Lending from the Viewpoint of an Individual
Introduction to Lending
When it comes to building wealth, there are two fundamental paths: either you own a lot of assets or others owe you a lot of money. While both focus on different ways of holding wealth, the former is rooted in the value of physical assets and the latter in the ability to lend and generate returns. In this article, we will dive deeper into the latter, lending.
Lending is a concept that touches our lives through everyday activities, such as holding a bank account. When you deposit money into said bank account, you are essentially lending funds to the bank. Banks don't let these funds sit idle; instead, they lend them to borrowers, whether it's for mortgages, credit cards, personal loans, or other forms of lending. This lending activity generates returns for the bank, making it a profitable business. As a depositor, it's crucial to consider the credibility of the bank to ensure the safety of your funds. Essentially, everyone would prefer to lend to a top tier bank such as FAB rather than lending to the fictional Volcano Bank in Pompey Island. This is the most impactful risk to consider when it comes to lending, the risk of the counterparty not being able to repay; credit risk.
Credit risk is the potential for loss due to a borrower's failure to make required payments on a debt, such as a loan or bond. It represents the risk of default, where the borrower cannot meet their obligations, which could lead to a financial loss for the lender or investor.
Let’s now take this a step further: your banker has called you and explained that they are willing to offer you a fixed return of 5% should you lock up your funds for a year. Knowing that you most likely won’t be using your funds for at least another year, the decision sounds like a no-brainer and you go ahead and book this deposit. This form of lending is not unique to banks, and most institutions would also give you a return for lending to fund their operations. To use an example, Nike owes lenders approximately 9 billion USD worth of long-term debt. Lending to non-financial and financial institutions is commonly known as a Bond.
Bonds are a financial instrument issued by entities such as governments, municipalities, or corporations to raise capital, with a promise to pay back the principal amount along with interest at a specified future date. They represent a fixed-income investment for the bondholder, who is effectively lending money to the issuer in return for periodic interest payments.
Nike is a good example as they have built a brand of reliability and likely to stay around for decades to come. When Nike seeks to fundraise from lenders, there are many suitors. On the other hand, an institution with less credibility such as Air Canada would have less excitement surrounding their fundraising. If they were both paying a 5% return, all knowledgeable and willing investors would give their funds to Nike, leaving Air Canada with no access to funds. Let’s now assume Air Canada were to offer 9% for the same length of time, some investors will definitely have their heads turned and rather take the higher credit risk to generate a nicer amount of return; this example portrays the linkage between credit risk and promised returns.
In the world of wealth management, you can lend funds to all types of companies and governments and generate returns according to the inherent credit risk and the terms of your lending agreement, the length of which we refer to as the Maturity.
The date for which the lender is legally bound to return the funds to the lendee. This effectively allows one to know how long is left until they receive back their original funds and the promised return
Usually, most investors would require a premium to lend funds over longer terms. (e.g. Yahya would rather lend to Nike funds over a one year period and receive 5% than lending to Nike over ten years and receive 5% a year. Yahya explains that he would prefer to have visibility on when he is receiving back his funds, and the sooner the better, as it gives him the illusion of control. Although this is not always the case, and especially not in 2023.
When lending rates are higher than what generally has been the case or is expected to be in the future, most investors would prefer to lock up their funds for longer rather than shorter terms given the belief that the current high rate environment won't last. To use another example, Sanjay knows that he most likely will not be needing his hard earned savings for another ten to twenty years, and believes that this 5% rate is historically high and believes it will not last. He therefore chooses to lock this up for ten years, as he knows that if he places it for one year, there is a strong possibility that upon maturity, he may not find the same level of return.
The two examples above portray two opposite factors when lending: Duration and Reinvestment Risk. Duration refers to the risk of locking up your funds for longer periods of time; the longer the lock up, the more difficulty exists around getting back your money if you need to earlier than originally anticipated. Reinvestment risk, on the complete opposite hand, is lending your money on short periods of time and being at the mercy of the market for what your return will be when you look to re-lend your funds for return in the future.
The global bond market is estimated to be 119 trillion USD globally (reference: Securities Industry and Financial Markets Association), indicating that there are countless bonds to choose from. Bonds are categorized as securities, meaning that the contract between the lendee and the individual holding the bond can be sold to any other investor/lendee. This ensures there is liquidity in the event the lender would like to exit the arrangement earlier than anticipated; in this case, the lender would have to sell at the value of the best buyer at the time (which could be either higher or lower than the maturity value).
Understanding Bonds with an Example
With a strong history of credibility and high-quality service in the travel industry, Fujairah Airways (FA) is looking to expand its operations by adding ten new flying destinations to its services. To broaden its offerings, FA needs to purchase ten planes priced at $100 million each. Therefore, they need $1 billion.
Fujairah Airways has made financial projections and are convinced that this amount will generate $200 million worth of profits throughout the year. However, the company doesn’t have money available. One of the ways to solve the problem would be borrowing directly from investors via corporate bonds.
The company takes $1 billion from global bond investors with the contractual agreement to repay the funds within five years by the day. The contract also mentions the payment of 5% per year to the bondholders as interest paid annually. All the payments fit the pre-defined schedule.
If Fujairah Airways fails to pay any bond payments, a court will seize operations, pushing the company toward bankruptcy. Bondholders would be among the first to get the funds from the company liquidation.
The interest rate depends on credit profile and maturity. If FA had a worse credit rating, FA would have to pay more to attract the same lenders to finance their operations.
Lending represents a key part for wealth management. By understanding the intricate relationship between credit risk, interest rates, and bond maturity, investors can manage their allocations better. Moreover, the concept of lending goes beyond traditional banking and extends to corporations and governments worldwide. The flexibility and size of the global bond market, coupled with the security of contractual agreements, make bonds a compelling option for investors aiming to optimize achieving their financial goals.
As you will see consistently in all our discussions, our recommendation when investing in any form of wealth is to diversify. Therefore when investing in Bonds, our strong recommendation is to diversify between more than 50 different bonds amongst different lendees in different sectors, geographies, and maturities. And, to go about owning a diversified portfolio of bonds, it would be best to get access through funds (mutual funds or ETFs).
For a further deep-dive into the mechanics of bonds, visit our insights piece here.
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