This is the continuation of the series “What Financial Terms Mean?” In the last series post we described what it means to own a stock or equity in a company. This post will answer the question “What do the terms “fixed income” or “bonds” mean?”
When you purchase a bond from a company or a government, you are lending money to that institution. So if Pepsi needs short-term money and their management has decided that they would rather borrow the money than use their current cash flow, they can go to the capital markets and offer to borrow the money from outside investors. The company would decide when they would like to pay back this money and the market would determine the amount of interest that they would need to pay for the right to have that money during the borrowed time.
Fixed income instruments or bonds can be for a very short term (as in a month or two) or they could want to borrow the money for as long as 30 or 50 years into the future. The company or government would decide their need and offer the bond with the stated time that they would like to have the money for their use.
Once the company has decided how long they would like to keep the money, the established interest rate that they would pay would be set by the current market conditions. There are two main factors that determine the amount of interest that the borrower would need to pay.
1) The first factor is how long they want to hold the money. Generally, the longer you hold the money, the higher the interest rate that would be required to be paid. 2) The second factor is how the company or institution is viewed as far as being able to pay back the money and the interest on time. Generally the interest rate is “fixed” so the income paid would be “fixed income”. There are independent agencies, such as S&P and Moody’s, that review how the government or company is faring financially and they would establish a credit rating for the bond issue.
The credit rating is used as an initial review and then most lenders would review to make their own determination of the ability of the borrower to repay the money in a timely fashion. The more financially strong borrowers would – as you would expect – be required to pay a lower interest rate and the riskier borrowers would have to pay a higher interest rate. This is how capitalism sorts out the needs all different types of investors and borrowers.
Our company philosophy at Crimmins Wealth Management on bonds is that they should be used to soften the volatility of the overall investment portfolio. Thus, we recommend that our clients only lend money to companies and governments that have been deemed to be a strong credit and thus highly likely that they will pay back the money on time with interest. We also do not want to be as negatively impacted by the biggest threat to bonds (which is rising interest rates) and thus we only want to lend money in the short term or less than five years before they would have to repay the money to us.
Just as you would suspect, lenders generally do not end up with great wealth as this only happens to the owners themselves who have taken the risks and thus get the rewards. But like most things, the all or nothing approach is never warranted and the vast majority of individuals will need a combination of bonds and stocks to accomplish their goals.