LEVEL: BEGINNER
There are two main ways to invest in a company: own equity or lend money. The former is what stockholders do, and the latter is what bondholders do. A bond is essentially a loan from the bondholder to a company or a large entity.
Bonds are usually given for a fixed period of time, and these can be short-term (1 month, 3 months, and so on up to 1 year), medium term (between 1-3 years), and long term (above 3 years, up to 30 years or more in very rare cases).
In addition to a time period, there is a coupon rate attached to bonds. If, for example, I buy a 10-year bond with a 5% coupon for $10,000, I am lending that amount of money to the bond issuer for 10 years, during which time I will get paid $500 per year. Since the bond lasts 10 years, I will get this interest on my money for those 10 years, at which point I will get my $10,000 principal returned to me.
Bonds and The Obligations of Debt
Bonds are rated by ratings companies such as Moody’s and Standard and Poor’s. These ratings are usually a letter grade that is given after analysts weigh a variety of mathematical and contextual data. This analysis is all an attempt to answer one question: How likely is it that the debtor is going to fail to repay the debt, or default.
This happens all the time with individuals and companies. While it is rare to happen to cities or governments, particularly in the developed world, such defaults do occur. In 2011, thirteen cities, counties, and municipalities in the United States defaulted. That is a small percentage of the total municipalities in the country.
When an entity files for bankruptcy, it is essentially asking the government to determine how its assets should be divided amongst shareholders, bondholders, and the like.
In good times, stockholders don’t need to worry too much about a company’s bondholders. Both want the company to grow and have cash, so that it can pay its obligations (for the bondholders) and increase its value (for the stockholders).
Bonds, Preferred Stock, and Common Stock
In bad times, however, stockholders and bondholders are essentially on the opposite side of a financial transaction that is overseen by a court of law.
When a company files for bankruptcy, it is asking the government to divide its assets in accordance with legal procedures that have been established as the law of the land. This is necessary for several reasons, but one of the most important is that the government decides who gets their money first.
Courts also need to determine how to process the bankruptcy in a way that is efficient and fair. Since any company has a bundle of assets in a variety of different things (cash on hand, bills of sale, inventory, buildings, patents, etc.), courts need to account for those assets and determine how they will be divided between owners of the company.
You might be surprised to learn that the owners of the company–that is, the shareholders–only get their money after the bondholders. This is because those bonds are considered liabilities, and remember that equity = assets minus liabilities. Those “liabilities” include bonds, which are essentially promises to pay back debt.
After all bonds and other debts are paid, any value in the company left over is divided up between owners. Owners of preferred stock get paid before owners of common stock, then owners of common stock get the rest.
It is important to remember that holders of common stock get paid last. If the company doesn’t have enough money to pay bondholders and preferred stockholders, holders of common stock get nothing. This is one of the largest risks in investing in common stocks.
Why You Must Hold Equity
That risk of equities has put off a lot of potential investors, who have felt that the safety of bonds is a much better option when it comes to investing. However, to simply hold all money in bonds would be foolish.
This is true for one main reason. Whenever an economy expands, the companies in those economies will earn more and more profits, so times of growth will benefit shareholders. While bondholders will get their promised returns, holders of equity will get their share of the profits.
Bondholders always have a limit on the amount of return they get on their investment. Shareholders, on the other hand, have the potential to earn an infinite return on their investment.