Latest / How Canadian Markets Work / Episode 33: What a Bond Really Is

Transcript

Episode 33: What a Bond Really Is · How Canadian Markets Work

• 0:00
  A bond is simply a loan you can sell to a stranger.
• 0:06
  Welcome to today's Deep Dive. We're unpacking
• 0:10
  a stack of educational scripts about market mechanics
• 0:13
  today. Yeah, to really demystify one of the most
• 0:15
  misunderstood financial instruments out there.
• 0:17
  Right. And if you are tuning in with us, our
• 0:19
  goal is to cut through all the jargon to show
• 0:21
  you that bonds aren't just, you know, boring
• 0:24
  paperwork sitting in a vault somewhere. No, they
• 0:26
  really aren't. They're basically the hidden plumbing
• 0:28
  that dictates how the entire financial world
• 0:30
  operates. Exactly. And I love that opening quote
• 0:33
  from the source text. A loan you can sell to
• 0:35
  a stranger. It's just a wondrously elegant definition.
• 0:39
  Because if you just sit with that idea for a
• 0:41
  moment, it completely shifts how you view the
• 0:44
  financial machinery around you. It really does.
• 0:46
  It's not just about borrowing money. Right. It's
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  about taking this very rigid legal promise and
• 0:52
  being able to transfer it to someone else entirely
• 0:54
  at a market price that is continuously fluctuating.
• 0:59
  And that transferability is what turns a simple
• 1:02
  debt into a global security. But... Before we
• 1:05
  can understand how bonds move markets, we really
• 1:08
  have to understand what this loan is actually
• 1:10
  made of. Yeah, the basic anatomy of the thing.
• 1:13
  Right. So let's unpack this. We need to move
• 1:16
  from the abstract idea to the four concrete pillars
• 1:20
  of a bond contract. Let's use the example from
• 1:22
  the text Bay Ridge Wind. Right, the renewable
• 1:25
  energy company. Yeah. So say they need a massive
• 1:29
  amount of capital, like $140 million, to build
• 1:32
  a new wind farm. They issue a bond. And that
• 1:36
  starts with the first pillar, the issuer, who
• 1:38
  is actually borrowing the money. In this case,
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  Bay Ridge Wind. And then the second element is
• 1:43
  the principal. Right. The par or face value.
• 1:45
  which is how much they promise to repay you at
• 1:48
  the very end of the line. And the sources note
• 1:49
  that in Canadian markets, for example, that's
• 1:51
  often broken down into a $1 ,000 face value convention.
• 1:56
  Yeah, that's very standard. And then the third
• 1:58
  pillar is the coupon. Because you're parting
• 2:00
  with your money, they have to pay you interest
• 2:02
  along the way. Right. So maybe a 5 % coupon paid
• 2:05
  out semi -annually. So you get $25 every six
• 2:08
  months. Exactly. And the final pillar is maturity.
• 2:13
  The exact date that the principal comes back
• 2:16
  to you, say 20 years from now. OK, so I want
• 2:18
  to push back on this a little bit. If a bond
• 2:20
  is literally just a schedule of payments, a specific
• 2:23
  date, a specific amount, why does the financial
• 2:26
  industry make it seem so complicated? Well, the
• 2:29
  complexity really comes from the second half
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  of that definition we started with. The selling
• 2:33
  to a stranger part. Exactly. Because it is a
• 2:36
  security that can be resold. If you were just
• 2:38
  lending the money to Bayridge Wind privately,
• 2:41
  you'd just put the contract in a drawer and wait
• 2:43
  for the checks. Right. But because you can sell
• 2:46
  this loan to a stranger on a random Tuesday,
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  three years before it matures, the market has
• 2:52
  to constantly calculate what that fixed schedule
• 2:55
  of payments is worth today. So the world around
• 2:58
  the bond changes, even though the bond itself
• 3:00
  doesn't. Right. Which naturally begs the question
• 3:03
  of how this compares to the stock market. Because
• 3:06
  most people listening are probably much more
• 3:08
  familiar with buying shares. Yeah, watching the
• 3:10
  daily ticker, the wild swings. Right. So we have
• 3:13
  to transition from the mechanics to the actual
• 3:16
  philosophical and legal difference. between a
• 3:19
  share and a bond. Let's do that because they
• 3:21
  really are completely different realities. Yeah.
