investors in the market bid bond prices lower. After all, who would pay $1000 for an IOU that pays $70 a year in interest when they can get $80, $100, or $120 from new bond issues for a $1000 investment?
It's crucial that you know bond basics before you chase the higher income offered by bond investments. There is risk involved here, and if you invest at the wrong time in these IOUs you can lose money. This is true for all bonds, even those issued by the federal government (T-bonds).