One of my proudest achievements since starting Blue Tree is that my blog about investing in the stock market has helped many families to start investing for the long-term. Many of these families had previously thought that investing in the stock market was too complex or scary.
I’m now challenging myself to help families learn an even more complex subject as part of my ‘How to teach your kids about …’ series! In this blog I’m going to help you teach your kids about the second largest global investment market (after real estate) … BONDS (also known as ‘fixed income’).
Globally, over $123,000,000,000,000 ($123 trillion) is invested in bonds!
As you’ll discover as we go through this blog, learning about bonds doesn’t just help your kids understand more about investing, it also helps them learn more about debt.
Setting up the discussion
I’ve put this blog into 5 parts. Parts 1 and 2 are the very basics of what a bond is and why people invest in them. Parts 3, 4 and 5 increase in their technicality and aren’t strictly essential for kids to learn but you might want to have fun trying to explain based on the below. I’m an actuary so I love technical topics so thought I’d see how much my 7 and 9 year old daughters could understand.
To make this fun, my daughters decided we should imagine that Subway (the sandwich restaurant chain) wants to start selling sandwiches on Mars (there is no rationale for this but it did make it quite a funny conversation).
When talking to my daughters about this topic, I asked them a lot of questions along the way. I’ve put these questions below so you can ask your kids.
Part 1: What is a bond?
In our made-up scenario, we have Subway wanting to sell sandwiches on Mars. To do this, Subway needs to borrow money to pay for the rocket ships and to build the new restaurants.
As it's a lot of money, let’s say $1 billion, Subway can’t just borrow from the bank. Therefore, Subway wants to borrow money from lots of different people like you and me.
They say, for every $100 you lend us, as a thank you for lending us this money, we’ll give you $4 each year (known as a ‘Coupon’). At the end of 5 years, they’ll give you all your money back.
By offering this deal to lots of people, it means Subway gets the money they need for their project and your $100 becomes $120 after 5 years ($100 plus 5 x $4).
This is the very basics of what a bond is doing. You are lending your money to a company, or it can be a government, and they pay you back with interest after a period of time.
The company who wants the loan will set how long they want the loan for. This is known as the ‘term’ of a bond, it could be months or many years. In our Subway example, the term was 5 years. The company also offers how much they will give each year as a thank you, $4 for every $100 invested in the example above.
My eldest daughter quickly realised that this is also about debt, i.e. Subway is using debt in the form of a bond to pay for the project on Mars. This is really important as it shows that whilst so many people are getting poorer from using debt to buy things they can’t afford, others are using debt in the form of investing in bonds to make themselves wealthier.
Part 2: Why do people use bonds?
People like investing in bonds as they expect their money to grow by more than if they put their money in the bank. In the example above, you expect to get $4 a year for every $100 you invest in a bond. If you put that money in a bank account you might only get $1 for every $100 saved.
Also, compared to investing the money in the stock market, there is a lot more certainty over how much you are going to get back from your investment. Whilst you might expect to make more money investing in the stock market (e.g. you could expect on average to get $7 a year for every $100 invested over the long-term), there is a chance of a big fall in the stock market in the short-term.
I asked my daughters:
“Let’s pretend you are 13 years old and want to start putting some money away towards buying your first car at 17, why wouldn’t you put all this money in the stock market?”
My eldest’s reply was “There could be a storm just before I turn 17 and I won’t have enough money for my car”. This is exactly right - investing in the stock market is for the long-term (over 8+ years) as there is so much uncertainty on the outcome of the stock market in the short-term.
In this scenario, they would be better off investing the money for the car in bonds as there is much more certainty over how their money will grow (but accepting it might not grow by that much).
My wife and I don’t invest in the bond market as the money we have invested is for the long-term. We therefore invest it all in the stock market. That being said, if we were to start saving for something over the shorter-term, then we would start investing in the bond market. Also, my kids’ savings are all invested in the stock market as they are not expected to need this until they are 18, so a long time away.
A key question is, why do bonds give a higher return than putting money in the bank? The answer is Credit Risk and this is where we start to get a bit more technical.
Part 3: What is ‘Credit risk’?
The amount you get from investing in a bond depends on how sure you are that you’ll get your money back.
I asked my daughters:
“Do you think it is safer to put your money in the bank or lend it to Subway?”
They both said they thought it was safer to put their money in the bank which is correct.
If you invest your money in our made-up Subway bond, then there is a chance that the mission to Mars fails and Subway loses a lot of money. It could mean Subway can’t afford to pay back the money you lent them via the bond. As a result, they don’t give you all your money back. This is known as ‘credit risk’.
As there is this uncertainty about whether or not you’ll get all your money back, Subway offers to give you more money if you give your money to them rather than put the money in the bank. This is why in the scenario above, Subway offers $4 a year for every $100 invested in their bond, which is much higher than the $1 a year for every $100 saved in a bank.
