Planet Money - SUMMER SCHOOL 4: Bonds & Becky With The Good Yield

Episode Date: August 18, 2021

A few years back, Cardiff asked for an unusual Christmas present: a junk bond... Parallel to the stock market, the bond market offers different levels of risk and reward. In this class, what is a bond, how do they differ from stocks, and how do they help companies grow? | Watch this Tik Tok to learn more and subscribe to our weekly newsletter here.Learn more about sponsor message choices: podcastchoices.com/adchoicesNPR Privacy Policy

This is Planet Money from NPR. Hey everybody, this is Planet Money Summer School. Six lessons on investing that you can take with you anywhere, literally in your ears. Today is class number four, investing in bonds. And the place to start is with how bonds are different from stocks. So when you buy a stock, you get part ownership in the company. So the stock price will swing up or down based on how well the company is doing. But when you buy a bond from a company, you don't get any ownership. What you get is a promise of being paid back your money after a fixed period of time.

Plus, you get regular interest payments. In other words, it's like you're giving a loan to the company. So hypothetically, if I buy a 10-year bond from Microsoft for, let's say, $100, it just means that at the end of 10 years, Microsoft pays me back my $100. And each year between now and then, it also pays me, again, let's say $5 a year in interest payments. That's it. And you could also invest in government bonds like U.S. treasuries, and it works pretty much the same. And to cover everything more complicated than that, we have brought in a Planet Money Summer School professor who specializes in bonds.

Okay. My name is Vicki Bogan. I am an associate professor in the S.C. Johnson College of Business at Cornell University. Yeah. And more specifically, Vicki, you have taught a course on all things bond markets, right? Exactly right. So fixed income securities is a class that I taught for about a decade. And it means everything bond markets, bond related.

So, Vicki, here's where I want to start. When I buy a bond from a company, I am effectively loaning money to that company. But why does the company want to raise money in this way by issuing bonds? Why doesn't the company just sell more of its stock or even just call a bank and get a loan instead? So borrowing money from the general public may be a cheaper way to get the funds that they need than going to a bank. Borrowing money from the general public may be preferred by a company as a way to get funds than actually issuing more stock, right? A company that's a publicly traded company can always get funds too by selling more stock on the open market. But when a company sells stock,

what are they doing? They are selling more of the ownership in their company. And so they're, you know, selling more of their company to the public and they may want to retain some of that ownership and upside. And the flip side of that, of course, is that I, as the investor, get a return from those steady, predictable interest payments from the bonds, which, by the way, might be especially nice if the economy turns bad. At least I can rely on those steady returns. There's also a benefit beyond just the return that you get. Investing in bonds as a household is a nice way to diversify your portfolio.

So you have a few stocks, you have bonds, you're diversifying your portfolio. So all of your money isn't tied to one company, one market, it's spread among a lot of different investments. And so it mitigates some of the risk for your portfolio. Okay, well, after a short break, we are going to present the story of how the staff at The Indicator, which is Planet Money's daily podcast, did the exact opposite of diversifying and mitigating risk. I was on The Indicator at the time this happened, when we actually bought the single riskiest bond in the country, and it took us on quite a ride. That is coming up after a quick break.

Back in December of 2019, I was the co-host of The Indicator, which is Planet Money's daily podcast, and my co-host, Stacey Vanek-Smith, heard me say that I thought a fun Christmas present would be something called a junk bond. So using a little slush pile of money that NPR has set aside for just these kinds of journalistic experiments, Stacey decided to get one for the Indicator team. The excerpt from the Indicator that you're about to hear is what happened next, and it is hosted by Stacey and producer Lina Sonsgiri. We decided that we were going to make a probably terrible, incredibly risky, but maybe, just maybe, very lucrative investment. We were going to buy a junk bond. We did not really know where to begin. So we called up one of our very favorite bond

market experts, Marilyn Cohen. She is the founder of Envision Capital Management. Hi, how are you? Top of the morning it is. I'm doing good. And we told her we want to buy a junk bond. She had some reservations. That is a terrible idea. Terrible. But why is it a bad idea? I mean, what is a junk bond? A junk bond simply is a company that issues debt that is not investment grade. Investment grade. So there are big ratings agencies that give companies grades based on their financial soundness. So a company like Johnson & Johnson or Microsoft have a AAA credit rating.

