Bond Revolution in Singapore : Lesson 8 – Making the Investment Decision
They say traders do not make the best investors. Agreed.
I am hardly a good investor because nothing I ever buy, I hold for long. Although there are some personal investments I have held because I forgot about or simply cannot be bothered look at. One good example would be a stock I bought about 20 years ago, before the CLOB collapse. I would prefer it just disappeared but I still get the quarterly broker statements, with that little measly 40 bucks there to remind me that I ought to do something about it serving just to haunt me as a bad investment decision and my ill discipline in personal wealth management.
As such, rather than commit the gross transgression of wilfully disbursing ill wisdom here, I enlisted the help of a good friend who happens to be a sort of Big Kahuna in credits to give me pointers in my amateur attempt to compile a, hopefully, not too misleading list of guidelines to present to a retail investor which I imagine to be a person like my father.
Do note that this lesson will not make a fixed income credit analyst out of you or many a 50 grand a month jobs will be lost. And that why fixed income credit analysts, which is not to be confused with a regular credit analyst, do not manage portfolios or trade ? I suspect it has got to be the occupational hazard of knowing too much perhaps ?
1. It is important to know thyself before making a bond investment decision (or any investment decision for that matter). What is the purpose of the trade, time horizon and risk appetite ?
Investment Purpose = for trading/speculation; as a hedge to equities or inflation; or for passive income.
Time Horizon = lock up period of cash. Short term (1-3 months), Medium term (>6 months – 2Y) and Long term (>2Y to maturity).
Risk Appetite = how comfortable would you be with a capital loss ? That is probably the hardest to assess because greed clouds our minds and gives us courage to be foolishly optimistic, sometimes, even in the face of danger.
Many of us do not separate the Fear vs Greed elements in our lives. The contrarian in each of us feeds off our greed, side stepping fear until reality bites. The flip side of the coin would be the herd approach and buying into “the trend is your friend” mindset and following thy neighbour.
I wish I could give a prescription for a perfect method to set thy own parameters but sadly, I have not attained a level of personal comfort myself only that I constantly reassess, ever occasionally, as my views and needs change.
2. Once the parameters are established. It is time to move on to product assessment.
Knowing the product requires a certain familiarity with financial terminology, if not just an understanding of the risks, which can be found in the previous chapters. There is little sense in plunging into a black hole of investment even if armed with a huge dose of common sense.
Approach a corporate bond from 2 angles. 1) the credit worthiness, 2) the interest rate risk and 3) the bond’s structure (including special features). The more important for the purposes of the discussion today would be the credit risk component. Interest rate risk is part of the macro environment risk and a lesson in economics.
Name familiarity is a double edged sword. Having heard of an issuer, particularly if they are a household name, lowers one’s guard and increases the likelihood of acceptance even if less homework was done. Familiar issuers will also have outstanding bonds which makes it easier to assess versus comparable names for value add.
The professional approach would be to read through the Information Memorandum which is never less than 50 pages. I suggest reading the basic termsheet for the summary and referring to the IM to check up on finer details. One would be surprised at how much company information one can glean from the IM if one bothers.
Independent research reports are also extremely useful in this part of the world, where equity reports are more commonplace. Credit rating agency reports can also be procured from banks although banks are only obliged to provide the IM and termsheet as a requirement.
What about unfamiliar names ?
The same homework would extend to a check on the country of origin. Admittedly, it could be more difficult to obtain information on obscure companies in far off lands. I do not try too hard because my premise is that if they would probably have a cheaper source of funding at home than for them to raise money in another country.
Moving on to the topic of value. One would have to assess if the coupon justifies the risk. The typical approach would be to compare the bond to other bonds of the same industry and same rating against the the risk free rate, which is the government bond yield.
Of course, that is not all. Demand and supply also plays a part. Rare names command a premium, common names are cheaper amongst other things. Rest assured, if it is a selling point, it would probably be highlighted.
Special features speak for themselves. Bonds issued off MTN programmes will all carry the same special features provided in the IM. However, standalone issues can sometimes have unique features that are necessary to assess. These could include secured assets, subordination, gearing covenants (which limits the company’s borrowing), parent company guarantees, call features and more. I am unable to cover them all in this chapter and will find time to expound further one day.
It should be safe to say that reading up should give one an idea of the financial health of the company and if it is over leveraged or has further funding needs in the future, both of which do not bode well for the credit spread.
3. If the decision is made to buy in a primary market, one would have very little time. These days, bond issues are announced in the morning and priced in the afternoon and mostly oversubscribed.
The secondary market is also prone to market movements in between.
Again, the usual drill is preferably not to chase the bond price. Leave a level that one is comfortable with and wait for the result. In the retail market, it is not unusual for the sales person to take a decent spread off the customer, as a transaction fee. Primary issues typically have a PB rebate, which is a rebate off the bond price for private bankers as an incentive for them to sell the bond to the retail market. The main reason being that diversifying the investor base will be supportive of bond prices as retail do not tend to trade as actively as institutions such as hedge funds.
4. Since the Global Financial Crisis (GFC) which we are still struggling to emerge from, it is imperative to manage investments actively. To review prices time and time again against the original benchmark comparables that were used at the outset of the investment decision.
It is not so much as to berate oneself, but to gauge suitability and any changes in personal risk appetite.
How does one hedge against credit deterioration from a retail perspective ?
That is a tough undertaking. Institutions have access to the credit default swap market for most liquid and rated names, although SGD denominated corporate bonds are not deliverable under CDS agreements, it is a decent proxy for credit.
Retail investors have no access to the CDS market and thus can only hedge themselves via short selling equity (as a specific credit hedge) or equity indices which is an imperfect option. Bond options are also not readily available as with short selling bonds.
Hedging against specific credit events is virtually impossible other than short selling the specific equity for the retail person and thus, the importance of proper investment analysis.
Hedging against interest rate rises is an easier affair. Some private banks offer interest rate swaps to clients and for those who have no access to that market, they can easily sell interest rate futures in the futures market or sell government bond futures. It may sound easy but it would be hard for the retail person to have a view on the interest rate market to form a strong enough opinion to make a pre-emptive decision.
5. A final consideration for investment I must mention is a component of market risk. That one should consider the illiquidity of the bond.
Local, unrated corporate bonds are less likely to be universally traded than global, rated names. That is a given. The OTC nature of the marketplace deems that banks are not obliged to make prices and one would have to find a willing buyer or seller before buying. There is every chance that the bond can stop trading in any instance.
Considering that banks will have less limits to trade perpetual bonds and sub debts due to their higher cost of capital (and thus, would translate to wider prices) is important to balance the higher yield one would demand as compensation.
The assumption is that the poorer the credit quality, the more volatile and less liquid the bond would be. That may not be the first thought in the initial investment decision but could cause one to rue the day in times of a crisis.
There is so much ground to cover that I do not feel that I have done justice in this little chapter. Experience and know how is not something that can be transplanted into a book let alone a mini bond guide. Yet I do think it is definitely a worthy preoccupation for me in the months and years ahead.