What to Consider Before Investing in Corporate Bonds

By Larry Swedroe | Jun 4, 2010

On Wednesday, we looked at the returns of corporate bonds and compared them with long-term Treasuries. Today, we’ll look at other factors you should be aware of before investing in corporate bonds.

Taxes
Interest on U.S. government obligations is exempt from state and local taxes. Interest on corporate bonds isn’t. Thus, if you have a state income tax, you need different yields from Treasury bonds and corporate bonds of the same maturity — the corporate yield would have to be higher.

This is why part of the higher yield investors require on corporate bonds over Treasury bonds is related to the difference in tax treatment. The other reasons for the higher required yield are credit risk, liquidity risk and call risk. (Many corporate bonds provide the issuer with the ability to redeem the bond prior to maturity.) Unfortunately, it looks like investors haven’t been adequately compensated for taking these risks over the past 85 years. And the main reason may be the call risk. Martin Fridson’s study, “Original Issue High-Yield Bonds,” found call risk to be a negative contributor to the return on high-yield bonds.

Diversification
Because Treasury securities entail no credit risk, there’s no need for diversification. Thus, you don’t need a mutual fund. Instead, you can buy Treasury securities directly, saving the expense of a mutual fund. Even Vanguard’s Short-Term Investment-Grade Fund (VFSTX) costs 0.26 percent. Other corporate bond funds can cost far more. Also, the market for Treasuries is the most liquid and transparent in the world, keeping trading costs down if you want to buy securities yourself or have an investment advisor firm do that. And you can even buy Treasuries at auctions, getting the same price as institutional investors.

However, as we move beyond Treasuries, the need for diversification increases in direct relationship to the credit rating — the lower the rating, the greater the need for diversification.

The historical evidence suggests you may be best served by excluding corporate bonds from your portfolio, using Treasuries and municipal bonds as appropriate — given their marginal tax rate.

If you need or desire more return from your portfolio, the evidence suggests that you should consider taking that risk with equities, not with corporate bonds or by adding credit risk. However, if you’re going to invest in corporates, the evidence suggests that you should stick with the highest investment grade bonds (as their risks mix better with the risks of equities) and avoid bonds that are callable.


From moneywatch.bnet.com published Jun 4, 2010

How to profit from the end of the junk bond boom

By Associate Editor David Stevenson Apr 12, 2010

When the world and his dog pile into a market as if there's no tomorrow, it's often a sign that you should do the exact opposite.

The latest headlines about 'junk' bonds are a classic case in point. You don't need to be a dedicated contrarian investor to get a bit uneasy when you read them.

In fact, there's such a buying frenzy now underway, it could even make sense for more adventurous investors to sell junk bonds 'short'. Here's how...

"Buy to the roar of cannon, sell to the sound of trumpets". This was the advice that British banker Lord Nathan Mayer Rothschild gave during the Napoleonic Wars on how to make the most of your money.

And it applies just as much today as 200 years ago. History shows that the right time to buy into a market is when financial Armageddon looms. And the time to get out is when the jitters have passed, and everyone's feeling upbeat again.

By March 2009, many investors had lost so much money in the stock market that they didn't want to know about buying shares. But if anything, they'd come to hate 'junk' bonds – lower grade IOUs issued by companies to raise cash – even more.

Even although these bonds rank higher in the pecking order for creditors if a business goes bust, prices collapsed as 'risk aversion' among investors soared.

The flip side was that the yields on some of the dodgier corporate issues climbed well into double-digit territory (bonds pay a fixed income, so when prices fall, the income yield rises). Basically, markets were saying that we were about to see an avalanche of bond issuers defaulting on their interest bills.

Some of these recession-induced jitters were understandable. Company cash flows, particularly in the US and Europe, were being savagely squeezed by falling sales and lower profit margins. In fact, by the end of 2009, the global default rate for high-yield debt hit 13%. In other words, one in seven junk bond issuers proved unable to service its debts.
Despite everything, junk bond prices have surged

But look what's happened to junk bond prices over the past year. March 2009 was, with the benefit of 20/20 hindsight, exactly the time to buy into the junk bond market, despite all those concerns.

