Heads You Win, Tails I Lose

When investors buy bonds, they sit across the table from a sophisticated adversary. The fixed income market does not attract the most gifted analysts, as the money is in the equity market. This is ironic, because the job is more complex. Corporate bond investors need to understand all the issues affecting equity valuation, for this is what is underpinning a company’s solvency. Businesses do not fail for lack of contracts, clients or inventory, but for lack of cash flow.

Many investors hold bonds in their portfolio for safety. This may be misplaced. US Treasury bonds trade in the deepest, most liquid market in the world, meaning that you can easily buy and sell at realistic prices. Default-free, non-callable, full-faith and credit obligations of US sovereign debt play a valuable role in protecting a portfolio in times of financial crisis. A study of market history shows us that the same is true of the less liquid gilts (the UK equivalent of the US Treasury). However, looking for safety in Europe is more difficult, as it has a central bank but not a treasury, and does not issue collective debt.

Unlike US Treasuries, corporations often issue debt with a ‘call’ option, giving the issuer the option to redeem or call the bonds after a certain date at a fixed price. If interests rates decline, companies exercise the option, call in the existing bonds (now paying a higher rate of interest than the market) and re-issue debt at a lower rate of interest. If interest rates rise, bond prices fall and the bond holder now holds a lower interest yield bond which shows a capital loss. High yield bonds present investors with the same callable disadvantages as investment grade bonds, with an increased risk of default. High yield bonds below investment grade are called ‘junk’ bonds for a reason. Caveat emptor.

It is a mystery why corporate bonds do not contain a ‘put’ option for the bond holder (an option which would allow the bond holder to enjoy the right to sell – put – the bond back to the issuer at a fixed price during a specified time).

During the past 30 years it has been easy to make money in bonds, as interest rates have declined to historic lows. This is no longer the case. Furthermore, investment grade corporate bonds, high yield bonds, foreign bonds and asset-backed bonds have characteristics which make them vulnerable in times of crisis, which argues against including them in a portfolio for investment protection.

Liquidity provides little value to the long-term investor, however corporate bond issues are much less liquid than government treasuries. Investors should examine whether they are adequately compensated over treasuries for the credit, liquidity and call risk they are taking, and not harbour false expectations that they will provide a safe haven in times of a crisis. They won’t.

Jeremy Blatch TEP
Society of Trust and Estate Practitioners Logo

This article was also published in the online and print editions of the Sur in English