Lesson 9: The Bond Market

L9.2 Barry Bonds Pic
Still not the type of Bond I will discuss. Image courtesy of milwaukeechiro.com.

The bond market is much larger in dollar amount than the stock market in the United States. This is mainly driven by the ability for governments (including federal, state, and local) to participate in the bond market to raise capital.  This large market also produces Treasury bond interest rates (or yields), which are closely monitored proxies for long term interest rates.  In short the bond market lacks the glamour of the stock market due to its slower moving nature, but it still holds a place of great importance in the U.S. capital markets.

Key Points

  • Bonds have many commonalities with the stock market including primary vs. secondary markets, OTC markets vs. exchanges, and brokers vs. dealers.
  • The two primary issuers of bonds are governments and corporations.
  • Treasury bonds are arguably the most important type of bond traded.
  • Municipal bonds are bonds issued by local, county, and state governments that have favorable taxation characteristics.
  • Corporate bonds have different characteristics than federal bonds.

The Similarities between the Bond and Stock Market

Before we delve into what separates the two it would be easier to identity what the bond and stock markets have in common. Both the stock and bond markets have primary and secondary markets. A primary market is where securities are issued for the first time (when offered to the investing public this is called an initial public offering (IPO)) whereas the secondary market is where securities are traded between investors.  In addition bonds can be traded either in over-the-counter (OTC) or organized exchanges with brokers and dealers providing liquidity to these markets.

The Differences between the Bond and Stock Market

Other than the obvious differences between the nature of the securities being traded (there is a lot more knowns with bonds compared to L9.3 Featured Image for Bondsstocks) the largest difference is between the market participants.  While only private corporations participate in the stock market, both corporations and government entities may raise capital in the bond market. The reason governments do not participate in the stock market is that they would be selling ownership claims (imagine a super bank owning a small foreign government…yikes). Governments still have to fund different activities such as infrastructure, defense, and social programs and thus may turn to bond debt to finance these activities.  This is what is referred to when people quote the “$3 trillion deficit” America possesses, its bond debt.

The Importance of Treasury Bonds

The 10-year Treasury bond plays a key role in the U.S. financial markets.  It is one of the main ways the U.S. government funds federal expenditures.  They also have very little risk associated with them as in theory the U.S. government can always print more money to pay these bonds off as they come due.

Because of the low amount of risk these securities possess, little return is offered. In fact in some years the rate of inflation has been higher than the interest rate (or yield) offered on 10-year Treasury Bonds.  It also noted that the interest rate offered on 20-year Treasury Bonds is consistently higher than the interest rate offered on 10-year Treasury Bonds. The reason for this is simple and ubiquitous. The 20-year Treasury Bond has a longer maturity than the 10-year Treasury Bond and thus has more inherent risk and as our risk vs. return principal dictates the higher this possibility of risk the more compensation that must be offered to investors.  The U.S. federal government is of course not the only government that can sell bonds and at any given time you can buy French, Russian, or Argentinian bonds.  Depending on the riskiness of the country issuing, different returns are offered.  Similar to corporate bonds, bonds offered by governments are rated by rating agencies.

L9.1 Inflation vs. 10 Year Treasury Yield
Graph of 10-Yr U.S. Treasury Yield vs. Inflation Over Time

 

Municipal Bonds

Municipal bonds are bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.  “Munis” have a small amount of default risk as a municipality can in fact default on its bonds. The two common types of municipal bonds are general obligation bonds and revenue bonds.  General obligation bonds are municipal bonds that do not have specific assets pledged as security for the bond and are instead supported by the “full faith and credit” of the issuer.  Bonds like this can also be referred to as unsecured bonds as there is no assets that serve as collateral for the bond.  A revenue bond is backed by the promised revenue of a project. An example of this would be charging fees to use a hospital or public port. These revenue streams provide funds to pay off the interest charges and principal of the outstanding bonds.  Revenues bonds can be referred to as secured bonds as there is an asset base supporting the repayment of the bonds.

One of the most important characteristics from an investor standpoint is that many municipalities place tax reductions or make the interest payments on the bond paid to the investor tax free, provided the investor is a resident of that municipality.  This is solely at the discretion of the issuing municipality, but for some high tax bracket investors muni’s present an opportunity to avoid large tax reductions from their investments.

