Loading

wait a moment

How and should you even invest in bonds? [Part 1]

start trading binary options

I get this question a lot, so I thought I discuss it in-depth in the next few articles. The post is geared towards investors based in Singapore.

Bond Fundamentals 101

The best way to think about bonds are that they are essentially IOUs.

Imagine a friend came to you looking for an investment. He has been working in the F & B industry for a couple of years, has saved up some money and is looking to come out to start his own café.

He doesn’t have enough money for the equipment and staff on day 1, and needs additional money to start his business. He owns a flat that is fully paid up, and some savings which he will invest into the business if he can find enough partners.

Now there are two ways you can invest – either the equity or the debt.

If you invest in the equity (i.e. buying shares of his newly formed company), you stand to make a lot of money if his café succeeds. However, there is no guarantee of this and how long it would take.

If you agree to lend him money however, you are “guaranteed” a fixed payment of interest and your principal back at the end of let’s say five years.

You agree to lend him money at a fixed rate of 7% payable semi-annually, and for him to return you the principal (i.e. what you lent him on day 1) at the end of five years.

Depending on your risk appetite and investment goals, you are going to gravitate towards either the equity or debt. Lending money for a fixed return for several years will sound very appealing to those who like certainty and the “guarantee” that the money will be paid back.

What most people miss out is that regardless of whether you invest in the debt or equity, you still need to analyze whether you think the business is going to work out or not.

If the business fails, it is very unlikely you are going to get any of your initial investment back even if you invest in the debt portion of the business.

Now, you could make the investment less risky by asking him to guarantee the principal by pledging his fully paid up property as collateral in the case the company fails.

The fundamental problem is that if he does that, the investment does indeed become less risky, but why would he pay you 7% if you are taking on less risk?

He would be able to get a better loan rate from the bank in that case if he was willing to pledge his property as collateral.

What I am trying to drive at in the above case study is that there rarely is a free lunch when investing in bonds. Borrowing at a higher rate often entails taking more risk (whether you know it or not).

 

My biggest problem with bonds

My biggest gripe with investing in fixed income instruments is that many a time, you are literally trying to pick up pennies in front of a steamroller.

Right now the Singapore Savings Bond yields about 2% (if you have more than $200,000 SGD to invest, various banks offer in excess of 1.85% as now).

Every additional extra percentage point of return you get entails taking more credit risk (i.e. the company not being able to pay back).

My own observation and research indicates the threshold for not taking real credit risk (assuming a maturity of about 5-6 years is probably in the region of 3.5% which is an extra 1.5% a year.

That’s honestly not a lot for the amount of work that goes into due diligence which I will talk about later.

Let’s unpack this for a moment.

A lot of people think that bonds are “less risky” than equities and therein lies the problem. This is one those good ideas that is stretched to the extreme and becomes illogical.

There are good bonds and bad bonds just the same way there are good companies and bad companies.

Investing in a bond of a company with incompetent management (or worst, fraudulent management) doesn’t make it any safer in my mind even though you are investing in the debt and not equity.

Likewise, I strongly believe that investing in the equity of the right business (or a low cost index fund for the long run) is far safer any day than investing in debt of a lousy business.

Now I understand that a lot of people will say that investing in stocks is risky because of the volatility and that makes them uncomfortable.

I completely get that.

The problem is saying that and investing in high yielding bonds doesn’t make your investments “less risky”.

It is just wishful thinking that doesn’t reflect the reality of the investment space. Wishing for something doesn’t make it true.

Just because I would love to buy fast growing companies paying good dividends with no debt and insanely cheap valuation ratios when the sentiment is good, and people are happy doesn’t mean I can.

That is just not how the market works.

The same thing applies to bonds. I agree that stocks carry inherent risks that you should be aware of but so do bonds and you really must understand what you are getting into.

 

Risk Free Rate, Research Hurdles and More Woes

You can think of the risk-free rate as the cost of borrowing where you take virtually zero default risk. In Singapore, your benchmark would be something like the SSB or a 12-month FD rate.

Again – going back to my own research, I would say that the point whereby you take on little credit risk yields you somewhere in the region of 3% to 3.5% for somewhere in the region of a 5-year maturity (your mileage is going to vary according to what you think real credit risk is but lets just run with my numbers for now).

Now, once you start pushing past that hurdle rate and look at bonds with higher yields, you are starting to take on real credit risk. Typically, in your due diligence process, you would be looking at things like:

  • Understanding the business model
  • Stress testing the financials
  • Due diligence on management
  • Country specific risks (bonds in emerging markets or developing Asian markets like Indonesia offer higher yields but come with their own risks)
  • Currency risks
  • Bond covenants
  • And so on.

If this looks familiar, it is because it almost the same process that I would take looking at when analyzing a company to invest in its equity!

I understand that many investors are not “greedy” in the sense that they are looking for returns somewhere in the region of 5% to 6%. However, this just seems like a lot of work trying to weed out companies that could potentially default for an extra 2% to 4% of return.

 

Trust me when I say you don’t want to be involved in a restructuring process

About three years back (how time flies), I wrote that I was quite interested in investing in distressed bonds in the O & G sector. I shied away from it given my own unfamiliarity with the restructuring process in Singapore but stayed a passive observer over the last few years.

The next section is based on my interactions with a huge number of people who have had to go through the restructuring process themselves.

You really do not want to be involved in a restructuring process. Period.

Many of the fixed income investors I know are typically much older (40+ to retirees) and I appreciate that many of them are investing with the view of getting a secure stream of cash flow post retirement.

A big reason cited is that they want peace of mind and not to think about price fluctuations.

Being involved in a bond restructuring process is about as disruptive to your life as you can imagine.

First off, the sums invested in single bonds are huge. Every single bond is a significant amount of money for the vast majority of the investing public.

The paradox of it being “less risky” has also led investors to invest more money than they ordinarily would have in “risky investments”.

When a business goes into restructuring, you can imagine the pain and anguish that accompanies it. These are hard earned savings over years or  decades that we are talking about.

Secondly, investors are really outclassed and at a huge disadvantage when trying to figure out what is happening. Put it bluntly, the management team not only has an obligation to its debt holders, but its shareholders, its employees and obviously their own jobs too.

They have the ability to make use of company resources to hire lawyers to guide them through the restructuring process.

Individual investors on the other hand lack the resources to do so easily. Imagine trying to understand what bond covenants are or figuring out what legal recourse you have.

Sure, you can hire a lawyer, but try to remember that you’ve already just lost huge amounts of money.

Good legal advice is not cheap.

I’ve seen investors band together to try to salvage their investments but again this doesn’t subtract from the energy expanded and resources drained.

Thirdly, the restructuring process can take years to unfold. I know investors “just want to get their money back” but that is not how the process works when a company is restructuring.

The best way I can describe it is that the restructuring process is really like a divorce. Both parties mistrust each other and just want it to be over and done with. The “divorce” is going to take far long than you want or think and when it gets acrimonious, both parties are going to try to extract the best deal for themselves.

Sure, some divorces end amiably. More often then that not things go south pretty fast and it gets messy really fast.

In short, it is true that bond investors are better protected then equity holders in the event of distress and restructuring. The reality is that you can expect a lot of pain even if this holds true.

 

Get binary options 100 bonus