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Risk and reward: make careful bond choices

Understanding bonds, part 3

Companies, governments, individual investors need or want bonds; they are bought and sold every day by the billions of dollars.

You now know what a bond looks like, what coupon (interest rate) it can pay, how much the face value ($1,000 principal) is at first issue, what the maturity date means, and what type of entities can issue bonds.

For a refresher, see last week's column in The Royal Gazette (http://www.royalgazette.com/martha-myron/article/20161015/bonds-good-bad-and-truly-junk)

Now, for a bit more.

Bonds have credit ratings, derived from the underlying issuer — a company or government — ranging from very, very creditworthy (safe investments) AAA to the truly junky epitomised as a C Grade or lower. D classification is a bond in, what else, default. In spite of the slang name, there isn't a J for junk.

Creditworthy provides the investor with an assessment of the scale of investment risk attached to a bond. The two cardinal rules of bond ratings:

1. High-risk speculative (not considered safe) such as double BBs to single-triple CCCs pay high interest rates.

2. Low-risk (safer, conservative) bonds pay low interest rates.

Sorry, but that is the way it is.

The safety conundrum has never changed. Investors demand higher returns, both in bonds and stocks, while failing to calculate the full investment risk (possibly zero); but, when capital market confidence is shaky, the crescendo trading pattern reverses into what has always been called the “flight to safety”.

High-risk securities (of all kinds) are sold off, and available cash flows to safe low-risk sovereign (and some corporate) debt. Read, US Treasury notes and bonds — still considered the safest investment in the world.

The interlink between bond coupon (interest rate), bond yield, and bond pricing. Readers, what do you think happens when everyone wants the safe conservative bonds? Or, what if no one wants the high-risk speculative bonds? It's as simple as shopping on Amazon — supply and demand determines the bond price and the bond yield.

Let's step back for a moment to review. A bond is a promise to pay back your principal, the face value or par, plus a coupon interest at a specific maturity time (two years, five years, ten years, 20 years, etc.).

Bonds are called fixed income because the coupon interest rate does not change, but the yield (the real interest rate) fluctuates depending upon demand. The Monkey Ward bond example of last week when issued had a face par value of $1,000, an interest coupon rate of 9.6 per cent, a yield of 9.6 per cent, and a maturity date of 20 years. After an original bond is issued, the bond security is then traded back and forth on secondary investment markets. Hypothethetically, then in today's low interest rate environment don't you think every investor wants this bond? 9.60%, just like the good old days in Bermuda. Of course! So, in the pricing process the cost of this bond gets “bid” up. Let's say you want that high interest rate so badly that you would pay $1,500 dollars (a premium instead of $1,000) for this bond. Your coupon rate is still 9.6 per cent, but is that your real interest rate, or yield? Take a guess?

The answer is no.

Why? Because when that bond matures, you will only receive $1,000 principal back, not $1,500. You will be taking a loss of $500 on the principal component of the bond. Doing the math as applied against the interest received each year, your real interest rate, or yield, is around 6 per cent.

Conversely, bonds classified as close to junk with iffy corporate structure backing — even if they have great interest rates — will sell at discounts to the par $1,000 value. Why? Investors aren't sure they will receive their principal back — so they get a haircut — in the meantime. The bond price gets bid down, discounted. Investors only pay $750 for a promise to be repaid $1,000 at maturity of the bond. This pricing pushes the yield up and falsely looks like a great idea.

However, lurking is the big ‘if'. Will I get my money back? Example: the bond defaults. Investors receive 50 per cent ($500). Is the coupon interest rate really 9.6 per cent? What happens if you and the company are lucky. You pay $750 for a bond that gives you back $1,000 at maturity. Is your real interest rate higher or lower than 9.6 per cent. Send me your answer.

Currently, some oil industry bonds are selling at huge discounts, i.e. 65 per cent. Do some research, then tell me if you think you will get your money back.

The control of a monetary system in a general overview. Investors like bonds as investments producing income. Governments, particularly, like bonds for controlling money flow, financing public debt, contributing to social programmes, shoring up treasury reserves within the country's economic system, and for capital project infusions (and years ago to finance wars).

Governments issue bonds, think of the US Treasury bond market auction that in 2015 alone issued $7 trillion in securities. Foreign countries in turn, international financial institutions, and commercial entities scoop up countless billions of these US bonds as well. China and Saudi Arabia have held very large US Treasury security positions (China the largest) but in recent months, both countries have steadily sold off billions into capital markets.

In the first of firsts last week, Saudi Arabia, facing its own large budget shortfalls brought on by the oil glut price collapse, issued $17 billion dollar-denominated worth of Saudi bonds. The event was so eagerly anticipated that tentative orders topped $60 billion. What was so special about these bonds?

Similarly, our Bermuda Government just paid off a huge amount of foreign creditors. How did we do that given we are in debt? Oh, we issued new bonds — but why wasn't the Bermuda resident population allowed to buy these bonds?

That's enough for bonds this week, readers, you have reached a saturation (or boredom) point on bonds. We Bermudians love to say: “It's got nothin' to do wif me.” That statement is highly debatable; bonds are incredibly important to the financial ebb and flow of our daily life. More in a few weeks.

One last little tidbit, the Saudi government in fiscal restraint mode last month slashed government ministers' pay by 20 per cent, and drastically reduced benefits, with speculation of more austerity to follow.

Twenty per cent, really. How does that compare to Bermuda's fiscal conservation?

Martha Harris Myron CPA JSM: Masters of Law — International Tax and Financial Services, Pondstraddler Life™ Financial Perspectives for Bermuda islanders with multinational families and international connections on the Great Atlantic Pond. Contact: martha@pondstraddler.com

Guide to bond ratings: the good, the bad and the ugly

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Published October 22, 2016 at 9:00 am (Updated October 21, 2016 at 9:30 pm)

Risk and reward: make careful bond choices

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