Which best describes how an investor makes money off debt? This was a question we received this week from a client who became interesting on the subject of debt as interest rates have been rapidly moving all over the world. Whenever the Fed increases or decreases their interest rates or interest rates naturally move up or down, debt comes to the forefront of financial conversations. The answer to the question “which best describes how an investor makes money off debt?” is not as simple as many people think as investors can make money from debt in many different ways besides the standard bond.
This is going to be a fun article. As with most articles, we do not give answers that are the most obvious as we try to think outside the box and give our clients and readers of this blog as many different perspectives as we can. The rest of this article will help explain the answer to the question: which best describes how an investor makes money off debt?
What is Debt?
We can simplify this for people who would like our definition of debt.
Debt is money borrowed to fund an initiative or purchase. For receiving that money, those who take on the debt (borrowers) agree to pay that money back at a later date and (in most cases) pay interest for holding that money.
When debt is discussed in financial circles, most of the time people are speaking about mortgages, auto loans, or credit cards. Like in our definition and using a mortgage as an example, a lender gives the buyer of a new home (congrats!) a lump sum in order to pay for the home they just purchased and the people who receive that lump sum agree to pay it back at a predetermined date and pay interest along the way.
Which Best Describes How an Investor Makes Money off Debt? The Obvious Way…
The obvious way an investor can make money off debt is by purchasing bonds. Bond are debt where stocks are equity. Makes sense. Right now, the 30 Year US Treasury Bond will pay investors 3.1% (interest rate) a year over the next 30 years to purchase those bonds and will give back the principal amount 30 years from now in full on the predetermined maturity date.
This means the following. We buy $100,000 worth of these 30 Year US Treasury Bonds from the United States government. Our agreement is the following. We agree to loan them $100,000 for the next 30 years. During that time, we will receive 3.1% on our money in the form of interest payments split up semi-annually over the next 30 years. This means we expect to receive interest payments twice a year with each interest rate payment being $1,550 amounting to $3,100 a year. Over the 30 years where the US government has our $100,000, we will receive 60 $1,550 payments which will total $93,000. On the maturity date 30 years from now we will get back our original $100,000 if the government does not default and keep the $93,000 in interest we received along the way.
Which Best Describes How an Investor Makes Money off Debt? The Not So Obvious Way…
Now to the fun part. We have already spoken about how buying bonds is a way to make money off debt. But what if I told you buying certain types of stocks was also a way to make money off debt? Let me explain.
Right now, we live in a time when interest rates are historically the lowest they have ever been.
This is a chart of the Federal Funds Rate over the last 60 something years. You might be asking why we are showing the Fed Funds Rate as opposed to something like mortgages rates since we are trying to see which best describes how an investor makes money off debt? There is a reason we are showing the Fed Funds rate.
Borrowing money from the Federal Reserve is not something an individual can do. It is something that only large banks, companies, and institutions have access to. Clearly, they have an insanely low interest rate when they borrow money from the Fed, a much lower interest rate than you or I have access to that’s for sure.
Companies have been borrowing money from the Fed hand over fist since interest rates have come down to such historically low levels. Why might you ask? Let’s look at two examples.
A company like Apple goes, “Hey Fed, we want to borrow 1 billion dollars from you, and since your interest rates are about zero, we will give you back the billion dollars plus the meaningless interest.” K, deal!
Apple takes that money and buys back 1 billion shares of their stock. Right now with Apple trading at $139.78, that would mean they purchased 7,154,099 shares. Every year, Apple pays its shareholders a dividend of $2.28 a share. Let’s say interest at the Fed right now is 0.50%. Apple borrows that billion dollars and pays itself (with the Fed’s money) $16,311,345 in dividends a year. All the while, the interest on the loan was only $5,000,000 a year. They are making $11,311,345 out of thin air.
As an investor, we can make money when we see companies who are taking on debt at interest rates that are lower than their dividend yield as they can do this hand over first. But buying back these shares does something else that can help us answer the question of which best describes how an investor makes money off debt?
Reducing Shares Outstanding
When Apple buys to 7,154,099 shares, they decrease the number of shares outstanding. If Apple makes $8.33 per share right now and they continue to buy back stock and make the same amount of money as they do right now, their earnings per share will go up because there are fewer shares outstanding. Let’s look at an example.
Steven’s stock makes $1,000,000 a year and has 100,000 shares outstanding. This means Steven’s stock makes $10 a share. If Steven’s stock company buys back 10,000 of those shares and still makes $1,000,000 a year, Steven’s stock will now make $11.11 per share and thus receive a higher valuation as the company is more profitable.
Wrapping It Up
How can we make money from debt? We for starters, we can buy bonds. On the other hand, we can buy stocks who’s dividend yield is higher than the yield on their own debt or invest in stocks who are aggressively buying back shares.