Zaks Investment Advisory Service

Stock and Bonds, in Further Detail

Last time we started talking about stocks, and how companies use them to obtain additional capital, while to us they represent one of our main investment options.

For companies, issuing stocks is not the only method of obtaining capital. They may also do so by issuing bonds. Bonds are very important financial instruments. For reference: in 2005, the total value of all American company stocks traded on US markets was about 18 trillion dollars. The value of all corporate bonds was about eight trillion, federal obligations of various types – about 11 trillion, and municipal bonds – about two trillion, i.e. the total value of bonds on the market is higher than that of stocks.

Corporate bonds are debt obligations issued by companies. Bonds differ a great deal from stocks. By issuing stocks, the company is selling a part of itself, while bonds are a way of temporarily borrowing money on the market under specific contractual conditions. When you buy company stocks, the company is not really promising you a thing. You (just like every other investor) of course expect the company to be profitable and for the stock price to go up. But the issuing company is not guaranteeing you this. The issuer of bonds, on the other hand, promises to pay you a coupon on a regular basis, and after a certain maturity date, to pay back 100 percent of the face value of the bond. For example, if you buy a 10-year bond with a six-percent coupon and a nominal value of $1,000, you will receive two 30-dollar payments a year (coupons are usually paid twice a year, half the coupon’s value at a time) for a period of 10 years, and get back the $1,000 after 10 years.

Just like stocks, bonds start getting traded freely on the market after their initial issue. For the most part, only large companies may afford to issue bonds. Small and medium-sized companies usually borrow money at the bank, just like us.

As we have already mentioned, companies are not the only ones to utilize bonds. They are also issued by the government (Treasury bonds, for example) and by various levels of local administrations (i.e. municipal bonds). The government may not issue stocks: as we have learned, the stock buyer becomes a partial owner of the issuing organization, and we (or anyone else in the world) have no way of co-owning the government. For this reason, the government borrows money by issuing bonds, i.e. temporary debt obligations.

The federal government issues bonds because it finds itself in constant debt: the money it collects through taxes is not enough to cover budget expenses. For reference: our 2005 federal budget was about 2.4 trillion dollars. That is a gigantic amount, but one should remember that our gross national product is 12.5 trillion dollars. The main budget items are Medicare and Medicaid, and other healthcare programs ($550 billion), defense ($420 billion) and interest payments on debt obligations – the very bonds it issued earlier but have now matured, or require coupon payments – $350 million. In addition, the federal government pays about $500 billion a year for social security, although this money is not a direct federal budget item.

Treasuries, or obligations, issued by the federal government are split into three types: bonds, bills and notes. “Bonds” are securities with an initial maturity date of 10 years or more. Federal obligations with maturities between one and 10 years are called “Treasury notes.” They do not differ from bonds in any other way. Meanwhile, instruments with maturities of less than one year are called “Treasury bills.” Treasury bills are a paragon of investment security. I will explain why this is the case in one of our next programs.

As I have already mentioned, individual states and counties may also issue bonds, which are called “municipal bonds.” The money from these bond issues goes to road construction and numerous other local projects.

Our government guarantees the payment of the coupon and the face value of the Treasury bonds, bills and notes. Corporations, on the other hand, are unable to deliver absolute guarantees. Bankruptcies are rare, but they do happen. What happens to a company’s stocks and bonds in such a case? Their prices drop, but differently. In case of bankruptcy, the company’s remaining assets are shared out in accordance with the seniority of the securities issued by that company. Bonds are “more senior” than stocks, which is why bond payments are made first. And only then, if there is any money left, does it get distributed among the shareholders: first to shareholders of the preferred stock, then the ordinary one. Often, there is no money left after payments are made to creditors, and the company’s stocks lose almost their entire value with the bankruptcy. This happens rarely, but it still worth keeping in mind (Enron may serve as a good reminder), which is why it is very risky to invest all your money in the stock of only one company. It should be diversified, a term we will keep coming back to in our future programs.

We have discussed two main types of securities: stocks and bonds. Which ones are better? Which ones earn higher returns? We will discuss that next time. But with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.