Continuing Bond Basics (Bodaciously)

OK, I have follower now.  I suspect somebody I love lobbied hard, but what the heck!

My last blog focused on bond basics: their initial pricing, end pricing, and what might happen in the meantime.

Now I want to talk a little about income streams.  You can (and should) think of a bond as an income stream.  Those bi-yearly payments will flow to you until the bond matures.  It's income, and very valuable, particularly as you grow older.  You may be surprised to know that traditional stock analysts also work from the perspective of an income stream.  They talk about the discounted (or present value) of a company's future income stream (the money the company will generate over time).  If you anticipate robust growth in a company's earnings, then you will pay more for the stock right now.  If it's going to decline over time, then you'll pay much less for that stock, even though it might be highly profitable right now.

What's the difference between the income streams from stocks vs. bonds?  Predictability.  Make a basic assumption about the company behind a bond, and you know precisely how much money that bond will generate over its life.  What assumption?  Well, will it go belly up?  In 2009, I asked that simple question about Goldman Sachs and JP Morgan.  Would they survive the tidal wave of mortgage failures, or not?  Since Uncle Sam had backed them to the hilt, I decided that they would, indeed, survive.  After that, everything was simple.

How about anticipating the future income stream of a stock?  Oops.  Get nineteen factors absolutely right, miss the twentieth, and a future Microsoft suddenly morphs into an also-ran.  In 2009, an almost endless string of stocks with unblemished histories of rising dividends suddenly cut those dividends to the bone, or eliminated them entirely.  JP Morgan went from $.38 a quarter to a nickel! Retirees trying to live on those dividends experienced an 87% cut in income.  And, the price of the stocked plummeted from $47 to $16, a 66% haircut.  Even though the stock has recovered robustly (to a recent $38, the dividend still lingers at a nickel.  Who know when it'll be back at $.38?  Now, what happened to Morgan's bondholders?  Nothing, absolutely nothing ... unless they sold in a panic.

A predictable income stream is golden.  It's why people go to work, it's why retirees love Social Security, and it's why people getting ready for retirement will often hand huge sums over to insurance companies in return for an annuity.  An annuity will promise a given return until the buyer's death.  A sixty-five year old might hand over $100,000 in exchange for a guaranteed $500 monthly check (6%) until she dies.  Most financial advisors will encourage her to do this.

Here's my question: why on earth is this gal not buying bonds in the same amount?  At age 65, she can reasonably expect to live perhaps 25 or 30 years more.  So, what if she bought bonds maturing in 2035 with that same 6% yield?  She would get her $6000 a year until 2035.  At that point, she (or her grateful heirs) gets her money back, all of it.  The boob with the annuity?  He's either dead, in which case the money's gone, or he's nearly dead, in which case the money will soon be gone.  So, what sounds like the better investment to you?

By the way, such bonds exist; I just checked.  One example: a Goldman Sachs issue has a maturity of 2036 and coupon of 6.45%. It trades under par (91.2), to yield 7.2%. You all know Goldman Sachs.  It's had a wild ride, but has weathered the recession.  It's high medium quality (A2 S&P, A- Moody's), and a bank that "too big to fail."   Now, I'm NOT saying to go out and buy that specific bond.  You would need to do due diligence; analyze the company and make up your own mind about whether it will still be around in 2036.  What I am saying is that there are plenty of similar issues out there, and most of them will be fine investments.

My next blog will focus bond critics, and why those guys may be missing the boat.