They're in good financial shape. If you lend the money, they will almost certainly pay you back. But not everyone gets a AAA. If a company is struggling, if lending the money is a bit risky, the company might get downgraded to a double A, a double A minus, or a triple B. And there's a credit ratings threshold. And once you fall below that, your bonds, your debt, is classified as junk. Junk. Maryland says the official term, by the way, is high yield bond. The yield is the interest payment you get when you lend money to a company, when you invest in a bond. And when companies dip into junk territory, they are considered really risky to lend money to.

Their bonds are seen as risky. So the company issuing those bonds has to offer really high yields, really high interest rates on those bonds to attract investors. So normally the bond market is considered very safe and not very profitable. The junk bond market is the exception to all this. It's risky and profitable. These are companies that are actually at risk of not paying investors back. This is, it's like junk bonds just means like risky bonds. This is like lending money to your flaky roommate.

Oh yeah, there you go. Right now, Marilyn says, the junk bond market is on fire. Corporate debt is at an all-time high. Interest rates have been low for so long that it's really cheap for companies to just borrow money for whatever reason. So they have been. For investors in bonds, this is not always great news because low interest rates mean you don't necessarily make much money on bonds. So more investors have been creeping into riskier bonds, hoping to make some money. Like us. Like us.

So we asked Marilyn how to buy a junk bond. You'd have to set up a brokerage account and buy the bond, you know, online. I am opening up my Fidelity account. So we roped in producer Darius Raffion. We said, hey, don't you have an online brokerage account? Want to help us get Cardiff a junk bond? So this one, it costs $1,000 for one of them. Okay, that's probably over our budget.

And you have to buy a minimum of $200. That's a little rich for our blood. So if you have $200,000, you can get these bonds. Can we organize by lowest to highest price? Let's do by lowest price. All right, so here's a bond issued by a company called Hornbeck Offshore Services. Offshore Services Oil? I assume it's oil, right?

Yeah, I would imagine so. So just to show you how cheap and junky this bond is, if that actually gets to maturity, which seems not likely, these bonds yield 146.7%. Okay. To put that in perspective. And over a what period? Over a year? Yeah, like a year and a year and change from now. To give you a frame of reference, a 12-month treasury is yielding 1.5%.

So 1.5% versus 146%. Nice. Okay. I mean, you know, there's like a good side to junk. Good yield for sure. So these bonds are $286.50 and a minimum of two. So that would be $600. Yeah. Okay. So what does it say. So that would be $600. Yeah.

Okay. So what does it say? Let's read it off. So we got two bonds from Hornbeck Offshore Services. Maturity date March 1st, 2021. So I'm hovering over it. Here we go. Place order.

Processing. Thank you. Your order has been placed. I feel like we need to name this bond. So it's a company called Hornbeck Offshore Services. Becky. Oh, I like Becky. Becky with the good yield. Becky with the good yield. So good. That high junk grade yield. Becky with the good yield. Becky with the good yield.

Okay. Well, we are the proud new owners of a bond for Hornbeck Offshore Services. And now just one thing is left. We have to give it to Cardiff. We have to give it to Cardiff. Okay. So you've handed me, Stacey, this blue folder. It's got bows on it.

I'm going to rip these off. This is a packet of information about the bond and articles about the company. And also, because it is an oil drilling company, fossil fuels, oil, we decided that Becky would best be represented as a dinosaur. Because oil comes from dinosaurs. Fossil fuels. So here is Becky, the little pink dinosaur. Becky with the good yield.

Team Indicator owns a junk bond. Hey, everybody. It's Cardiff here again. That excerpt you just heard was from December 2019. After the break, we'll learn a bit more about Becky and what happened to her. Okay, we will soon return to the story of Becky, the riskiest junk bond that we could buy. But first, a quick caveat. Do not try this at home. We bought a junk bond to help us understand all bonds and because it was fun,

not because this is a smart way for people to invest. It really, really ain't. And I am now joined once again by Professor Vicki Bogan of Cornell. Vicki, am I just a silly, silly man for wanting a junk bond for Christmas? Um, well... I'm just going to take that as a yes.

