August 24 2012
CORPORATE BONDS
The Federal Reserve has indicated strongly that if it does not see an acceleration of growth soon (as opposed to a continuation of GDP growth between 1 and 2%), it will return to its “quantitative easing” program. This means outright purchases of bonds. That is, rather than lending to banks (with government bonds as collateral) for the sake of inserting additional liquidity into the financial system, the Fed’s goal is to directly raise the price of long-term bonds. Raising their price is equivalent to reducing their yield. In turn, the Fed hopes, this will provide an incentive for households, companies and local governments to borrow and spend. I personally do not believe this will be any more effective than previous similar programs. But, that’s not the point here. Rather, it suggests that the low yields on government bonds will continue (unless the economy breaks out of its lethargy sooner than the central bank expects).
Investors looking for yield in the bond market, therefore, must look away from Treasuries. (Investors willing to abandon bonds can find yields in other markets. In previous issues of this Report I have presented how our firm has utilized high dividend paying stocks, buy-writes, REITS and other strategies.) We have been putting client money into corporate bonds for a long time. Here’s a brief survey of the market, and its risks.
Corporate bonds are a member of an asset class identified by “Credit Risk.” Definitionally, credit risk means risk of default, one cause of which is bankruptcy. More on this later. The class comprises:
– Sovereigns, or debt issued by governments. Investors now accept the possibility that even “industrialized” countries can conceivably default on their debt.
– Emerging market government bonds. Also known as sovereigns, but the market uses the “emerging market” label for countries with greater risk (and history!) of default. What determines a country falling into the first or second category is not totally transparent (and I hope to devote a future issue of this Report to this topic).
– Agencies. These are quasi-government entities which issue lots of debt. The best example is the old “Fannie Mae” – Federal National Mortgage Association. Most governments create entities like this to support particular areas of their economies. Emerging economies, in addition, have national “development banks,” which function like agencies and borrow lots of money which they then lend.
– Supra-nationals. Crazy word, no? These are entities which “lie above” any individual country. The World Bank is the biggest example. (The International Monetary Fund would be one, too, but they get their finds directly from governments, rather than borrow in the open market.)
– High grade corporates. Corporate bonds issued by companies rated BBB and above by credit rating agencies.
– High yield corporates. Bonds issued by firms rated below BBB. Note that they should really be referred to as “low grade,” to be consistent. Wall Street is smart about labels!
– Asset-backed securities. You thought these would go away after the financial meltdown of a couple years back? They haven’t, and they shouldn’t. Here’s a typical type: A sponsor buys consumer “receivables” (e.g., car loans) from a bank. Puts them into a legal entity, commonly a Trust, which then issues bonds, the proceeds from which go to paying the bank for the assets. Voila! The attraction to investors is that these bonds pay more than Treasuries (anything pays more than Treasuries today!). Furthermore, the Trust issues bonds along a continuum of credit risk and associated yields. Investors, therefore, can choose the yield-risk pair that fits their needs and risk tolerance.
The last few sentences bring up the key point about corporate bonds and the others on this list: credit risk. I need to leave this for a later issue, where I’ll discuss all sorts of risks presented by corporates: credit, interest rate, call, and more. I’ll explain the difference between credit risk and default risk. I’ll go through senior vs. subordination, secured vs. unsecured, fixed vs. floating-rate. I may even talk about credit derivatives! Finally, something to look forward to.
