“Do you want to go to lunch?”
“Sorry, no money, payday isn’t until tomorrow.”
“Come on, lets go, I’ll lend you $5.00 until then.”
“Ok, sounds like fun.”

One friend has just “invested” $5.00 by lending it to another. All this friend wants in return is good company for lunch. Her risk is minimal, she is lending to someone she knows will pay it back (low investment risk) and for a very short term (low inflation risk). We too can invest in the debt of others; we can be money lenders, not borrowers.

On a very simple level, this can mean lending money to someone we know and charging them interest. How much interest we charge depends on the risk involved. In this case I am speaking purely of a business transaction.  I know that lending to family and friends may have other factors that come into play, but you have to decide how to factor them in; however, looking at it strictly as an investment, you need to look at the likelihood that you will be paid back, what else you could do with the money, the inflation rate, and how long they want the money.

The likelihood that you will be repaid is the credit risk. If your conscientious brother, who doesn’t ever buy on credit, loses his job, and then wrecks his car the week before he starts a new, higher paying job, and wants to borrow enough to buy a clunker to get him by for a while, I’d say the credit risk is pretty low. If your sister, who always has her credit cards maxed out and frequently misses payments, wants to borrow money for a dress she just has to have, I’d say the credit risk is somewhat higher. As far as credit risk goes, the safest investments are those backed by the U.S. Government such as Savings Bonds, Treasury Bills and Notes, and Government backed mortgages. With these you know that you will get a specified amount at a specified time. The chance of default, of the debt not being paid, is slight.

If you are thinking of lending money to someone, you need to think of what else you could do with the money. You could, of course, spend it. You are not enjoying your money, so you need to charge your borrower for enjoying it. You could put it in the bank and earn some interest (but not much). You should charge your borrower at least that. You could buy stocks. Stocks can increase or decrease in value; if your borrower is a good credit risk, you charge less than stocks make in the long run, because you aren’t likely to lose money.

You also need to look a the term of the loan. By lending the money, you are temporarily giving up use of it. If I lend you $5.00 for lunch, and you pay me back tomorrow, that $5.00 that you return is still worth what it was. If you keep it longer–5, 10, or 30 years, it won’t be. You have to pay me the difference for me to stay even. If I lend you money at a fixed rate, the longer the loan, the more I am going to charge you because I don’t really know what’s going to happen down the road, and I want to protect myself. I may be willing to lend you $5,000 for a year at 5%, but if you are keeping it 30 years, I want more because I don’t know what inflation is going to do down the road.

Most of us do not invest by loaning money to people we know. If we invest by lending money, we buy bonds or bond funds. Bonds are simply IOU’s issued by companies, state and local governments, or the Federal government. When you buy a bond you are lending them money. They agree to pay you a certain rate of interest every year, and at the end of the term, to pay the bond off. Bond funds are run by mutual fund companies and pool peoples’ money to buy lots of bonds.

There are two types of risk mainly associated with buying bonds, credit risk and interest rate risk. If a growing but stable company wants to borrow money to invest in updated machinery, their credit risk is likely to be low. The bond will be rated A . That means that the experts who figure these things think that they will not have a problem paying this debt. If a company wants to sell bonds to finance the hostile takeover of another, these may be considered higher risk, or Junk bonds. They will pay a higher interest rate than A bonds, but you run a greater risk of not being paid at all. Bonds backed by the government generally have the lowest credit risk. They pay less interest too, but many government bonds of various types are exempt from some taxes, which makes the return better than the yield.

If you buy a 30 year treasury bond at 5% interest, I’d say it is safe to assume that if you hold that bond for 30 years you will get your principal back, plus 5% interest per year. That’s safe, right? Well, yes and no. I talked earlier about inflation and what it can do to cash investments. That holds true for bonds as well. If inflation is 6% you are, in essence, losing money on this bond.

There is another way you can lose or gain money on this bond too. It is called interest rate risk. Interest rates are constantly changing. What the interest rate is today is dependent on the rate of inflation, the interest rate charged by the Federal Reserve, the number of borrowers vs. the number of lenders, and other factors too numerous to name or explain. If you have a $1,000 government bond that pays 5% interest for 30 years, and today I can go buy one that pays 6%, I am not going to want to buy yours, and since your money is in that bond, you can’t use it to buy a 6% bond (though, of course, you can use other money you have). If for some reason you want to sell your 5% bond,
you are going to have to do something to make me want to buy it from you rather than the 6% bond I can buy today. How do you do that? By lowering the price, of course. You have to make it cheap enough to make up for the lower interest rate. This is how you can lose money on bonds even if they are “safe” government bonds. At the end of the term, the owner will get $1,000 back. This works both ways though. If I own a 6% bond and the going rate is 4%, the value of my bond goes up, and people will pay more to get the higher interest rate.

Bonds are categorized by the risk level and the term. Some bonds are only for months. They are short-term. There isn’t a lot of interest rate risk in these because interest rate changes are usually gradual. It isn’t likely that the kind of bond I buy today at 6% will pay 8% six months from now.  Intermediate term is a fuzzy category but is more than short term, less than long term. Long term is generally 10 years or more. If the credit risk is equal, the longer the term, the higher the interest rate.

You can go to a broker and buy individual bonds (if you have enough money), banks sell US savings bonds in small denominations, and you can invest in bonds through mutual funds. I’ll talk more about mutual funds in a later post.

Any questions about bonds or other debt instruments, just leave a comment and I’ll do my best to answer.

RAnn

(This post was written by RAnn, a full-time paralegal and mom from New Orleans. She has an 18 year old son, a 15 year old daughter, and a 6 year old daughter. She blogs at This That and the Other Thing (http://rannthisthat.blogspot.com) and for her Alumnae Association (http://mfaea.blogspot.com) Besides blogging, she enjoys reading, being a Girl Scout leader, and travel.)