So, Vicky, in the excerpt, we obviously did not buy, like, the regular bond of a nice, safe company that would very likely pay us back. Instead, we bought a junk bond, which is like the deadbeat roommate of the bond market. But that's also why a junk bond pays a much higher interest rate because it's more risk, more return. And we also heard the interest rate you get on junk bonds compared to the very low interest rate that you would get paid if you bought a treasury. So tell us what we should know about treasuries. So when we think about treasury bonds, that's when the institution that's borrowing money is the U.S. government.

Nobody thinks the U.S. government will decide not to pay back their debt. And so generally, U.S. treasuries and U.S. government debt is considered to be risk-free. Risk-free or like as close to a guarantee that you are going to get paid back that money. Exactly. So as close to a guarantee as possible. And so generally, the interest rate on U.S. Treasuries is the lowest interest rate out there. is the lowest interest rate out there.

And then anything more risky than a U.S. Treasury, the issuer is going to have to pay a higher interest rate. Yeah, and because the interest rate on Treasuries is always the lowest out there, it's also the interest rate that all the other bonds are based on. Something else we learned in the episode is that for a lot of individual bonds, the minimum price you have to pay is a really high one.

And also that bonds in general just kind of seem a bit more complicated than stocks. You know, bonds have maturity dates. They have specific interest rates. You have to know the credit ratings for the bond. And maybe that's why fewer American households own bonds than stocks. Way fewer households. Do you think that American households are missing a chance to diversify their investments by not having more bonds? Yeah, actually, I'm a strong proponent of diversification of household portfolios. I think bonds are an important component of a household portfolio.

And an easy way to diversify your portfolio is through a bond fund. And so the same way we talk about investing in the stock market through mutual funds, you can buy a bond fund where you can diversify across a lot of different types of fixed income securities by buying a bond fund. And so that's a way that households can kind of dip their toe in the water and start investing in bonds and get to learn more about bonds. And more safely than taking all their money and just buying one or two bonds too, right? taking all their money and just buying one or two bonds too, right?

Exactly. And definitely more safe than taking all your money and buying a junk bond. Fair enough. You just had to get that one dig in there. I'm just joking. I know, I know. No, we appreciate it. Well, our listeners have been patient. And so now we return to the story of Becky. Part two of the Becky story takes place in February 2020, a couple of months after we bought Becky and just before the COVID pandemic swept through the U.S. It was hosted by Stacey Vanek-Smith and by me. Just how risky was our investment in Becky? Well, a couple of months after we made this purchase, we called Claire Boston to ask.

I was walking down the street and you said, oh, we bought Hornbeck. And I audibly gasped. Claire covers the bond market for Bloomberg. Hornbeck is an extremely risky company. You guys didn't just pick, you know, like a higher quality junk bond. A higher quality junk bond. Yeah, we know how to pick them. I know.

Claire says the junk bond market is a pretty big and varied place, and not all junk bonds are created equal. So there are three basic tiers. We mentioned company credit ratings. Triple A, double A, single A, triple B, et cetera. These are all desirable ratings for a company. These are so-called investment grade ratings. It's a lot like a person's credit rating.

If you're below triple B, though, you're now in junk bond territory like our bond. The first year is double B. That is what we would call the high quality junk. No one is worried about them not being able to pay back their bonds. For instance, some of Ford Motor's bonds are in that category. Also, JCPenney and Twitter. And a record number of U.S. companies are issuing junk bonds now, Claire says. Companies have started borrowing unprecedented amounts of money and using it to buy up other companies and to expand their operations and do all kinds of things.

And why not? The money's cheap. But all that debt will bring your credit rating down. And that's why so many big, stable companies are in the junk category right now. And then sort of the biggest part of the junk market is sort of that single B range, so call it the middle. You know, and so that's kind of what people consider to be traditional junk. So, you know, a little riskier companies like Bethlehem Steel, Revlon, Uber, a lot of companies that are still considered to be solid companies, just maybe having some cash flow problems. And then the lowest tier is CCC. That's where we bought. Yes.

