“What about corporate bonds,” Linda asked. “Are they safe?” “Not always,” said the adviser. “Sometimes they can be just as risky as common stocks.” “Hold it, please!” interjected the husband. “I’ve heard about stocks and bonds all my life, and I just realized that I don’t understand, in depth, what the heck the difference between them truly is.” “It’s simple. With a corporate bond, instead of buying a share in a company, you are making a loan to the company. Instead of becoming an owner, you become a creditor. Whether the company makes a profit or suffers a loss, it promises to pay your interest every year and give you back your entire principal at the end of the term, just like any loan. In essence, they get your money. You get a piece of paper—the bond certificate—that says they owe you the money.”
“Can you give me an example?” “Sure. Let’s say you buy a $10,000 General Motors 6.75 percent bond maturing in 2028. All that means is that you are making a loan to General Motors for $10,000. GM is promising to pay you 6.75 percent interest per year. They’re also promising to return your principal, in full, in 2028.”
“We get the bonds directly from General Motors?” “No. You get them through a broker, just like a stock. And just like a stock, they fluctuate in price in the market—the bond market. If too many people are trying to buy them, they go up in price. If too many are trying to sell them, they go down in price.” “Why would anyone want to sell them?” Linda asked.
The adviser smiled with respect. These were not dumb questions! “Let’s say you buy a $10,000 bond from a company. Now, instead of $10,000 in the bank, what have you got? You’ve got a piece of paper that says, in effect, ‘IOU $10,000.’ Can you take that IOU to Toys-R-Us and buy your kids a couple of new bikes? If you lose your job, can you use it to pay your mortgage? No. So the first reason anyone might sell a bond is need—because they need the money.
“The second reason,” he continued, “is fear. Let’s say you bought a bond in UCBS. And let’s say, since UCBS is losing so much money, the rating agencies—Moody’s, S&P, and Fitch—downgrade the company. What does that mean? It means all three agencies agree there’s a greater chance than before that this company will default, that it will miss an interest or principal payment.” The adviser paused for a moment to find a way to bring the point home.
“You seem to be the type of people who would never dream of defaulting on your mortgage payments, but believe me, there are big companies defaulting on their bond payments all the time. That’s where the fear comes in. If investors are afraid the company is going to default, they sell. That drives the price down. And if UCBS actually does default, forget it! The value of UCBS bonds can go to 25 cents on the dollar, maybe even down to zero, just like a stock. Their bond is their word, and if they break their word, their bond is next to worthless.”
“That’s hypothetical,” she said with a bit of discomfort as she thought about her father. “Can you give us some real examples?” The adviser bent over to dig a folder out of his lower left file drawer. Within half a minute, he pulled out a big 11- by 17-inch sheet of paper and placed it before the couple, covering the book on safe investments that he had opened in that same spot a few minutes earlier.
On the sheet, hundreds of bonds were shown, all casualties of the tech wreck, the recession, the bankruptcy crisis, or just bad management. They saw Revlon’s 6-year bond, which fell from $975 to $450 following downgrades in ratings. They saw American Airlines’ 2-year bonds, which plunged by nearly half. They also saw bonds issued by Kmart, Lucent, Polaroid, AT&T, Qwest Communications, Electronic Data Systems, and many more—all clobbered in value after downgrades in ratings. “See my point?” the adviser said at last. “A lot of these bonds plunged just like stocks!”
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