Weekend Wondering: Mentors, Corporate Bonds and Returns

DISCLAIMER: the following does not constitute investment advice, the information is provided on best-effort basis and the author is not liable for accuracy of the information presented

There are few simple yet important lessons that I have learnt to appreciate over the little time I spent doing trading.  A wise mentor once said, “there are three types of people: those to make it happen, those who watch it happen, and those who wonder what happened”. Wondering isn’t a bad thing, it allows thoughts to crystalise, and often offers perspectives.

This weekend, I came to realise that whilst academic findings often do not predict empirical observations, alarm bells should ring when empirical observations converge to academic findings. And here I recall yet a simple conventional wisdom that was passed down years ago by another mentor – “everything is connected”. A phrase succinct and simple on surface, and understandably, does not mean much without context and perspectives.

The perspective was the strong rally in Singapore Government Securities (SGS) last Friday afternoon, the very same day US nonfarm-payroll numbers were expected. Before answering the question of “how corporate bonds performed”, I decided it was more interesting to return to fundamentals – what are you buying when you buy corporate bonds?

With yet thanks to another mentor, it’s easiest to understand the capital structure of a company via the income statement. The company generates revenue, pays costs to run the business – and then comes interest payments (non-payment is an event of default, here is where most bondholders sit on the capital structure). If the business is still in the money after paying interest, then comes taxes – only then comes equity (dividends, retained earnings etc.)

So with this picture out of the way – we can then say that equity investors try to attach a price to the earnings risk of a company (and alongside any related events such as dividends), and as bondholders – you are really attaching a price to the risk of a company to repay obligations you set forth in the first place. I.e. at what rate would you lend money to this company for a given number of years? But interest rates don’t stay constant, and therefore instead of deciding an outright rate, we often look at risk-free rates. In short:

Credit Premium    =   Corporate-bond yield    –     risk-free rate

There was a need to get this out of the way, because here is where the elephant of the room gets introduced – “everything is connected”

In equities, you are taking earnings risk of a company, you price earnings risk, but in credit you are taking repayment risk of the company – i.e. if risk-free rates move upwards and your corporate-bond yield did not reprice, that means credit premiums are now lower. In short, if 1 year ago you could lend money to the government for 5 years at 5% per annum, and company X issued a bond at 10% coupon, your credit premium is 5.00%. But say 1 year later today, 4-year interest rates are now 6%, and your bond is still yielding 10% – would you continue lending to the same company at only 4.00% above risk-free rates, assuming that the repayment risk of the business has not improve/deteriorated from a year ago?

As for everything in life, it’s not a simple dichotomy of “compress means sell; widen means buy”. The trick is always where to draw the line – and for that there is no modus operandi. But what I’ve been taught, by yet another mentor of mine – is to always have a game plan. And so whilst lying down for a break during climbing, I decided it would be interesting to scan the Singapore corporate-bond universe to compare a corporate bond’s performance against its equity performance since inception. It gets a bit academic now, and I realise it is often not predictive of empirical observations, but I thought it would be interesting because:

• Assuming equity price changes reflect earnings risk of a company, it would somewhat reflect repayment risk of the company too
• When compared to the credit returns of corporate bonds (i.e. stripping out weakening of bond prices due to changes in risk-free interest rates), they should exhibit some connection

And here I answer the question which I had asked above: “so how did corporate bonds perform?” by presenting below, a list corporate bonds in the SGD market where credit- and equity-returns have differed by more than circa 50%:

So much for wondering…