Tell me about this lowest tier. These are companies that definitely you could think about potentially running into trouble and not being able to pay their obligations back. Like maybe going bankrupt or something like that. Even in the best of times, investors are a little sort of wary of really loading up on CCC debt. Hornbeck Offshore Services is in that lowest tier. Of course it is.

That's where we invested. Hornbeck, the company, is based in Covington, Louisiana, a little city right near the Gulf Coast. The company is based in Covington, Louisiana, a little city right near the Gulf Coast. Hornbeck was founded in 1997 by Todd Hornbeck, and he is still the company's CEO. Hornbeck has about a thousand employees, and it owns a fleet of boats that it hires out to supply people and equipment to offshore drilling sites. Now, we tried to call Hornbeck a bunch of times, but... Yeah, that was the closest thing we got to a response.

Okay, so we've established that Hornbeck's debt is in the lowest level of junk right now. Claire Boston says actually a lot of oil companies are in that situation because low oil prices have pushed a lot of these companies into troubled territory, but especially companies like Hornbeck. Not only is it energy, which is kind of an out-of-favor sector right now, it is the most out-of-favor of the out-of-favors. Ooh, how come? It is an offshore drilling services company. And offshore drilling is basically the category of the market where energy companies are exploring for oil,

not, you know, in the ground or in the swamp, you know, in the U.S., but deep underwater. And super expensive. Exactly. And so those companies need the highest oil prices to make money. And so I talk to a lot of investors for my job. And I have investors that say, oh, you know, like, we think parts of energy are OK. But right now, very few of them are willing to take a risk on offshore. OK. But right now, very few of them are willing to take a risk on offshore. Five years ago, a share of Hornbeck stock cost about 23 bucks. Right now, it's around 60 cents a share. In fact, right after we bought our bonds, Hornbeck was suspended from trading on the New York Stock Exchange because its share price had dropped so low. David Deckelbaum is the Managing

Director of Equity Research at the investment bank Cowan & Company. Stacey, you called them up to figure out what this would mean for us, for our investment in Hornbeck. Hornbeck's had a rough time. Yeah, that's right. So do you think we'll get our money back? When you acquire a distressed debt instrument, you know, I think it's, you know, you can always, but once you're involved in a distressed situation, it's a matter of negotiation. And, you know, sometimes a company can be so down and out that they just elect to go bankrupt and wipe out all of their credit or wipe out all of their bonds. But, you know, keep in in mind, most of these companies are run by folks that

want to stay employed, that don't necessarily want to go bankrupt. So I think what you tend to happen is usually there's some sort of exchange, and the current bondholders would have to agree on that. Hey everybody, it's Cardiff, and we now move forward in time to part three of the story, which takes place in August 2020. It begins with Claire Boston of Bloomberg getting ready to deliver some news about the fate of Becky. You know, way back when you did that, it was pre-COVID, but the company was already having some serious struggles and had started to do things that looked like perhaps it was going to file for bankruptcy. Then, of course, like the world fell apart and COVID happened and we kind of forgot about Becky for a little while. Kind of did stop paying attention, yes.

And so now I have some updates for you. I checked in. Check in on Becky. I had a feeling this day was coming. Yes. Okay, so first update, Hornbeck is bankrupt. Yeah, that's very sad. I actually tried not to look up Hornbeck, but this news did come across my screen at one point. So I knew it. I just didn't want to know what it meant for us. So I've avoided looking too much

into it. I mean, in a lot of ways, it's not that surprising. Over the last six months, thousands of U.S. companies have filed for bankruptcy. It has been a really brutal time. Yeah. And I mean, Hornbeck, I remember, was struggling before the COVID pandemic came along. I mean, it already couldn't pay its debts back then. Yes. So Hornbeck declared bankruptcy. But, you know, even if a company declares bankruptcy, if you have a bond, you will typically get paid back in the bankruptcy settlement, right? At least in part. So, you know, we're not necessarily in terrible shape. I asked Claire, okay, please look into this for us. Tell us what happened to Becky. So I am a nerd.

