Bond interest rate irrelevant, if principal not returned
Continuing Series Bermuda Investment Primer Chapter 3: BondsWhen is a bond not a great investment? When the bond issuer defaults on repayment of the principal.
Investors value stocks based upon their ability to appreciate over time. Investors value bonds based on the probability of getting their money back.
Here is another truism.
The higher the rate of interest paid by a bond issuer, the higher the risk of default. Why?
What’s wrong with getting a great rate of return? Isn’t that what an investor is supposed to do, obtain the best rate out there? In theory, yes!
In practice, that rate depends on a number of interlinked factors. What many investors tend to focus on is the pure interest rate, without considering how the bond issuer is able to honour that high rate.
One Simple question. If you understand that global capital market interest rates are running around a 2% interest rate annually (or less) across the prevailing investment spectrum, and an open market bond is paying 8%, first impression can be how great is that?
The serious (and sceptical) investor research, however, will focus on financial strength (and business motives) of the bond issuer which could be a government, a corporation, a municipality, or a private construction facility. The more serious question is how are the bond issuers able to generate that interest rate of return? Is possible that that the bond issuer is taking a greater risk, projecting an ability to repay that may not be sustainable?
Illustration: a composite client case from long ago and far away, facts and circumstances changed to protect confidentiality.
In early 2000, the individual walked into a financial institution for some serious investment advice. He had a problem. He relates his investor history. Three years before, he had plunked a large tranche of his savings into some Government of Argentina and Government of Brazil bonds. Total investment, around $200,000 with 50% allocated to each government. Such a great deal the interest rate promised to be paid by both governments on these bonds was 13% per year.
Translated into maths dollar terms, the client expected to receive $26,000 per year in interest alone on his principal investment.
For about a year and a half, his expectations were met that interest arrived like clockwork every six months, right into his custody account.
According to Federal Reserve Statistics, average interest rates in 1997 for certificates of deposit and Treasury bills were running around 5%-5.5%. Thus, investors were delighted and scooped up these Argentinian and Brazilian bond offerings in no time.
He stated again that this investment opportunity a great deal for him.
He didn’t have a huge amount of savings, but if he could put the rest of his money out like this, it would be terrific. He mentioned that he felt he had been pretty successful with his investments, mostly local Bermuda shares, and a few mutual funds.
The individual felt so good about finding these investments (with that great rate of interest) that was more than double what he could obtain in a locked up for five-year term deposit.
We finally arrive at the crux of the matter, and his real concerns.
He produces a statement mailed to him by his broker. It was lengthy, with relatively convoluted legal terms, barely understandable to a layman investor.
The message was simple, but not readily obtainable by the small investor. All major financial news media (Bloomberg, etc) had reported the announcement from the Argentinian government that bond holders were being offered 30% of their original principal investment. In essence and in fact, the Government of Argentina had defaulted on their sovereign debt.
This individual was incredulous when he realised that of the $100,000 he had invested with a ‘safe’ government, wasn’t safe while $70,000 was lost forever. We reviewed the statement, and he resignedly signed off on the vote to accept the discounted balance, knowing that if he did not his chance of receiving anything back was zero.
But it paid such a great interest rate, he said to me.
Moral of the story. Don’t cry for Argentina, cry for yourself. The interest rate on a bond is completely irrelevant if your principal is not returned in full to you.
What is a bond? There is an old expression: stocks you own, bonds you loan. Just the opposite of stocks! When you purchase even one share of a company stock, you own an equity piece of that company and as a minority owner you have certain rights such as voting for the Board of Directors.
When you buy a bond or a bond fund, you are loaning money to the bond issuer, such as a corporation, a municipality, or the government. You are actually holding their liability to you. For them, it is one way to raise capital, generally, without giving control to a shareholder.
Bonds are debt. Successful bond offerings are contingent on the future promise to pay back that debt.
That promise all depends upon whether on a government or corporation has the means to make payment in the future.
Can a bond be just a loan between neighbours? Maybe. How about a loan for your house? Maybe as well, but more slanted toward the bankers as they are the ones receiving interest payments, not you.
Always be a cynic when it comes to investments. Never rate an investment a success until, and this is a big until, your cash plus a decent profit is back in your hand. Numbers on paper are meaningless bringing to life the adage, “show me the money.”
Martha Myron, CPA CFP (US) TEP JP is an international Certified Financial Planner™ providing Financial Counsel for Cross Border Living™ on international tax, estate, and retirement strategies for Bermuda residents with US connections, and US citizens living and working abroad.