Lost but not forgotten
September 11, 2020 by The Q.ai Team
If you feel like this year has been the literal equivalent to trash, you’re not alone. And no, we’re not referring to Keeping Up With The Kardashians being cancelled this week.
We were inspired to launch Investing Reimagined because we wanted to help people become more confident with building wealth outside of a typical 9-5.
Just know that we’re almost halfway through September, and we can all very soon mentally unload 2020. If you’re looking for some good news, try reading this in the morning and/or before bed.
We hope that these weekly emails have been enlightening, enjoyable to read and something positive to look forward to.
Biggest headlines of the week
- There’s a new sheriff
in townat Citi (and it’s a woman!). Jane Fraser makes history as the first female CEO of a major financial institution in the U.S. She will start her new position in February and will be replacing Michael Corbat, who will be retiring after spending eight years at the company. Read more.
- JP Morgan found that some of its employees pocketed COVID relief money. It has also asked its senior staff to return to the office this month. For obvious reasons, we’re going to focus only on the high quality tea.
- After an employee noticed “suspicious amounts of money” were being deposited in the bank accounts of employees, it prompted an investigation.
- The bank found that $250 million was distributed to ineligible recipients who had improperly applied for relief. Naturally, those people were fired.
- This money would have gone to small businesses that were hit hard by the pandemic and were shuttered for several months as a result. SMH.
- Markets have entered what we call a “correction.” Bull, bear, correction – these are all ways to describe market conditions. Corrections aren’t always a bad thing.
- A correction means that there has been a 10% or more decrease in price at the most recent peak, but in a short window of time. However, when more time passes, that is when the term bull and bear starts to get thrown around.
- A bull market is when there are many investors who wish to buy, but not many willing to sell. Prices go up fast, and if you get in early enough you can turn a profit real quick.
- A bear market is the opposite. Stocks are losing value because so many investors are selling. You could say that the massive tech sell-off we saw last week had “bearish” characteristics, but because it was only for a few days that would still technically fall under “correction territory.” Also, things aren’t really considered a bear market until the decline exceeds 20%.
Could the California wildfires lead to another financial crisis?
California already had to deal with rising sea levels, and now it has the deal with the reality that 1 in 4 houses are considered high risk from wildfires.
As a result, the value of the homes decline, increasing the risk of a homeowner defaulting on their mortgage. Homeowners in California are already seeing insurers raising the prices, and with the fires becoming a yearly occurrence, tourism has also been impacted, too. All of this is risky for residents, investors and local government.
Why does this matter?
The 2007-2009 financial crisis happened when people stopped paying their mortgages due to the value of homes declining and variable interest rates becoming too high.
At the time, new laws passed that deregulated the financial industry. This allowed banks to approve interest-only loans to people who would have otherwise not been qualified (i.e. their credit was bad).
- Interest-only loans have an adjustable interest rate, which means that if you have signed a loan with a certain interest rate, it could go up (or down – but in this case it went up) at any given notice
- It also only requires payments of interest, not the loan itself (aka the principle), for the first 3-5 years
- Some of these homeowners had mortgages that were worth 100% or more of the home value, meaning they were borrowing way beyond their means
In 2006, when the price of homes declined for the first time in decades, and the supply of homes outpaced demand, interest rates started to go up, making monthly payments too expensive for homeowners. Houses were also worth less than what was paid for, so selling would be at a loss. Many ended up defaulting (stopping payments and surrendering ownership).
The Great Recession was damaging to so many, which is why there’s been concern over what’s been going on along the West Coast. This depressing fire tracking map illustrates just how serious this all is.
Why investing in bonds are great for portfolio diversification
Sorry – but how could this not be included
Bonds are fixed income securities that act as an IOU between the lender and the issuer. Issuers can be companies or governments of all levels, while lenders can be individuals or firms. Bonds are typically issued to raise capital for new projects or hiring initiatives.
There are three main reasons to invest in bonds:
- Generating income via coupon payments
- Diversifying a portfolio and reducing risk
- Holding capital while putting it to work
New investors to the market typically know that there are three common ways to invest: cash, stocks (equities) and bonds. However, while most people at least think they know what a stock is, relatively few have as firm as grasp on bonds.
Q.ai is here to bridge that knowledge gap. We’re going to discuss:
- What a bond is
- Some of the distinguishing features of a bond
- Recent legislative changes regarding this type of security
What are Bonds?
Bonds are known as fixed income securities, also known as a debt security. These are loans you provide to an issuer (typically a company or government). This provides a fixed interest payment to the you, the lender.
The purpose of a bond is to raise capital for various projects. For instance:
- Governments often use bonds to cover expenses such as infrastructure improvements (roads, government utilities, etc.) and wartime purchases
- Governments may also use funds for purposes such as building new schools or funding various social projects
- Companies borrow bonds for several reasons, but the primary benefit is that it’s a way to quickly raise capital without selling stock or borrowing from a bank
- Companies can use this capital to fund new projects, hire employees, build a factory, etc.
All bonds come with details of the loan and repayment, such as when the bond owner will receive their principal back, as well as what the interest rates are. Bonds are considered low-risk investments because of these terms. Usually, a bondholder will receive interest payments a set number of times per year until the contract is up, at which point they will receive their full principal back.
How Do Bonds Work?
When an entity needs to finance a new venture, they can issue a new round of bonds to investors. Typically, these bonds are traded on public markets, though some trade over the counter (OTC) or in private sales.
The bonds trading network is known as the debt market because the transactions are selling corporate debt to investors, who then become debtholders until the company pays back the lender.