Corporate Bonds

As a whole corporate bonds function similarly to government based bonds, but they have some differing characteristics. In general, corporate bonds pay a higher return than their government counterparts due to higher perceived risk of default on corporate. In the last lesson I discussed how the rating agencies rate the corporate bonds on the perceived risk of default the list of which I have provided again.  In addition corporate bonds are almost always issued in $1,000 par value, have the standard coupon payment structure, and may have a call provision which enables the issuing company to buy back (or “call”) the bond after a certain time period has elapsed.

Zero Coupon Bonds

A zero coupon bond is a type of bond that does not pay the investor interest payments but instead sells at a deep discount and is redeemed at maturity for a higher value.  In zero coupon bonds the investor forgoes the coupon payments in return for buying the bond at a discount and receiving a higher principal amount when the bond matures. For example you could buy a bond for $500 that in five years matures for $1,000 that offers no coupon payments. Many federal and municipal bonds function as zero coupon bonds.

Definitions

  1. Municipal bonds: Bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.
  2. General obligation bonds: Unsecured municipal bonds that are backed by the “full faith and credit” of the issuing municipality.
  3. Revenue bonds: Municipal bonds that are secured by the revenue stream that will result from the completion and operation of the project the bond is funding.
  4. Call provision: A provision on bonds that enables the issuer to buy back bonds for a fixed payment that results in ceased interest payments to the investor who owns the bonds.
  5. Zero coupon bonds: Bonds that do not offer interest payments but are instead issued far below par and mature at par. The difference between the issuance price and the maturity is the yield the investor receives.

Further Reading

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Student Loans and Paying for College (Part 1)

I can’t tell if the money is coming out or going into the hat. Image courtesy of saleshq.com

So you got accepted to the school of your dreams?

Congratulations! I’m happy for you! My next question merits a bit of scary thought. How are you going to pay for attending that school? Maybe you have wealthy relatives. If so, count your blessings and the rest of this post is irrelevant for you so you can move on to something else.  For the rest of us…paying for college is no laughing matter. Cost is one of the top determinants of where an individual chooses to attend college (I was one of these individuals). As tuition continues to rise and the job market continues to flounder financial aid for students is becoming a very ubiquitous issue that merits a bit of explanation and study.

Key Points

  • There are some key differences between scholarships, grants, and student loans.
  • The FASFA is arguably the most important financial aid form to complete.
  • Scholarships, grants, and student loans are the most popular methods to pay college costs.
  • Your financial aid office at your school is your friend not your foe.

Grant, Scholarship, or Loan?

Let’s start with the good news. There are entities out there who will give you free money to attend school. These entities can be the school you choose to attend, the company your parent(s) work for, or even the federal government. This “free money” or “gift aid” is usually referred to as grants and scholarships.  Grants are financial aid packages usually given on a financial need basis. Scholarships are financial aid packages usually given on a merit basis.  It is important to note that while scholarships and grants do not usually require repayment they may still have performance conditions attached to them (ex. You cannot fall below a certain G.P.A. while attending school). The largest provider of grants is the U.S. federal government.

Here’s the bad news: this form of aid may not cover all the costs of attending college. When gift aid isn’t enough we must turn to student loans which are loans specifically provided to individuals attending universities that do require repayment. The largest provider of student loans is again the U.S. federal government though there are private student loans offered by banks, credit unions, and universities.

How a Piece of Paper Can Save You $100,000

The Free Application for Federal Student Aid (FASFA) is arguably the most important form to fill out when it comes to financial aid for paying for college.  By filing out the FASFA you are essentially revealing to the government how much of the cost of attendance your family will have to pay (the exact term for this is expected family contribution) and how much of the bill the government will cover.  Needless to say the FASFA is a pretty thorough form that will ask family net worth, family income, number of family dependents, etc.  I do not recommend lying on this form. Why? Because the information you enter is cross referenced with the friendly, neighborhood IRS (Internal Revenue Service) and the last thing someone wants is a call from the IRS regarding the apparent fraud you filled out on the FASFA.