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  Equity, like a share, is what the text calls
• 3:26
  a residual claim. You just get whatever is left
• 3:29
  over after everyone else has paid. Right. It's
• 3:31
  essentially a hope. You have unlimited upside,
• 3:34
  but no guarantees. Whereas debt, a bond, is a
• 3:38
  contractual claim. It's a strict promise with
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  real legal force. So what does this all mean
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  for you as an investor? It feels a lot like The
• 3:46
  difference between accepting a guaranteed fixed
• 3:48
  salary versus taking a profit share agreement
• 3:51
  with no safety net. That's a really great analogy.
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  You're making a very deliberate trade off. Right.
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  The bondholder gets certainty, but they sacrifice
• 3:59
  the upside. So if Bay Ridge win triples in value
• 4:02
  because of some new technology, the bondholder
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  gets nothing extra, not a single dime, just their
• 4:07
  twenty five dollars every six months. The shareholders
• 4:10
  get all of that upside. But the downside is where
• 4:14
  this really matters. What's fascinating here
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  is the stark legal asymmetry. Oh, absolutely.
• 4:20
  If a company skips a stock dividend, they haven't
• 4:23
  done anything legally wrong. Shareholders might
• 4:26
  be mad, the stock might drop, but it's fine.
• 4:28
  But if they miss one single bond coupon payment?
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  It's a default, with severe legal consequences.
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  Bondholders can literally force the company into
• 4:37
  bankruptcy to get their money back. Which logically
• 4:40
  leads us to ask, what actually happens when a
• 4:42
  company breaks that promise and fails? Right,
• 4:44
  the worst day queue. Yeah, the capital stack.
• 4:47
  This is the financial queue during insolvency.
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  And it's so important to realize that this queue
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  only matters on the worst possible day, but it
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  completely dictates the outcome. Let's visualize
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  this. The failing company is a sinking ship.
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  Who gets the lifeboats first the secured creditors
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  they have a claim on specific assets like maybe
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  a mortgage on the company's building So they
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  just take the building exactly. They're insulated
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  next in line is senior unsecured debt, right?
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  They have the first claim on whatever is left
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  after the secured folks are done Yeah, and then
• 5:20
  below them is subordinated debt Which literally
• 5:23
  means they rank behind the senior debt in the
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  contract and then preferred shares. Mm -hmm and
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  then dead last plunging down with the ship are
• 5:32
  the common shares. OK, I have to ask a question
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  on behalf of the listener here. Sure. If common
• 5:36
  shares are dead last and they frequently get
• 5:38
  completely wiped out and receive nothing in bankruptcy,
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  why is the stock market so much more popular
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  for everyday investors? Well, it all comes back
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  to the price of that residual claim. The bondholders
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  are insulated from the worst of the crash. Recovering
• 5:52
  maybe cents on the dollar precisely because they
• 5:55
  traded away the upside. Right. Shareholders are
• 5:57
  dead last, but their upside is totally uncapped.
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  When things go well, they keep everything. So
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  if missing a bond payment can force a company
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  into bankruptcy and liquidate everything in this
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  ruthless queue, why do companies risk issuing
• 6:11
  debt at all? It's a fair question. Why not just
• 6:14
  sell more shares? Yeah, exactly. But the sources
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  outline three main reasons companies actually
• 6:19
  prefer debt. Cost, control and tax. Right. Cost
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  is simple. Debt is usually cheaper because the
• 6:26
  lender is taking less risk by being higher in
• 6:28
  that capital stack. And control makes sense too.
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  Borrowing money doesn't dilute the existing owners.
