Over the weekend, I damaged an armpit muscle.
Some people might tell you that this was a direct result of monkey-climbing up a set of playground swings. But the honest truth is: I strained it with all the back-patting.
The week before last, I was exclaiming in awe about the Apple share price (see the [further] collapse of the Apple Share Price). And then the earnings announcement came last week, and there was general excitement about the Apple share buyback plan (see Why Debt Can Be A Fabulous Thing). This week:
If I were Paul Krugman, I would be claiming credit for this in a blog post about knaves and fools*. And I would be mouthing off highly quotable quotes like:
“The point is not that I have an uncanny ability to be right; it’s that the other guys have an intense desire to be wrong. And they’ve achieved their goal.”
But I’ve learned that making such a claim can result in damaged armpit muscle. So instead, let’s credit Billionaire Alisher Usmanov and his announcement that he just spent $100 million on Apple shares. Which I think is enough of a segue into the new record that Apple set yesterday:
This is just the first step in the Apple plan to have more debt and less equity (again, like I said last week, debt can be fabulous). But because I’ve already posted about the good reasons for doing it, I’m going to take this moment to talk about bonds and how they work.
What is a Bond
A bond is an IOU note from a company (known as a “corporate bond”) or from a government (known as a “sovereign bond”)**. And unlike borrowing from the bank, where the lender (the bank) gets to determine the terms of the loan – a bond offering allows the company/government to set the terms of the loan, and then invite members of the investing public to lend them money by “taking up” some of the bonds that are issued. And by doing so, the investors would be agreeing to the borrowing terms set by the bond issuer (the borrower).
On the bond note***, you’ll be told how long the bond will last for (the maturity), how much you’ll be paid each year until then (the coupon), and how much you’ll get at the end (the face value AKA the nominal value).
The “bond” entitles the holder to a pre-determined set of cash flows. With the above picture, the bondholder would get:
- $50,000 every year in coupon payments (5% of $1 million) – and I threw in “semi-annually” to let you know that you’d get paid that in two installments (so that’s $25,000 every 6 months).
- And $1 million at the end (1 May 2043)
Many people (finance students included) would say that you’re earning 5% interest per year on such a bond. That would only be true in one particular situation. But before I get there:
What is a Bond Yield
When we talk about interest on a bond, we use the term “yield” instead (its longer name is the “yield-to-maturity”, or YTM, which tells you how much interest you’ll earn on your investment each year until the bond is repaid/matures). And that’s because the price of a bond will change, but the future repayment is already set. So any change in the price of a bond will change the effective interest (yield) that you earn.
A simple example: if I paid $1 million on 1 May 2042 for the above bond, here is what my payoff will look like:
In the above situation, I would earn 5% on my investment of $1 million in a year – so my yield-to-maturity is equal to my coupon rate of 5% (this is the “one particular situation” where the finance student statement is true).
But let’s say that Microsoft also has a $1 million bond in issue, but they’re paying a coupon of 16%. Would you still pay $1 million for an Apple bond? Not at all. You’d sell Apple bonds, and buy Microsoft bonds. This could push the price of Apple bonds down to $0.9 million. And at that point, you’d be happy to buy Apple bonds:
Why? Because if you put $0.9 million in the bank, and you knew that it would grow to $1.05 million in one year’s time, then the bank would have to be offering you an interest rate of 16.7%. In the same way in this example, the yield on the hypothetical Apple bond is therefore 16.7%; which is much greater than the coupon rate.
And the situation could be reversed if Apple was offering a higher coupon rate than other similar players in the market. People would bid up the price of Apple bonds, resulting in the YTM being lower than the coupon rate:
What is My Point?
My point is that this talk of bond yields can get confusing. Earlier this week, there were news articles about bond yields reaching “record lows”. To the lay person, this sounds like a bad thing. But actually, “record lows” for bond yields means that bond prices are reaching record highs!
So when you hear about falling bond yields, you should be thinking “Sherbet, look at all those fools racing to invest in bonds”. And when you hear about negative bond yields, you should be thinking “Why would someone want to lose money on their investment from the start?”
And Back to Apple
Apple’s bonds are offering coupon rates of 0.45% on 3 year notes****, 1% on 5 year notes, 2.4% on 10 year bonds, and 3.85% on 30 year bonds.
Those are absurdly low rates.
Everyone should still be buying Apple shares.
*I couldn’t resist bringing him up. For those who are unfamiliar, Paul Krugman is the democrat-mouthpiece economist and über-Keynesian blogger for the New York Times. He’s totes besties with Ben Bernanke; and he’s famous for knowing that he’s right about everything economy-related. He received the Nobel price for his work on New Trade Theory – which has made him insufferably smug. And on Sunday, he defended himself against criticism with the above declaration.
**There are other issuers, like municipalities (“municipal bonds”) – but corporates and sovereign bonds are the ones you hear spoken about most often. But don’t confuse this with a “mortgage bond” – which has nothing to do with what we are talking about here. Mortgages are referred to as “bonds” because the house is “bonded” to the lender until such time as the mortgage has been repaid. I know it’s confusing.
***There are very few physical bond notes in use today – the certificate would be electronic. So no more finding government bond certificates in grandma’s papers and realising that you’re rich, alas.
****Bonds are also sometimes known as “notes”. Usually, bonds that are issued with shorter-term maturities (5 years or less) are known as “notes”. Longer-term maturities are bonds.