Different states and schools have different deadlines than the federal government (the deadline page can be found here). It is very important to not miss these deadlines as you would be missing out on free money…ouch.  Usually the deadline for the upcoming school year is before the fall of that academic year (Ex. If I were attending LSU from Fall 2015 – Spring 2016 I would have to submit the FASFA before June 30, 2015.)  Another important aspect of the FASFA is that you must reapply each year you want to receive some form of financial aid.  Why? Let’s say that your second year of college your family wins the lottery (or your father loses his job).  This new source (loss) of income will show up on your FASFA and as a result the federal government will expect a larger (smaller) expected family contribution. To capture situations like this the federal government and universities require the FASFA be completed each academic year. Thus write down your log-in information and keep it in a secret, reliable place.

Scholarships

Scholarships are a merit based form of gift aid and are arguably the most sought out form of financial aid. They are offered by universities and many private and non-profit organizations.  The best ways to find these financial gold mines are contacting the university you plan to attend or performing your own private research.

A quick caveat about private research on financial aid: Beware companies that want you to pay for scholarship or grant searches.  Most of these companies want you to pay for results you could get by googling ‘’popular scholarships”.

Once you find a scholarship that you fit the criteria for, apply.  Though sometimes a pain you are sacrificing your time for a chance to lessen that financial burden (I personally applied to a scholarship offered through the finance department at my school and received $3,000 from it. Not bad for spending an hour on the application.)  Scholarships have their own deadlines and criteria so pay close attention so you don’t miss out.

Grants

Grants are a financial need based form of gift aid and take up the greatest percentage of total financial aid offered to students.  They are commonly offered by both colleges and the federal government.  The federal government has quite a few notable grant options which will be discussed in part two.

Apart from being based on financial aid vs. merit, grants function in the same way as scholarships. Based on the results of the completed FASFA different grant options may be available.  Once again grants may have terms attached to them so be sure you understand the terms of agreement when you accept the financial aid.  What do you do if the scholarships and loans are not enough? Other than working three part time jobs, you may want to consider taking on a student loan.

Student Loans

So you have crunched some numbers and discovered that the grants and scholarships just won’t cover all of the expenses. Now what?  You could put the remaining costs on a high interest credit card and bite the bullet, but I would not recommend that.  Seeing the need for a reliable source of student loans the U.S. Department of Education created a loan program to help fill the gap in paying for all of college costs. Some banks and other financial institutions began to offer student loans. The major distinction in the world of student loans is that there are federal student loans (government) and private student loans (non-government).  In many of the cases federal student loans have some key characteristics (fixed low interest rate, possible tax reductions, and post-graduation payment plans) that make them superior to most private student loans.  To apply for a federal student loan you must complete your FASFA (told you it was kind of important) and the results of the FASFA will dictate which types of federal loans you are eligible for.

 

Student with ball and chain attached
You shouldn’t feel like this. Image courtesy of McCarthy’s Weekly.

 

If there is one take away from this lesson let it be this: Your school’s financial aid office is your friend when it comes to paying for college; go to them if you have financial concerns.  For now let’s look a bit more in depth at the different types of federal grants and loans available to students.

Definitions

  1. Grant: A need based form of gift aid which usually does not require repayment.
  2. Scholarship: A merit based form of gift aid which usually does not require repayment.
  3. Student loan: A loan made to a student in college which may either be administered by the federal government or a private financial institution.
  4. Cost of attendance: The total cost of attending a particular university for a certain period of time (usually a year) and includes expected costs such as tuition, room and board, books and supplies, etc. This metric is used in calculating the amount of financial aid offered.
  5. Expected family contribution: The expected dollar amount the family of a student is expected to contribute to college expenses. This metric is used in calculating the amount of financial aid offered.

Further Reading

Lesson 8: Let’s Talk Bonds

 

Bond actors
This is not the type of “bond” I will be discussing. Image courtesy of moviepilot.com

The bond market. You may think you haven’t heard about it.  You are probably wrong. In addition to occasionally hearing about “rallies” in the bond market most Americans has heard of the $3 trillion deficit the U.S. government currently faces.  What makes up this deficit? Treasury bonds. These bonds and other securities the U.S. Treasury issues help fund the activities of the U.S. Government and have an integral role in the bond market. The bond market is comprised of many different types of bonds which can greatly vary in features. Let’s explore some basic functionality.

