Saturday, December 17, 2016

Bonds is love, bonds is life

Hey, what is up everybody? I recently read about bonds being the favored investment instrument of the wealthy, and that made me really want to get into the bond game. After doing some research and trying to recall what I learned in university way back when I was still a bright-eyed kid filled with optimism, I could only come to one conclusion about bonds. Corporate bonds are like watching Melissa Benoist in her role as Supergirl or a warm brownie drowned in melted chocolate with a scoop of Häagen-Dazs vanilla ice-cream on top. In other words, bonds are sweeeet. To be more specific, the concept of corporate bonds is awesome as overpaying for anything can lead to disaster. Just to clarify, I’ve never invested in a bond and my knowledge of bonds is limited. However, I do think that I can share some interesting points with someone who might also be new to bonds. I would also like to say that I’ve been hearing that the US bond market is overvalued right now, so you might want to be cautious there. Aight fam, let’s kick this bad boy off with a list of the positives of owning bonds:

Update on the Greedy Dragon portfolio: I recently purchased 100 shares in GameStop at USD 25.28 per share.

1) Bonds are less risky as a slimy or incompetent management team will have a harder time fucking over bondholders than they do shareholders. Management can slash or eliminate the dividend anytime, but the company is still legally obligated to pay interest on its bonds. Management can wreck their company’s stock price by engaging in value destroying activities or issuing a bunch of new shares, but the company is still legally obligated to redeem the bonds at face value when they mature.

2) You can also make a lot of money in bonds if you buy them at the right price. I’ve read crazy stories of people, during the great recession, getting yields to maturity of 15% to 20+% on bonds of companies that were unlikely to default on its debts. Even earlier this year, you could find bonds issued by decent natural resource companies with yields to maturity close to and even north of 20%.

3) In the event of bankruptcy, bondholders are more protected than shareholders. Yes, bondholders would no longer receive coupon payments in the event of bankruptcy, and might even lose a large chunk of their capital. However, bondholders would still be better off than shareholders in that situation as bonds have seniority over equity in the capital structure. In other words, bondholders would get paid from the proceeds of the liquidation before shareholders get paid. Alternatively, there might instead be a reorganization where bondholders get ownership in the company (which is less indebted) and shareholders get significantly diluted if not totally wiped out.

4) The predictability of the bond’s cash flows is another neat thing about bonds. Imagine the amount of options you would have when it comes to managing your portfolio if you could reasonably count on large cash inflows twice a year, even in the shitty years (bonds generally make coupon payments twice a year).

5) Due to the predictability of the bond’s cash flows, it’s much easier to value bonds than stocks. You don’t have to forecast the company’s future profitability. So, the risk of overestimating future cash flows and therefore overvaluing the security is reduced.

6)The bond might contain covenants that limit how financially degenerate management can be. Covenants that require the company to not exceed a certain debt/EBITDA ratio and to maintain the EBITDA/interest ratio above a certain level restricts the amount of debt management can take on.

It ain’t all rainbows and orgasms, though. There are risks associated with bond investing. As mentioned earlier, bondholders would no longer receive coupon payments and might lose a significant amount of their capital in the event of bankruptcy. Even if you did get all your capital back, bankruptcy can be a long ass process. So, your capital could be tied up for quite some time in the event the company goes belly up. Also, the bond you invested in might be subordinate to other series of bonds issued by that same company. A series of the company’s bonds might also be secured by specific assets, so there will be less assets to pay off the other bonds in the event of liquidation. The bonds may also include terms that allow the issuer to redeem the bonds early, defer coupon payments, make coupon payments in the form of additional bonds instead of cash, and etc. For the shitlords out there who don’t like to read, bond investing is definitely not for you. It’s so important to read the terms of the bond to know exactly what you’re buying.

Some of the ways you could reduce the risk of investing in bonds is to only buy the bonds of companies that 1) generate enough cash flow to comfortably cover the interest on their debt and 2) has significantly more assets than liabilities on their balance sheet. A company with significantly more assets than liabilities is more likely to be perceived as financially sound, and therefore has an easier time issuing new bonds to pay off maturing bonds. A company with a lot of assets will also have the option of selling some assets to raise cash to pay off maturing bonds. You also reduce your risk if you buy bonds at a discount to face value. Say that company FU goes bankrupt and the proceeds from the liquidation of its assets is only enough to pay back bondholders 65 cents on the dollar. A person who bought FU bonds for 70 cents on the dollar would be better off than the bondholder who paid 98 cents on the dollar for the same bonds.

Another way to reduce risk is to make sure that the yield on the bond you are analyzing is high enough to compensate you for its credit risk. To assess credit risk, you need to look at the historical default rates and the loss given default for bonds with that credit rating. Let’s say for example that BBB bonds have a historical default rate of 5% and a loss given default of 50%, the investor should then require a credit risk premium of 2.5% to buy BBB bonds. If memory serves me right, the required yield on the bond is the credit risk premium + the rate on a government bond with the same maturity. I personally would aim higher than the required yield  because I want to earn above average returns, and because I think that interest rates in the US are artificially low. Oh yeah, the whole thing about getting paid an adequate return to assume credit risk? Well, that shit only works if you have a diversified bond portfolio. While it doesn’t always work out in real life, the idea is that on average the good bonds will generate enough profits to more than offset the losses on the bad bonds. However, it doesn’t matter if you got a high enough yield on the bond if that’s the only bond in your portfolio and the bond’s issuer goes bankrupt. All the coupon payments will be gone and you’ll be hanging around McDonald’s at fucking 3 AM because you can’t sleep as you’re worried sick about the bankruptcy process. Bond investors should also be wary when chasing yield in a stable environment. There is usually a reason why a bond has such a high yield when the overall yield on corporate debt is at historical lows. Unless you’re really good at analyzing bonds, it’s better to wait for a crisis when you can find many bonds that are mispriced relative to their risks as a result of market panic.    

So, if I think that bonds are so freaking awesome, then why haven’t I bought a bond? The answer is I’m still new to bonds and I still have a lot of learning to do before I’m confident in my ability to invest in bonds. One hurdle I see preventing me from investing in US corporate bonds is the yuge withholding tax of 30% that the US government slaps on interest payments to foreigners. There might be a way for me to reduce the withholding tax by filing some form, but I still need to do more research on that. According to my broker, you need to be an institutional investor or a high net worth individual to buy individual Malaysian corporate bond issues. So, investing in individual Malaysian corporate bonds might also be out for me. My rugged individualism won’t permit me to invest in a bond unit trust fund. If I’m not the one calling the shots, then I had rather not invest in that asset class at all.  

Bonds can be an excellent instrument for investors looking to generate passive income and preserve wealth. However, stocks have historically outperformed bonds. For someone like me who’s looking to hustle his way to the top, my portfolio wouldn’t be bond heavy unless there is a selloff in the bond market or a sector of the bond market. Whether or not bonds is a tool that will help you achieve your financial goals is something that you will have to decide. Thank you for reading. Take care and stay rational.

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