Introduction
Bonds and Cash
When you buy bonds, you become a lender
- As a lender, you are legally entitled to interest payments each year as well as a principal payment when the bonds mature
- When you keep your money in cash, you earn interest and you can retrieve your original investment any time you want
- A stockholder is an owner; a bondholder is a lender. By buying bonds, you are lending your money to a company or a government.
- The borrower must pay you interest, which is a fixed amount of money as stated in the bond’s legal agreement (the bond indenture). On the date that the bond matures, the borrower must pay you the stated value of the bond, the principal.
Because bondholders are legally entitled to interest and principal, bonds are generally a less risky investment than stocks. The bonds of companies and foreign countries are not risk-free, however. These borrowers might not have the cash to pay what they owe, forcing them to default on your loan to them. The debts of the U.S. government, known as Treasuries, or T-bills, T-notes and T-bonds, are risk-free since the Treasury can always print money to pay its debts, and can therefore never default.
The lower the risk of default, the lower the interest rate the bondholder will receive.
You can lose money, even with Treasuries: if you decide to sell your bonds before they mature, they might be trading in the bond market for less than the price you originally paid. This will happen if interest rates rise. If interest rates fall, however, you can sell your bonds for more than their original cost — a capital gain. - If you keep you money in cash, it doesn’t need to be under the mattress; it can also sit in an insured chequing, savings or money market account, or in a certificate of deposit (CD). In these accounts, you can earn some interest (not much) without risking your principle.
The best argument for holding cash is as a safe haven until an attractive investment opportunity comes along — hopefully, in the stock market.