• 6:34
  You don't give away voting power. But the third
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  one, tax, is really profound. Here's where it
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  gets really interesting. The tax system actually
• 6:42
  encourages corporations to take on the risk of
• 6:45
  borrowing. If we connect this to the bigger picture,
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  it fundamentally shapes corporate finance. Interest
• 6:50
  paid on debt? is generally tax deductible for
• 6:53
  the company. Oh, wow. So it lowers their tax
• 6:55
  bill. Exactly. It's a pre -tax business expense.
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  But dividends paid to shareholders are not deductible.
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  They come out of after -tax profits. Wait, really?
• 7:03
  So structurally, debt is just heavily subsidized.
• 7:05
  It is. It makes debt structurally cheaper than
• 7:08
  equity, which pushes companies to use it. OK,
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  so we see why companies want to sell bonds and
• 7:13
  why the legal certainty appeals to investors.
• 7:16
  But the sources make it explicitly clear that
• 7:18
  bonds are not just safe. No, not at all. They
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  are what we call differently risky. Let's transition
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  to those hidden risks that you take on when holding
• 7:27
  a bond. The text breaks down four core bond risks.
• 7:32
  The first one is straightforward. Default risk.
• 7:34
  Yeah. The borrower just fails to pay. Right.
• 7:37
  The ship sinks. Yeah. But the second one, interest
• 7:40
  rate risk, is trickier. If general interest rates
• 7:43
  in the economy rise, older bonds with lower coupons
• 7:47
  become less attractive. Right, because if I hold
• 7:50
  a bond paying 5 % and new bonds are paying 7
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  %... No one wants your 5 % bond. So to sell it
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  to a stranger, I have to drop the price, my market
• 7:58
  value falls. Exactly. It's an inverse relationship.
• 8:01
  Rates go up, bond prices go down. And then the
• 8:03
  third risk is liquidity risk. Right. If you need
• 8:05
  to sell your bond... You might not find a buyer
• 8:08
  at a sensible price. It's not like tapping a
• 8:09
  button to sell a stock. Because it's a fragmented
• 8:11
  market. But the fourth risk, inflation risk.
• 8:15
  That's the one that feels the most insidious
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  to me. It really is. Earning a 5 % coupon while
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  inflation runs at 6 % means you're literally
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  losing purchasing power. Every single year. Even
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  if every single payment arrives perfectly on
• 8:28
  time, it just feels so unfair to have a contract
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  honored perfectly, yet still end up poor in real
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  life. This raises an important question though.
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  It encourages you to think critically about how
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  safety, in purely nominal terms, can actually
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  guarantee a slow erosion of real wealth. Right.
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  And just as a quick side note from the source
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  material for retail investors in Canada interest,
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  is actually the worst taxed type of income. Yeah,
• 8:53
  that really shapes where you should hold these
• 8:55
  assets, usually in tax sheltered accounts. Definitely.
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  So to distill this deep dive down for you, a
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  bond is a contractually fixed schedule of payments.
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  It contains four elements, issuer, principal,
• 9:07
  coupon, and maturity. It is a legal promise,
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  not a hope. Right. Placing you higher in the
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  capital stack, but capping your upside. Companies
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  love debt for control and tax benefits, but as
• 9:17
  an investor, you are trading stock market volatility
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  for four distinct quieter risks. Beautifully
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  summarized. But we want to leave you with a final
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  lingering question to ponder on your own today,
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  something that really builds on this text. The
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  sources distinguish between the promise of a
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  bond, which pays in nominal dollars, and the
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  hope of a stock, which relies on residual earnings.
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  But if we live in a world where central banks
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  routinely target continuous inflation, effectively
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  guaranteeing that the purchasing power of those
• 9:48
  nominal dollars will shrink over time, Are we
• 9:52
  fundamentally mislabeling these assets? Oh, that's
• 9:55
  a brilliant thought. Over a 30 -year timeline,
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  which asset is truly the safe one and which is
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  the risky one? It really makes you rethink what
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  safety actually means in investing. It does.
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  Thank you so much for joining us on this deep
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  dive today. We appreciate you being here to explore
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  these concepts with us. Yeah, thanks for listening.
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  We'll see you next time.