Key Points

  • A bond is a debt security that obligates the borrower to pay a specified amount to the investor on a given date and usually includes coupon payments.
  • A bond offers investors returns through appreciation and interest (coupon) payments.
  • A bond has many distinguishing features including par value, maturity, coupon rate, issuer, credit rating.
  • There is an inverse relationship between bond yield and bond price.

Continue reading Lesson 8: Let’s Talk Bonds

Lesson 7: Stock Market Indices

Stock Chart Going Up
Lines Going Up = Good in Finance

In the last lesson I mentioned how my father would always mention to me how “the market was up”.  Knowing now that there thousands of companies traded in the equity markets you may wonder what my father meant by “the market”. Was it that on that day he saw more green, upward arrows on MSNBC than red, downward arrows? Was it that on that particular day his stocks were doing well and he wasn’t paying attention to the other stocks? He was most likely looking at stock market indices such as the DJIA, S&P 500, or Russell 2000. These indices (or indexes) are commonly used to describe the health of the overall stock market and as a result are closely monitored day in and day out.

Continue reading Lesson 7: Stock Market Indices

Social Media Isn’t Just for Poor College Students Anymore

Image Courtesy of the Helen Brown Group

Think the only people who tweet are college students and hipsters? Think again.

Key Points

  • According to Ledbury Research, a U.K. based research group, at least 75% of high net wealth individuals (HNWI) use social media regularly.
  • 33% of the wealthy use three or more social media outlets.
  • LinkedIn is the most prominent social media website used by HNWI followed by Facebook.

Continue reading Social Media Isn’t Just for Poor College Students Anymore

Lesson 6: The Stock Market

Now that we have some working knowledge about what a stock is and how it functions let’s discuss how it is traded. The stock market is one of the most often discussed things in everyday financial life. To this day in discussions with my aging father he sometimes makes the comment “Did you see what the market did today?”  The U.S. stock market is half of the size of the U.S. bond market. So why does the stock market get all of the glory, media attention, and yelling pundits? It gets this following because it is the place where people can go from rags to riches (or vice versa) very quickly, or to be blunt it’s exciting. You will see that much of the stock market is very jargon heavy so at any point remember that the definitions of the terms can be found at the post in case you need a quick refresher. So what are the mechanics of this wondrous machine?

Continue reading Lesson 6: The Stock Market

Lesson 5: Let’s Talk Stocks

You’ve heard a lot about it. You may have flipped past MSNBC and saw the green and red arrows and the acronyms and wondered “What does it mean?” and “Why do people care so much?” Before we go into what those arrows mean and why the talking heads on those networks continue to blab on let’s strip away all the opinion and discuss the facts concerning stocks. (You’ll notice I am not going to discuss much of the mechanics of how stocks are traded that is the subject of the next lesson).

Continue reading Lesson 5: Let’s Talk Stocks

All About Interest Rates

So we have discussed a bit about returns and rates, but there is some terminology that needs to be addressed and will make you a bit better off for knowing it. At the end of the day interest rates are pretty powerful things that shape the entire financial system, so let’s learn a little more about them. (Warning: simple math ahead so non-math types bear with me).

Continue reading All About Interest Rates

Lesson 4: Diversification

 

“Don’t put all your eggs in one basket”

-An interpretation of a line in Don Quixote

So we know that given a return we don’t want to take on any more risk unless we have the possibility of more gain. Great! How do we minimize the risk we already have?  As the cliché phrase above hints at one way commonly used to manage risk is the practice of diversification.  Let’s start by defining it.

Key Points

  • Diversification is an essential aspect of any investment strategy
  • Diversification decreases risk of a portfolio by decreasing volatility of the entire portfolio
  • Diversification is useful up to a point, but exhibits diminishing marginal returns

Continue reading Lesson 4: Diversification

Lesson 3: Risk and Return

It has been in my learning experience that there is no one definition of the word risk. There are many variations on the concept and many ways to view it.

Risk in my opinion could best be described as “uncertainty of results due to the inherent unpredictable nature of the future”. To put risk differently if you had psychic powers and could accurately see what the future held you would have no risk in your life as there would be no uncertainty to outcomes.

 Key Points

  • Risk is the chance that your expectations concerning a return are not what actually occurs
  • There is a fundamental relationship between risk and return of an investment

Continue reading Lesson 3: Risk and Return