I pulled the restructuring plan out of the bankruptcy documents. Oh my gosh, we love nerds so much. Yes, what did they say? Give us all the details. Do you want the good news or the bad news? Because actually, I think it's actually mostly bad unfortunately okay okay but but that means there is some good news yes yes i love this glasses have full cardiff garcia that i'm meeting this is wonderful yes i am saying there's a chance. Yes. I am saying there's a chance. Exactly. Okay, Stacey, I'm ready.

Our junk bond Becky, hit me. What has happened to it? Okay, so we know a few things. The company that issued the bond, Hornbeck Offshore Services, declared bankruptcy back in May. Claire Boston, who covers the bond market for Bloomberg, said, good news and bad news. Okay, so you guys are going to get about $5 back. Oh, okay. Really?

For both bonds, $5? Both bonds, $5. Wait, the good news is that it's not nothing? Yes. So the good news is that we are getting an amount back. The bad news is that we're getting $5. Yes. So Cardiff apparently is actually less than $5.

It's more like $3, but Claire was feeling generous, and so she rounded up for us. Much appreciated. So you're saying our two bonds that we paid $600 for are now worth about, rounded up, $5 or so. Yeah. Okay. I guess the follow-up question is, why did we get so little?

Where did our $595 go? What happened to you and the reason that you guys are getting so little is that you're sitting kind of back in the line. So, Cardiff, you can think of it like boarding an airplane. First up, you know, you have the people with small children, active military. Those guys, super premium bondholders, they get 100% of their money back. Then you've got, like, the platinum members., they get 100% of their money back. Then you've got like the platinum members. They got about 88% of their money back. Then way, way, way, way, way, way down the list.

You guys. General boarding. And you're getting half a percent. Yeah. I mean, OK, so remember, though, the potential payoff here was really high, 146%. We would have more than doubled our money if Hornbeck had pulled through and had not gone bankrupt. But of course, that is the dark side of junk, which is that if a company goes under,

junk bond holders are really far back in the line. You lose your shirt. And we lost our shirts. We lost our shirts. So Becky, our $600 pair of bonds is now worth roughly a cup of coffee. So with the heaviest of size, we did indeed lose all that money on Becky. But we also gained some lessons for how to invest in the bond market from that adventure. We'll share those lessons after a quick break. Hey, everybody.

Cardiff here, joined once again by Professor Vicki Bogan of Cornell. Vicki, as you just heard, we lost the vast majority of our money on that junk bond. And it was a good example, I think, of the most obvious kind of risk that comes with investing in bonds, which is just that you won't get paid your money back. That's called default risk. And even though we bought a junk bond, regular investment grade bonds also do have default risk. It's just much, much smaller.

You're probably going to get paid back. But there are other kinds of risks that people should know about when investing in bonds too. So when we talk about bonds, again, we're talking about investing in a security that promises to pay you a fixed amount of money. That's a fixed amount of money that you're going to get over time. If you think about or add inflation to that mix,

inflation to that equation, if there's increase in inflation, that fixed money that you're going to be receiving is going to have a lower buying power, lower purchasing power. And so that's the risk of investing in something that's giving you a fixed return over a specific amount of time. And so that's the inflation risk that you're taking on when you purchase fixed income securities. Yeah. And I think it might be worth using the same hypothetical example from the very beginning of the class here. So remember, we have a 10-year bond from Microsoft and we bought the bond for $100. It pays $5 a year in interest. And then of course, at the end of 10 years, we are also going to get our original $100 back in a lump sum. Well, all that money we're going

to get from Microsoft in the future is fixed. It will not change. But if there is very high inflation in the future, then it means that the same amount of money won't go as far. It won't be able to buy as much stuff. That's what the definition of inflation is. And so in a way, when you buy a bond, it's like you're making an educated guess that inflation won't do that. Or at least you have to factor in what you expect inflation to be when deciding whether you want to invest in the bond.

