(Please note that I have read several books on the subject of asset allocation and fixed income securities before arriving at my opinion, including "The Art of Asset Allocation" by David Darst, "The Aggressive Conservative Investor" by Martin Whitman, and "Unconventional Success" by David Swensen. I would advise any novice or serious investor read books authored by investment giants such as these before arriving at their own conclusions.)
It's often overwhelming thinking about investing, let alone getting involved in the actual process. Researching stocks, purchasing investments, and hanging on through the emotional and financial highs and lows can certainly take a toll on even the strongest of investors. Perhaps the most nerve-racking issue for many novice and seasoned investors alike is asset allocation, and asset class selection. Many portfolios fail before they are even created simply through misallocation, chasing returns, and misunderstanding various asset classes and their correlations.
One of the most difficult asset classes in which to invest is the corporate bonds asset class. The novelty associated with them is simple: corporate bonds provide a premium over government bonds and government treasuries, with "less risk" as compared to corporate equity (preferred or common shares). As with equity, there are many types of debt securities that an individual can invest - regular corporate debt, convertible debentures, junk bonds, etc. The variety of private debt available to public investors alone should caution the average investor.
While corporate bonds can provide much higher returns than Treasury or government bonds in shorter timeframes, it is simply a matter of risk vs. reward. Corporate bonds attract higher yields the more doubtful their interest payments become. If an investor is fortunate to find a high-yield bond that performs well, great! You can outperform Treasuries, at least in the short run. I argue there are several problems with investing in corporate bonds that are both deep and resoundingly negative.
1. Callability: One of the biggest issues with corporate debt is the result of callability. Many investors buy into higher yield debt, expecting to be the next Michael Milken. Unfortunately, usually, investors of debt junk debt, or even lower grade investment debt face the unenviable and helpless callability of debt. You see, as debt becomes more attractive to investors, providing higher yields, the greater the chance that the debt will be called in the future. If a company starts with a lower debt rating, such as a CCC, it will garner a higher coupon rate than a similar bond holding a higher debt rating, such as BBB or AAA (a rare debt rating to achieve). If an investor were able to successfully decipher that the CCC company had attractive future prospects, or was "turning the corner", they may believe that they can achieve greater returns with less risk - a perfectly acceptable conclusion. The issue, however is that, as bondholders, the investors are unable to stop the corporation from calling their debt (literally buying them out - or more generously termed refinancing), in order to reissue debt at more favourable terms. Although investors may be astute in finding a great investment opportunity, they will fail to reap the rewards as a debt rating improves. In the meantime, the shareholders reap maximum rewards of the turnaround company, as the interest load decreases, and cash flow increases.
2. Risk: Most investors have been educated to believe that debt is less risky than equity, and therefore any debt security investment is valuable to individuals. In my opinion this is simply untrue. Consider the situation: a corporation continues to show deterioration in its operations, and this begins to hinder its debt ratings. As debt ratings decline, interest yields need to increase, and the market value will continue to fall to meet investors demands for risk premiums. An investor in these debts would hardly conclude that they are experiencing less risk. In fact, one could argue that the risk of such debt is similar to equity itself. In the quest to decrease risk and reduce portfolio correlation, corporate debt hardly provides assistance to either of these goals.
3. Risk premium: Currently, corporate bonds carrying a triple A rating (AAA) carry a forecasted yield of 5.53% (source Moody's Corporate Bonds Yield Forecast, July 2008, http://www.forecasts.org/). At the same time, the 30 year U.S. Treasury Debt (also carrying a AAA rating) carried an arguably risk-free projected rate of 4.52% (http://www.forecasts.org/). The 1% premium is hardly conducive of adequate risk-reward payoff, when considering many companies have lost their coveted ratings in the last ten years, including the likes of Coca-Cola and 3M. At last count (April 2008), there were only six companies in the United States to hold AAA ratings, and only two, Exxon Mobil and General Electric have held these ratings since 1980. Considering the risks associated with holding bonds, even of the most highly regarded debt-worthy companies, the risk premium is just not there to justify purchasing these bonds either.
To conclude, in my humble opinion, any purchase of corporate bonds, even the most trust worthy of such bonds, fails to provide ample reward for individual investors. In my eyes the results are clear: (1) corporate bonds fail to reward investors for their intuitive research and insight, as bonds are called before they provide the great returns; (2) the risks of corporate bonds, especially in tougher economic times (like the times we are experiencing now) hardly provide any portfolio protection or diversification from equity risk that is expected (too highly correlated to equities) to warrant introduction of a large investment in them; and (3) even the most highly rated corporations fail to provide ample risk premium versus the risk free Treasury rate available in the marketplace. In light of these results, I have maintained minimal exposure to such assets (under 2% of my portfolio), and believe that all but the most sophisticated investors should keep minimal allocation in these securities. Most of my fixed income securities are held in e-Series TD CDN Bond Index funds to reduce my fees, allow for multiple monthly purchases, and avoid risks associated with more "profitable" endeavors in the fixed income space.
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