Prices have surged, so yields have dropped sharply. High-yield bonds now pay out an average of 8.6%, says Bank of America Merrill Lynch. This may still look like a decent return, but it's actually the lowest since October 2007. That, by the way, was just before financial markets fell apart last time.

And 'spreads' – the difference between yields on junk bonds and US Treasuries – have now narrowed to their lowest levels since December 2007.

Is there much justification for this? Well, there's been a slight improvement in terms of defaults. By the end of this year's first quarter, the default ratio had dropped to one in ten (from one in seven), and is forecast to fall further throughout 2010. So fewer companies are under the cosh. But a 10% default rate is still hardly anything to cheer about.

Yet now, it seems investors just can't get their hands on enough junk. These bonds account for "the biggest share of corporate debt sales on record" reports Bryan Keogh in BusinessWeek. "Global high-yield bond sales hit $91bn this year, or 12% of total issuance, almost double last year's share, according to Bloomberg data. Investors wagering on an economic rebound are snapping up securities even from first-time issuers".

In other words, investments that couldn't be sold for love nor money a year ago are currently being bought with relish. Yet potential returns are now much lower, and some of the sellers have no market track record.

"Most of the major concerns seem to be gone", Calvert Asset Management's James Lee tells Bloomberg. "It's a self-fulfilling cycle. Cash is coming into high-yield, and high-yield managers are putting cash to work". Indeed, "it's hard to find debt that investors don't like", says Agnes Crane on Sify Finance.

Alarm bells should be ringing for contrarians

Cue Rothschild's trumpet blasts – it's time for contrarians to get worried. "Lenders don't seem to be good learners", says Crane. "To judge from the credit market, the 2008-9 crisis might never have happened. The current buying frenzy looks like a return to an old bad habit".

There may be plenty of junk bond buyers chasing yields down right now, but there are plenty more borrowers in the pipeline. We flagged in the magazine last month that $700bn of dodgy debt in the US alone will mature between 2012 and 2014, and so will need refinancing: Why 2012 really is doomsday.

Compared with just $21bn maturing this year, that will be "an extraordinary surge", says Nelson D Schwartz in The New York Times.

More corporate borrowers will have to compete with each other, as well as with cash-strapped governments, for whatever funds will be around. And as lending risks rise, much higher junk bond yields around the world look likely. Borrowers will "get crowded out or will have to pay significantly more", says Tom Atteberry of First Pacific Advisors.

All bad news for junk bond prices. But as an investor, what should you do?
How to cash in on the the junk bond boom

Clearly, not joining in the junk bond party will stop you losing your cash in it. But there is also a way you can make money here.

The ITraxx Crossover 5-year Total Return Index is a measure of the default risk of 50 of the most liquid European High Yield corporate bonds. As investors' fear of default falls, and junk bond prices rise, the Index goes up, as has happened recently. The Index is almost at its highest level since Bloomberg records began in 2006.

But if default worries resurface and junk bond prices decline, the Index will fall. And if you want to buy something that will take advantage of such a drop, the less than snappily titled db x-trackers iTraxx Crossover 5-year Short Total Return Index ETF (GY: XTC5) should do the trick. That's because it's effectively selling the Crossover Index 'short'.

It isn't without risk. Selling short rarely is, and you lose money if the index keeps rising. It's also quoted in euros, so there's currency risk too, if the pound recovers. It's also worth having a look at the detail of the ETF's construction to ensure you understand how it works. But if you believe the junk bond boom is nearly over, this could be a good way to cash in.


From money week published on Apr 12, 2010

Four Best Ways To Invest In Bonds

Michael Schmidt, 04.30.10, 06:56 PM EDT
These strategies will help you build your portfolio.