It's one of the risks that you have to take into account. Yeah, I think for any investment that you make, it's important to do your homework. One of the biggest risks when you think about investing in bonds is interest rate risk. And that is the risk that the value of the bond that you're holding goes down when interest rates go up. We should first stop to note something that we have not brought up yet, which is that you can buy and sell bonds after they have originally been issued. So if, for example, you buy a 10-year bond from a company for $100, as in our hypothetical example, you can sell that bond after two years if you want,

but the price of the bond will no longer be $100. And Vicky, this gets to your point about interest rates. One of the things that can change the price of the bond is if interest rates throughout the rest of the economy change, because the interest payments that we get from that bond are fixed, but the rest of the economy is now using new interest rates. I taught fixed income securities for almost 10 years at Cornell. And one of the biggest principles that I tried to reinforce in my class, and so I told my students, if you don't remember anything from this class, you need to remember this. students, if you don't remember anything from this class, you need to remember this. And it's that the price of a bond changes in the opposite direction to interest rates. So if interest

rates go up, bond prices go down. If interest rates go down, bond prices go up. So yeah, let's use our hypothetical example one last time. But this time, let's say that interest rates throughout the rest of the economy have gone up. In other words, that there are new bonds being issued with higher interest rates. Well, we originally bought a $100 bond that pays 5% a year and lasts 10 years. But let's say after a couple of years, interest rates go up and now there are new bonds that pay 7% a year,

which means that the value of our bond has gone down because there are better options out there for people to buy, other bonds that pay more interest. So if we want to now sell our bond, its price will have to go down. We won't be able to sell it for the same amount that we bought it because interest rates went

up and so the bond price went down. And that's why bond prices move in the opposite direction as interest rates throughout the economy. Yeah, that's a great way to characterize it, right? So the value of this stream of cash flows is not as great as it used to be when interest rates rise. All right, Vicki, one last question. It might be the most important question. Do you know any good bond market jokes?

No. I looked around. I couldn't find any. I didn't know I was supposed to bring jokes. You weren't supposed to. I was just wondering if you had any. I was going to bring the jokes, but I couldn't find any good ones. Okay. I mean, you know, that sounds like a challenge. After we finish, I'm going to have to go back and see if I can find a bond market joke.

This is a great homework assignment for extra credit, right? For students. And for our listeners who want even more extra credit, don't just send us bond market jokes. Also send questions that you might have about anything we have covered throughout Planet Money Summer School. Send those questions to planetmoneyatnpr.org, and we will answer as many of those questions as we can in an upcoming Planet Money newsletter. Again, that's planetmoneyatnpr.org for your questions and, sure, bond market jokes if you can find them.

And finally, before we let you go, some vocab words for you. The three kinds of risk that come with investing in bonds. Default risk, that you won't get paid back. Inflation risk, that the purchasing power of the money you make on your bonds will be eroded by rising prices. And interest rate risk, that interest rates will go up in the rest of the economy, so the value of your bond will decline. And that's it for the bond market. The next class is a fun one. We will be discussing all things financial bubbles, what they are and how they affect us, and why financial bubbles are what they are and how they affect us, and why financial bubbles are the only possible answer to the question,

what do stocks and bonds have in common with tulips, bicycles, and beanie babies? See you then. This is Season 2 of Planet Money Summer School. If you want to catch up on Season 1, the easiest way is just to Google Planet Money Summer School, and you'll find a page where you can see all of last year's episodes on how to think like an economist and even a final exam for when you're done. Planet Money Summer School is produced by Audrey Dilling with help from Alexi Horowitz-Ghazi and Isaac Rodriguez. It is edited by Alex Goldmark. Our project manager is Devin Meller, and special thanks

to Liana Simstrom. I'm Card Meller, and special thanks to Liana Simstrom. I'm Cardiff Garcia, and I'm also the host of my own podcast called The New Bazaar, to which you can now subscribe at all the usual podcast places. And that's bizarre like the marketplace, B-A-Z-A-A-R. Planet Money is a production of NPR. Thanks for listening. production of NPR. Thanks for listening. And a special thanks to our funder, the Alfred P. Sloan Foundation, for helping to support this podcast.