The borrower issues bonds on the debt market with exact details on interest rates, interest payments, and the date of repayment for the principal. This last date is known as the maturity date – when a bond “matures,” the issuing company has to pay the holding investor the face value of the bond (the principal).
The issuer is responsible for setting the face value of the bond, typically at par with a face value of $1,000 per bond. The face value is how much the issuer will pay the bondholder come maturity.
- The face value is an important metric to known because bonds frequently trade investors’ hands after the initial purchase.
- It’s not uncommon to find some types of bonds on the secondary market trading for $950, when the face value of the bond is $1,000
- Some bonds may issue at an initial price of $1,050 but name a face value of $1,000– still a fair trade if the bond pays interest
Interest payments, also known as coupons, are the primary way in which a bond generates returns to investors. These payments are made at set coupon dates.
It’s common to see semiannual (twice yearly) coupon dates, but not all bonds will set the same coupon dates – or the same coupon rates.
The coupon rate is the interest rate of a bond. The terms of the coupon rate will be spelled out in the bond when it is issued. Some bonds may offer variable interest rates, while others have fixed interest rates.
The exact coupon rate is determined by several factors
- Most importantly, the creditworthiness of the issue and the time until maturity
- For instance, companies with poor credit are by definition at a higher risk of default on their bonds
- Therefore, they pay higher interest to compensate for the fact they may be unable to pay back the bond come the maturity date.
On the other hand, companies that issue bonds over a period of years or even decades pay higher interest rates to balance the risk of inflation against the coupon.
It’s worth noting here that TIPS (a type of Treasury bond) are an unusual government bond in that they pay interest and also adjust the principal for the price of inflation throughout the bond’s lifetime. This is another way that bonds can protect investors against the risk of inflation.
What are the Main Types of Bonds?
A bond’s type is determined by the issuing entity. There are four main types of bonds available on the market, each with various subtypes that carry different terms.
- Corporate bonds are issued by companies. These are some of the riskiest bonds available but can offer greater rewards.
- Investment-grade bonds have a higher credit rating than high-yield bonds but may offer lower interest
- High-yield bonds have a lower credit rating than investment-grade bonds but offer higher interest as compensation
- Municipal bonds are issued by states and cities. These bonds are usually a safe bet but do carry some risks.
- Government bonds are issued by sovereign governments; collectively called “treasuries.” Typically, these are the safest kind of bond for investors to buy.
- Agency bonds are issued by government-affiliated companies such as Freddie Mac. These bonds typically have lower interest rates than some corporate bonds but higher rates than government bonds.
Why Invest in Bonds?
There are several reasons that an investor may purchase bonds, but the underlying principles come down to steady returns and lower volatility than other securities. For instance:
- Most bonds pay interest semiannually – while the amount isn’t enormous, owning a large number of bonds can lead to hefty returns
- An investor may use bonds to diversify and reduce the overall risk of their portfolio
- Investors can increase their income in the short-term by investing in a large number of non-Treasury bonds
- Properly utilized, bonds provide a safe way to balance risks in the stock market with steady returns and repayment of bond coupons and maturities
- Investors also use bonds as a way to “hold” their capital in a semi-safe place
An investor who purchases a bond and keeps it until maturity will receive not only coupon payments, but also the principal of the bond upon maturity. This is a way to put your capital to work and receive it back at the end of a set time frame simultaneously.
Bonds in Recent News
In March of 2020, the Federal Reserve slashed interest rates to near-zero and purchased $1.7 trillion in Treasuries in the months afterward.
- This venture was a play to “fix” the bonds market in order to reduce the costs of long-term borrowing
- Overall, this move was an attempt by the Fed purchase as much long-term debt as the government could reasonably handle without tanking the market
- There are many reasons for the Fed to take such actions in unprecedented times
It’s not surprising that the Fed is spending so much on bonds to correct the market. Some, however, do find the new policy they’ve put in place to guide their buying program a tad surprising.
Bonds in Recent Legislation
After big U.S. companies issued the corporate bonds mentioned above, it was widely expected that corporations would slow borrowing across the board. This move could have a detrimental impact on the economy at large.
To counteract the impact of slowed borrowing, in June of 2020, the Federal Reserve unveiled sweeping changes to its bond purchasing policies.
In simple terms, the Fed eased restrictions during the pandemic in order to increase the flow of credit throughout the economy. The two biggest changes include:
- Buying eligible corporate bonds on standard indexes in the stock market instead of focusing solely on corporate bond ETFs
- No longer requiring certification that a company isn’t (1) insolvent (bankrupt) and (2) also can’t access funding at reasonable rates
This new regulation also requires companies to prove they have no conflicts regarding the CARES Act in an attempt to prevent government officials who own qualifying businesses from taking advantage of the newly available funds.
What happens next?
While the full effects of this plan are unknown as of yet, the hope is that by partially deregulating which bonds the government can purchase, the Fed can bolster companies small and large in their time of need. The true impact of this plan, however, is TBD.
The Bottom Line?
Bonds are basically loans you provide to a company or government. It’s a nice way to add diversity to your portfolio and lower risk. There’s many different kinds of bonds out there, and they exist because the issuer needs to raise money – ya know, to buy stuff and do things with it.
The Big Short is an entertaining retelling of the ’08 financial crisis. Yes, Selena Gomez has a cameo. Yes, this movie was nominated for major awards. Yes, it was based on a true story (and a pretty awesome book by Michael Lewis). Also yes, take it with a grain of salt. It’s only good entertainment.
In the words of Politico, “some have argued that The Big Short is unfairly brutal to Wall Street and the financial sector. They’re wrong: it is appropriately brutal to Wall Street and the financial sector.”
Check out the movie and decide for yourself.