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A large number of retail investors are more familiar with investing in equities (stocks) than there are with bonds. The reason is simple, the “smart money” in Singapore have been recently burnt by failing bonds and defaults. Articles on our richer citizens being burnt are aplenty – here, here, here, here and here – and it’s easy to see why the average retail investor might want nothing to do with bonds right now.
Another reason is the minimum to invest in corporate bonds is usually at least $250,000 per tranche (not everyone has a quarter-million lying around) and one must be qualified as an accredited investor. MAS defines an accredited investor as a person that has net personal assets of at least S$2 million or earned an income of at least S$300,000 in the last 12 months. Do these people have more money than sense? Maybe. Are the banks too lax in doing their KYC or too aggressive in pushing out junk bonds? Maybe. There will never be a straight answer to this question, but these investors have no easy recourse in times of distress.
This article may be ill-timed as the Federal Reserve will be embarking on a rate hiking marathon, but that doesn’t mean that bonds will remain irrelevant. In fact, bond prices are inversely correlated to the federal funds rate which make bond mispricings and shocks more likely.
Bonds actually outweigh equities in terms of size. The global equities market size is roughly US$69 trillion, but the global bond market size is in excess of US$100 trillion. But due to the visibility and volatility of stocks, most retail investors usually know way more about stocks than bonds.
The bond market isn’t just large, it’s diverse as well – you have corporate bonds, municipal bonds, sovereign bonds, mortgage-backed bonds, and zero-coupon bonds. Further, within various corporate bonds, there are convertible bonds which the bondholder can convert into equity. Some bonds have equity kickers or warrants attached to it depending on how it was structured.
Usually a company only has one type of common stock but it can have many kinds of bonds. Apple’s shares are traded under the ticker symbol AAPL and it is its only tradeable class of shares in the market. However, Apple has 46 different bonds (46!). ExxonMobil has 19 different bonds. Most other companies that issue bonds do the same: they have different types of bonds – which can be intimidating and confusing for first-time investors.
Our earlier article described the basics on the pros and cons of bonds, here we shall delve into greater detail.
Most brokerages offer a basic bond table from which the investor can decide which bond to analyze in greater detail. Referencing Fundsupermart’s bond screener, here are what the columns of a typical bond screen look like:
Bonds can be highly complex as there are numerous other measures to evaluate a bond’s features like convexity, effective duration, key-rate duration, etc. But retail investors need not fret or get intimidated by these – using basic common sense can help one be a sensible bond investor.
The risks for bond investing is basically everything that’s already risky for stocks, and then some. But this interesting way of looking at risk for bonds may sharpen you as an investor.
“Bond investing is a negative art.” – Howard Marks
When investing in stocks, one rightly thinks of default as a major risk. But for bonds, default risk is taken even more seriously even for investment-grade bonds. You are forced to look at every possible way a company may default. Default doesn’t necessarily mean ceasing to pay interest, it could mean breaking bond covenants.
Covenants are legally binding and are often attached with most bonds. Covenants often forbid the issuer (company) from undertaking certain actions or require the issuer to meet specific requirements.
Example: The bondholders may set a covenant stating that Company A’s net debt/EBITDA ratio never exceeds 2, restrict its management from paying dividends (typical in private equity deals), maintain a minimum amount of working capital, retain key employees, and/or have gearing ratio not exceeding 40%. The list is endless as there are various ways to set covenants.
A company in breach of a covenant will face consequences. A company that breaches a covenant is deemed to be in technical default, which would lead to a downgrading in its credit rating. Worse, by defaulting, sometimes the lender has the right to call back the obligation. It pays to read the bond document and study the covenants carefully, and analyze if the company is realistically able to meet all covenants without breaching until the date of maturity.
Rating changes have a huge impact on bond prices. This is where Howard Marks explains how one can make money from it (by thinking inversely). Let me explain: By buying a AAA bond, you get the best quality bond the bond world can offer. However, the only way to go is down and a change from AAA to AA+ — even though it’s still investment grade — can have massive repercussions on the bond’s price, leaving investors nursing losses on a “safe” bond. It’s even worse if the bond is downgraded from investment grade to junk.
Inversely, by investing in lower rated bonds, there is a chance that there may be a positive re-rating upward. A jump from junk to investment grade has often seen an outsized increase in price. This is because many institutional investors with mandates that restrict them to only buying investment grade bonds will gobble up the newly rated bond.
An astute investor will take this mindset of viewing securities from a negative point of view first and apply that to stock investing as well. Being defensive means you might miss on out investments, but it’s better to miss some and make on a few than to hit as many as possible and lose a lot.
How do you avoid being one of those accredited investors that were burnt? Thinking hard about the risk, doing your own due diligence and never taking advice from your private banker/relationship manager at face value.
Several of the companies that defaulted were in the oil & gas sector. Some investors bought their bonds after oil prices crashed to $70 to $80 which sent their YTM soaring to double-digit levels – extremely attractive for yield chasers in a yield-starved world. Some investors who went in at those levels were betting on an oil price recovery, which would translate to more bookings (revenues) which would then keep the interest payments afloat.
But by thinking negatively, one would avoid such bonds as investments. You might perhaps miss a great money-making opportunity if the companies were rescued – but they weren’t.
By assuming the worst, the investor automatically evaluates the company in the scenario where oil prices hit $20 and analyzes if it can continue as a going concern. If it will still do ok at $20, then the price crash is a great opportunity. But if not, then best avoid it.
Reinvestment risk is one of the most ignored risks in the bond world. Reinvestment risk occurs when interest rates move:
Similarly, callable bonds are subject to reinvestment risk. Should the company prematurely redeem the bond, you must seek a new bond at a lower yield (if interest rates have fallen) or suffer a loss (if interest rates have risen). The Federal Reserve has been raising rates and is likely to continue to do so. So we’re seeing an upward trajectory in bond yields, which means downward pressure on bond prices which explains the current bond meltdown.
By using a bond ladder strategy, you can mitigate reinvestment risk by buying bonds at staggered maturity dates. This helps to smooth your returns instead of having your bonds mature all at once. And of course, as much as possible, hold quality bonds till maturity to mitigate capital losses in a rising rate environment.
Bond investing isn’t as scary as its formula nor recent news coverage portrays it to be. It’s an important asset that diversifies one’s portfolio, but as with all investments, prudence takes center stage in doing your due diligence. Just like equity, knowing how to take care of your downside is just as (or more) important than focusing on your upside.