The Intrinsic Value of Bonds
Stock ownership, with common stocks at least, represent a claim on the income stream of a company, and may provide at least a decent amount of dividends over time. However, this can vary considerably, and companies are under no real obligation to pay out dividends, and they may not even have sufficient resources to do so, which would be limited to profits in excess of what they decide is needed to further grow the business.
A business may choose instead to reinvest all or part of their profits in order to further increase their capacity, or to pay down debt, or to buy back stock, or for any reason they decide.
Common stock, the kind that individual investors almost always buy and hold, therefore does not have a reliable income stream like bonds do, and this income stream is where the intrinsic value of bonds is derived from.
With bonds, you know that you will get a certain rate of interest over a certain term, and the only way that this doesn’t happen is that if the bond becomes defaulted. If a bond defaults, this means that the company or the government has gone completely belly up, and are liquidating their assets.
If this doesn’t happen, and it rarely happens with high quality bonds, then you get paid the interest that has been agreed to. This means that the bond is worth a known amount over time regardless of what happens on the secondary market as far as its trading range at any given time.
This intrinsic value, it’s known value over the life of the bond, is the main reason why bonds are more stable price wise than stocks are. The price of stocks is almost purely dependent upon what people are willing to pay for the stock, and while the prospect of a dividend stream will keep it from going too low for very long, there is a wide tolerance for price to dividend ratios before investors will swoop in and drive the price up.
With bonds, there is much less tolerance for this, and if a bond becomes undervalued, this undervaluation will become much more clear and this will indeed cause investors to buy it if it becomes too much of a bargain. So even in the face of higher interest rates, the risk exposure with bonds is considerably less than with stocks.
Bonds Therefore Are More Reliable
In terms of the interest income earned, once again, only default will prevent investors from getting the full value of their revenue stream. With stocks, whether or not one gets an income stream at all depends upon business circumstances, which do fluctuate.
In terms of the value of the instruments should they need to be sold, bonds retain their value generally better than stocks do, and this has to do with the fact that their interest income is so much more reliable.
If things do go sour, and the bondholder does default, if the bonds are issued by a company, bondholders get paid first, and then preferred shareholders, with common shareholders being last in line.
There is often only enough money to pay off the bondholders, and by the time the company gets around to looking to pay shareholders of their stock, there may not be anything left, and this certainly may be the case with common shareholders.
By the time this happens, the value of these common shares will be driven into the ground anyway, and the fact that it is unlikely that they will get anything out of the liquidation of the company plays a big role in this.
Bond defaults do not happen that often with the higher rated bonds, and this is something that you see a lot more with what are called junk bonds, but even in the case of investing in junk bonds, the bondholders are a lot better off than the shareholders.
One can choose to buy bonds from the soundest and most reliable of companies though, and there are certainly tiers here, where one chooses the tier of reliability along with the accompanying interest rates which reflect the relative safety.
With stocks, we may seek out the more reliable ones as well, blue chip stocks versus stock from companies less established or stable, but the correlation of safety with bonds is much stronger. Even the soundest of stocks can take a long term hit due to market conditions, and therefore selecting stocks based upon company stability only deflects part of the overall risk involved, and often not even that significant of an amount in time frames other than very long term.
Since we’re only worrying about their going out of business with bonds, if we’re investing in bonds long term, this puts us in a position to manage our risks here much more effectively, as well as having less risk to manage.
Should we wish, we can even select the additional security of government treasuries, where the government has to go under to produce a default. If that happens, especially if this is the U.S. government we’re talking about, we will have more to worry about than the value of our bonds, as this would leave the entire world economy in shambles.
The Shorter the Time Frame, the More Sense Bonds Make
The stability of market pricing is another advantage that bonds have over other investments, and this is particularly the case in shorter term timeframes, such as 3 to 5 years. This is not a time frame that you can say very much about stocks for instance, and investors are generally discouraged from investing in stocks over this time frame, if the objective is just to hold them for this length of time that is.
One can use the same strategy with bonds though with a much greater reliability and much less risk of having to sell the bonds at a net loss once interest income is accounted for. This feature is one of the biggest reasons why bonds are such an attractive investment for those who are in their later years or for anyone who will need to sell part or all of their investment during these shorter time frames.
This is not to say that bonds aren’t risky at times in these timeframes, but the real risk is from interest rates and not so much from the market. One does need to be careful with bonds if interest rates are expected to rise dramatically though, if one is planning on selling them during this time that is.
The myriad of choices in the bond market also represents a distinct advantage over stocks. One gets to choose the level of safety, anywhere from on the riskier side with lower rated bonds such as corporate junk bonds, to what are considered to be virtually risk free, and get paid various rates of interest according to one’s selection and preferences.
U.S. treasuries, for instance, are the safest investment out there period, even safer than putting money in the bank if you are putting more in there than your deposit insurance will cover. It is the government that steps in to bail out banks or compensate depositors during bank failures, so money owed to you by the government is safer than your own money at a bank.
Bonds also are issued with a variety of different features to suit individual investor preferences, with the terms of the bonds adjusted to reflect these changes. Some of these features are designed to benefit the bondholder, such as the ability to buy them back when they wish, but investors are compensated for this with higher rates, otherwise no one would buy them.
Other bonds may be set up to benefit investors, with features such as the ability to sell them back to the bond issuer directly, or to convert them to shares in the company as one desires, and this may be seen as a benefit to certain investors.
With all of the money in the stock market worldwide, around 30 trillion dollars at last count, the stock market is certainly very vibrant and very popular. There is almost 80 trillion dollars in the bond market though, and this consists of all the debt that governments hold, and these days that alone adds up to some very big numbers all by itself.
People often lament about how much government debt we have, and all the interest governments pay out each year, but this interest is getting paid to someone, the holders of the debt, the bondholders. A lot of people use bonds to supplement their income and may even live quite well off of them in their later years.
Bonds are worth considering, to some extent, at any point in one’s life though, as one seeks to build the ideal investment portfolio that is best tailored to one’s long term needs.