Bond Revolution In Singapore – Lesson 2 : Risky Business
Bond Revolution In Singapore – Lesson 2 : Risky Business
There is always risk abound and around us. For me, there is nothing more risky than buying strawberries because they are invariably sour over here and I hate to artificially sweeten them.
I am hardly qualified to give a lesson in risk and have every confidence I will miss out something here. Nonetheless worth a shot mainly because I am so bad at it, I can only hope to make sense to an audience who is, I boldly assume, less informed than me.
We shall not talk about banking risk today. None of that Value At Risk (VAR) models and liquidity risk, all those taboo words I cringe and dread to hear.
This is a layman risk lesson talking about good old fashion common sense risk in buying a bond, of course.
People tend to assume that bonds are less risky than stocks and yet harder to access and assess. TRUE ! Bonds are indeed more complicated to understand and yet, it also means that you are not doing your stock analysis properly. To be honest, I suspect that is mainly because people buy stocks on different time horizons and a speculative nature of investment.
Let’s start.
Shall we say there is intrinsic and extrinsic risk ?
Intrinsic risk would be the bond itself and would directly affect the paper that you own. It is the risk of the sour strawberry.
1. credit risk of the issuer and we know even governments can fall. Even apparently solid companies and governments may not have sound borrowing strategies. This leads to cash-flow problems when they have to repay too much debt in a short period of time and the financial crisis of 2008 has proven that.
When a company pays more to borrow, the prices of its existing debt would automatically or rather, logically, be discounted to the new borrowing price.
The tricky nature of issuances these days, I notice, is that companies complicate their debt by issuing out of a subsidiary (they call, at times, a funding vehicle). These subsidiaries are guaranteed but not public listed. We will save this topic for another day.
There are books written just about how to assess credit. Suffice to say, I have not read that many of them and I would like to take this opportunity to debunk the theory of a risk free asset here.
2. duration risk is the tenor of the bond. Technically, we should be compensated with a higher yield for longer dated papers because our money is locked away for a longer period of them.
For floating rate notes whereby the interest rate is not fixed, the duration risk still does matter but can mostly be expressed in a wider spread you receive.
There are several exceptions to this including the interest rate outlook which is covered below.
3. seniority of the paper
Rule of Thumb
Senior ranks pari passu (“on par”) with other company creditors or, as in the case of banks, depositors.
Subordinated ranks under senior. In bank bonds, subordinated extends to Upper and Lower Tier Capital. Lower is usually better. Convertibles fall somewhere in this class but since we shall assume convertibles are part of equity for now.
Secured bonds (asset backed papers) is a lien over a specific asset or a loose group of assets. Usually the asset is a significant one that generates returns like a building. The impression is that senior bond holders will not have the rights over the asset over the secured bond holder.
Preferred shares or perpetual securities or just 1 notch above common stock holders. Both, technically, do not have legal maturity dates, however, there are some perpetuals that do. Most perpetuals also have several call dates along their lifetimes.
Another subtle difference. One is traded on the stock market and the other could be. Perpetuals sound much less risky to me and of course, perpetuals can do done in bulk as they could have a wholesale tranche which makes them more important to companies.
The key to perpetuals is whether they are cumulative or non cumulative. Saw a recent one labelled “old style” which meant the coupon MUST be paid; there was another one sold as a “senior perp” which meant that the bond will rank along with senior bondholders in the case of a default.
I suggest this, “WHEN IN DOUBT, ASK !”
The higher the coupon, the higher the reinvestment risk or the higher the bond price versus a low coupon bond.
Always remember, most bond mature at par, ie. to the dollar. Thus the higher the price, the worst case redemption value is 1.00.
We can talk about convexity of the curve (yes, the curve is not a straight line) later if I get enough requests. If not, get a textbook or check out Wikipedia.
5. covenants (Special features)
Common ones include change of control clause, allowing bondholders to put the note back to the issuer if there is a substantial change in ownership. There is also the loan to valuation ration that real estate companies can subject themselves to to protect bondholders. Poison puts are less common in Singapore, protecting bondholders from hostile takeovers.
Extrinsic risk is essentially the market risk you face when owning a bond. It is the risk of the strawberry going bad because it was not refrigerated or bruised from poor packaging. Hmm… poor analogy.
1. interest rate risk
This is about the most important consideration when buying bonds, given that most papers pay a fixed coupon. This is also about the most hardest risk for a layman to assess these days.
But if I was a layman, and not someone who has traded and continue to follow interest rates before, I would start with just looking at the INFLATION RATE. Now, that is dangerous too because it would make a whole lot of papers out there look quite bad if not for the abundant cash sitting in all your bank accounts.
2. political risk
This is something quite alien to this part of the world and yet the bond you buy is also somehow subject to the sovereign risk of its country of domicile and countries of operations.
Imagine a company with extensive operations in Nigeria ? Or listed in Syria ? Tricky.
Legislations also play a part. Some may know that GBP denominated Greek bonds were paid for in FULL.
3. foreign exchange/currency risk
A topic for another time. Lets assume we all buy bonds in our native currency to avoid confusion.
4. liquidity risk
Important and yet, largely ignored but many retail investors. Can you liquidate the bond in a hurry ? What price do you have to pay for that ?
Liquid bonds are bonds that always have a willing buyer and seller. In most cases, these are the government bonds. Corporate bonds, especially those bought OTC (over the counter) may not have a price in times of distress. I speak from experience in this matter.
An assumption many have is that the larger the issue size, the more liquid the paper. This may not necessarily be true.
Conclusion
From strawberries to bonds, I am more comfortable with bonds. Strawberries are just too hard.
Bonds are easy if you grapple the bull by its horns, armed with a good dose of common sense and a questioning mind.
A good building starts with a good foundation and an inquiring mind. There is no harm looking stupid and asking dumb questions like I did and continue to do.
“Knowledge is the only instrument of production that is not subject to diminishing returns.” John Clarke
Have a good day.