For the casual observer, bond investing would appear to be as simple as buying the bond with the highest yield. While this works well when shopping for a certificate of deposit (CD) at the local bank, it's not that simple in the real world. There are multiple options available when it comes to structuring a bond portfolio, and each strategy comes with its own tradeoffs. The four principal strategies used to manage bond portfolios are:

--Passive, or "buy and hold"
--Index matching, or "quasi passive"
--Immunization, or "quasi active"
--Dedicated and active

Passive Bond Strategy

The passive buy-and-hold investor is typically looking to maximize the income generating properties of bonds. The premise of this strategy is that bonds are assumed to be safe, predictable sources of income. Buy and hold involves purchasing individual bonds and holding them to maturity. Cash flow from the bonds can be used to fund external income needs or can be reinvested in the portfolio into other bonds or other asset classes. In a passive strategy, there are no assumptions made as to the direction of future interest rates and any changes in the current value of the bond due to shifts in the yield are not important.

The bond may be originally purchased at a premium or a discount, while assuming that full par will be received upon maturity. The only variation in total return from the actual coupon yield is the reinvestment of the coupons as they occur. On the surface, this may appear to be a lazy style of investing, but in reality passive bond portfolios provide stable anchors in rough financial storms. They minimize or eliminate transaction costs, and if originally implemented during a period of relatively high interest rates, they have a decent chance of outperforming active strategies.

One of the main reasons for their stability is the fact that passive strategies work best with very high-quality, non-callable bonds like government or investment grade corporate or municipal bonds. These types of bonds are well suited for a buy-and hold strategy as they minimize the risk associated with changes in the income stream due to embedded options, which are written into the bond's covenants at issue and stay with the bond for life. Like the stated coupon, call and put features embedded in a bond allow the issue to act on those options under specified market conditions.

Ladders are one of the most common forms of passive bond investing. This is where the portfolio is divided into equal parts and invested in laddered style maturities over the investor's time horizon. Dividing the principal into equal parts provides a steady equal stream of cash flow annually.

Indexing Bond Strategy

Indexing is considered to be quasi-passive by design. The main objective of indexing a bond portfolio is to provide a return and risk characteristic closely tied to the targeted index. While this strategy carries some of the same characteristics of the passive buy-and-hold, it has some flexibility. Just like tracking a specific stock market index, a bond portfolio can be structured to mimic any published bond index. One common index mimicked by portfolio managers is the Lehman Aggregate Bond Index.

Due to the size of this index, the strategy would work well with a large portfolio due to the number of bonds required to replicate the index. One also needs to consider the transaction costs associated with not only the original investment, but also the periodic rebalancing of the portfolio to reflect changes in the index.

Immunization Bond Strategy

This strategy has the characteristics of both active and passive strategies. By definition, pure immunization implies that a portfolio is invested for a defined return for a specific period of time regardless of any outside influences, such as changes in interest rates. Similar to indexing, the opportunity cost of using the immunization strategy is potentially giving up the upside potential of an active strategy for the assurance that the portfolio will achieve the intended desired return.

As in the buy-and-hold strategy, by design the instruments best suited for this strategy are high-grade bonds with remote possibilities of default. In fact, the purest form of immunization would be to invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be needed. This eliminates any variability of return, positive or negative, associated with the reinvestment of cash flows.

Duration, or the average life of a bond, is commonly used in immunization. It is a much more accurate predictive measure of a bond's volatility than maturity. This strategy is commonly used in the institutional investment environment by insurance companies, pension funds and banks to match the time horizon of their future liabilities with structured cash flows. It is one of the soundest strategies and can be used successfully by individuals. For example, just like a pension fund would use an immunization to plan for cash flows upon an individual's retirement, that same individual could build a dedicated portfolio for his or her own retirement plan.

Active Bond Strategy

The goal of active management is maximizing total return. Along with the enhanced opportunity for returns obviously comes increased risk. Some examples of active styles include interest rate anticipation, timing, valuation and spread exploitation, and multiple interest rate scenarios. The basic premise of all active strategies is that the investor is willing to make bets on the future rather than settle with what a passive strategy can offer.

Conclusion

There are many strategies for investing in bonds that investors can employ. The buy-and-hold approach appeals to investors who are looking for income and are not willing to make predictions. The middle-of-the-road strategies include indexation and immunization, both of which offer some security and predictability. Then there is the active world, which is not for the casual investor. Each strategy has its place and when implemented correctly, can achieve the goals for which it was intended.


From FORBES published on 04.30.10, 06:56 PM EDT