My daughters and I then came up with a new sandwich chain of restaurants called ‘Underground’. They also want to borrow some money so they can sell sandwiches on Mars.
I then asked my daughters who they’d rather give their money to, Subway or Underground? They both said “Subway” as it’s bigger and they’ve heard of Subway and like their sandwiches.
I then asked:
“What would Underground have to do in order for you to give them your money rather than Subway?”
My eldest said “Give me more money each year, say $10 a year!”
(For the record, my youngest said “Give me unlimited sandwiches!”)
This is exactly right - a company that is less likely to pay back the money you lend, will offer a larger coupon as a thank you and to compensate you for the risk.
(A company's credit rating helps people understand how likely a company is to pay back the money borrowed, e.g. a company with an AAA rating is very likely to pay back what they borrowed).
Whilst there is a risk that you don’t get all your money back from investing in a bond, the risks are still much lower than investing in the stock market. Below I explain why.
Part 4: Stock market vs Bond risk
To explain the difference between stocks and bonds, I pretended that my friends and I owned our new made-up sandwich chain of restaurants, ‘Underground’. We owned it as we all bought shares in the company via the stock market. All together we invested $100 million!
My daughters on the other hand lent money to Underground via a bond. They lent them $100 million.
The company now has $200 million in the bank ($100 million from my friends and I investing in them via the stock market and $100 million that my daughters lent them via the bond).
Sadly, Underground doesn’t manage to sell any sandwiches on Mars so it loses a lot of money. So instead of having $200 million, it now only has $100 million in the bank!
You might think that we have all lost half our money, however, that’s not how it works. As my daughters lent Underground money via a bond, they were given their money back before any money was given to the shareholders. This means they get all their $100 million back (although miss out on the interest / coupons they were expecting as a thank you). On the other hand, my friends and I who invested are left with nothing as there is no money left for us.
This highlights why investing in the bond market is less risky than investing in the stock market.
I then reminded my daughters (well, daughter, as my youngest had lost interest by now), why people still invest in the stock market.
If Underground had managed to find people (or Aliens) to buy their sandwiches on Mars, and suddenly had $500 million in the bank, my daughters would get their $100 million back plus the interest. My friends and I would get the rest of the money in the company, this would be equivalent to $400 million less the interest paid to my daughters (assume $20 million).
Whilst there is less risk when investing in bonds compared to investing in the stock market, you still need to manage this risk. Let’s talk about diversification.
Part 5: Diversification
If you lend all your money to one company (investing in a single bond), that company could go bust and you'd get back a lot less than you put in.
Therefore, similar to investing in the stock market, you don’t want to invest your money in just one company. You should consider investing in lots of different companies.
Like when explaining this concept for the stock market, I got the lego bricks out (again) to help illustrate!
If you have 10 big bricks to invest and you give them to one company, say Subway, after 5 years you are expected to get your 10 big bricks back plus 10 smaller bricks (interest / coupons).
If something went wrong and Subway went bust then you could lose a lot of that money.
If instead you invested in lots of different companies, represented by 10 big bricks of different colours. After 5 years you are expected to get your 10 big bricks back plus 10 smaller bricks.
If something went wrong with two of those companies, you could lose some of the money you invested in them. However, you would still have the money from the other bonds and be better off.
This is why many investors invest via an investment fund which invests in lots of different bonds on their behalf.
Selling bonds
There is another big topic about investing in bonds which is really important and that is all about what happens if you want to sell your bond before the term of the bond.
Given that is a really tricky topic, I will cover this in more detail in a separate blog, assuming people enjoyed reading this blog (please let me know if you did! will@bluetreesavings.com).
In short:
As interest rates go UP, the value of your bonds goes DOWN.
As interest rates go DOWN, the value of your bonds goes UP.
Summary
The bond market is so big that it makes sense that our kids should have a basic understanding of what a bond is and why people invest in bonds.
Remember a bond is like giving a company (or the government) a loan. In return, you get some interest (coupons) and your money back after a period of time.
People invest in bonds as the expected return is higher than putting your money in the bank and there is much more certainty about what you are going to get compared to putting your money in the stock market.
Generally, bonds are used by people who want to invest money for the shorter-term (less than 8 years), whereas investing in the stock market is for the long-term (8+ years).
Teaching your kids about bonds is a way of showing them that whilst some people borrow money (use bad debt) and can get poorer, people who are using bonds are lending their money and getting wealthier.
Thanks for reading!
Will
P.s. Grandpa's Fortune Fables helps kids learn all about looking after their money and investing. Get a copy for your kids, nieces/nephews, grandchildren, schools and friends so more kids grow up looking after their money. Available at Amazon.co.uk and Amazon.com.
