Bonds for dummies

Stocks are easy to understand, you own part of a company --> company makes money --> you make money. easy-peasy.

Bonds on the other hand confuse the heck out of just about everyone, even (especially) those that sell them. I have read countless dry, boring pages on how bonds work, prices, yields, jargon, and almost all totally uncomprehencible.

So how do bonds work? Well I think I have a understandable, if not exactly technically perfect, method of explaining bonds, here goes...

"My word is my bond"

You have all heard that saying. What does it mean? A bond is a promise, more specifically a promise to pay back borrowed money.

Say it's lunch time, your friend Jon comes up to you and asks to borrow $10 for lunch money. He promises to pay you back $11 tomorrow. His promise is his bond, he might even write it down on a piece of paper.

"I Jon will pay back Steve $11 tomorrow for a loan of $10 today."

Boom we just created a bond.

We have all the parts of a bond in the example above, we have a bond price, $10. We have a interest rate, $1 per day, and we have a maturity date, tomorrow.

Now what if you only had $10 to lend, but your other buddy Jack, also wants to borrow $10 for lunch, but Jack gets his allowance tomorrow, so he offers to pay you $12 tomorrow. The bond you bought from Jon just lost value, as the $10 you loaned to Jon for $1 could have earned you $2. On the other hand if Jack only offers $0.50 you look like a star with your bond from Jon. So as you can see the value of your bond changes with the interest rate being paid, as interest rates move higher, your bond is worth less, if interest rates move lower, your bond is worth more.

What makes interest rates go up or down? Supply and demand, mostly, but also risk. Say Jon and Jack are both competing for your lunch money loan. The one who offers the best interest rate is probably going to win; as long as they are equally trustworthy.

But what if they aren't equally trustworthy? what if Jon is a stand up, honorable, prompt, courteous and trustworthy guy and you know he is going to most likely pay you back (government bond). On the other hand Jack, is a unreliable, jerk who always breaks his promises. You might think twice about lending to Jack (Junk Bonds). Because people are not as trusting of Jack, and they know they might lose their money, they are less likely to lend to him, that is, unless he offers a higher interest rate. If you know your money is safe with Jon you might lend it to him for $1, but since Jack is less reliable, and you are taking a bigger risk lending to him, you want $3 from him before you are willing to lend to him. The quality of the borrower has a big impact on the interest rate they have to pay to attract investors.

So that's bonds, not so hard right?

TL;DR: I would gladly pay you Tuesday for a hamburger today.


--
Robert Reynolds, GBA
Certified Group Benefits Advisor
Hendry McKenzie Reynolds Employee Benefits Ltd.

Toll Free: 1-888-592-4614
rob@hmrinsurance.ca
www.hmrinsurance.ca

E.O. E.