Bonds often get overlooked by retail investors. In traditional portfolio management, they are the second most important asset class after equities, but a quick search online will reveal a far lesser interest in these financial instruments compared to equities, forex or even commodities.
So what are bonds? Bonds are debt. By buying a bond issued by a company or government, you are buying a fixed date debt repayment (set at 100; the actual price of the bond may differ from this), alongside a coupon to compensate you for the risk of non-payment. Bonds are graded by ratings agencies by their creditworthiness. Above BBB is considered ‘investment grade’. Junk bonds have lower investment grades, and are considered at serious risk of default.
Some investors deliberately buy distressed debt in the hope of carving out favourable terms during liquidation. This is not a wise strategy for retail investors. Without a well-funded legal team and senior debt, this is a recipe to lose money.
Retail investors should strictly limit themselves to investment grade debt (BBB and above). One of the issues facing retail bond investors since 2008 is the extremely low yields on this debt. The yield refers to the expected profit on the bond purchase, and decreases as the price goes up. Bonds can trade at parity, or at 100, where the cost is the same as the final refunded amount. In this case the yield would equal the coupon. Bond prices can fall below this level, increasing yields. Two examples are below:
A major company with an investment grade credit rating issues a bond with a coupon of 5%. It currently trades on the market at:
- 100. The yield will be 5%.
- 95. The yield will be 10%, since there is both a 5% price increase between 95 (current price) and 100 (par), and the 5% coupon.
- 105. The yield will be 0%. The coupon is cancelled out by the price being higher than the final amount to be repaid.
The government bonds of some countries with excellent credit ratings, notably Germany and Japan, have negative yields. This seemingly strange state of affairs happens when investors are required to have a portion of their portfolios in debt. The cost of buying negative-yielding bonds is worth it to guarantee the security of their money.
The return on US Government securities (‘T-Bills’) is often referred to as the ‘risk free rate’. This is because financial calculations assume a US government default is impossible. Therefore, the return offered by US Government debt is a kind of minimum floor all other debts are measured against. Since 2008, this yield has at times been close to zero or even negative, though it has increased slightly since.
Government bonds or corporate bonds?
You are unlikely to find much yield in government bonds, unless you invest in riskier debt eg that of Latin American countries. Some countries, especially in South America, are known to fail or even refuse to pay their debts. In Europe this has also happened before in Greece. This is disastrous for investors, and has led to most portfolio managers avoiding the debt of these countries.
Corporate bonds are often a better place to look for higher yields. Be careful to check the rating of the company concerned as well as the bond. Should the firm go bankrupt, liquidators will attempt to pay bond holders but you are unlikely to recover the full amount. The bonds of companies in financial distress can trade as low as 25-30. In theory the yields are immense – in practice the fees of lawyers and liquidators destroy most of these returns. Very very occasionally, distressed debt will recover due to an improvement in business conditions.