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Evaluating bond risk

Bonds have a reputation for safety, but these days they come with risk. Andrew Allentuck explains the risk behind the ratings

It’s tough to get off-farm investing right. Capital markets are perilous places. It’s as vital to control risks as it is to make a profit. After all, you don’t want to put all your money in one stock or even one sector or type of asset. But some assets, especially bonds, have an awful lot of risk these days.

Buy government bonds before interest rates rise, as they eventually will, and you will wind up with a guaranteed loss if you sell before the bonds mature at face value. If you hold long-term government bonds that, these days, have pitiful interest rates of as little as 1.8 per cent for 10 years or 2.4 per cent for 30 years, you will have to carry losses until you get your inflation-eroded money back or take the capital loss if you sell earlier.

Corporate bonds

The solution is to skip the government bonds and buy high grade corporate bonds that have far higher interest rates to compensate you for taking on the risk of rising interest rates. For example, you can buy a Fairfax Financial 6.4 per cent issue due May, 2021 that has recently been priced to yield 5.4 per cent per year to maturity or a longer dated Brookfield Management 5.95 per cent issue due June, 2035 recently priced to yield 5.70 per cent to maturity.

Long government bonds, in spite of paying returns that barely equal to the forecast rate of inflation in Canada, 2.3 per cent for as far as anyone can see, will make their interest payments on time and return their principal at maturity. The printing press guarantees that — government can make as much money as it needs to satisfy its obligations.

With corporate bonds, the outlook for timely interest payments and principal is not so clear. Some investment grade credits can suddenly default. Case in point: MF Global Holdings Ltd., a New York-based commodities and derivatives trader and a very important dealer in U.S. government securities. On Oct. 31, 2011, it filed for bankruptcy after it made a wrong bet on European government bonds. Headed by Jon Corzine, a former chairman and CEO of Wall Street investment bank Goldman Sachs and a former U.S. Senator and New Jersey Governor to boot, the company put billions on a bet that bonds from Spain, Italy, Portugal and other European debt-burdened European countries would rise in price when they worked out their budget problems. The countries did not solve their problems, as we know, and MF Global suffered huge losses.

Making matters worse, MF Global, which previously had investment grade ratings on its bonds, used a reported US$891 million in customer funds to make up for its own lack of cash to cover the losses which it incurred on its own account. MF Global’s fall from grace was swift, for within days of the news that it had misused customer funds — some estimates ran as high a US$1.6 billion — it was insolvent. It was the biggest default since Lehman Brothers in 2008.

Cases like MF Global are rare, for most companies slowly ascend to investment grade or slowly descend to junk. To sleep well at night, investors who want bonds to stabilize their portfolios should stick to investment grade debt.

Bond ratings

Moody’s Investors Service, one of the world’s largest bond rating agencies, compiles default data on all the world’s bonds. The data show the wisdom of sticking to investment grade debt which, though grading systems vary slightly from Moody’s to Standard & Poors to Fitch Ratings and Canada’s own DBRS (formerly the Dominion Bond Rating Service), consistently demonstrate the wisdom of avoiding junk.

Using global data, investment grade bonds have a one year default rate of just 0.02 per cent compared to a one year default rate of bottom of the barrel junk with C ratings, 9.4 per cent. Within five years of issue, 1.40 per cent of investment grade debt flops. For bottom of the barrel junk, the failure rate within five years of issue is an astonishing 43.65 per cent. Rates of failure rise with time, for it takes a while for companies to get into trouble. If you are thinking of long term investments in high yield junk, the odds are seriously against you.

The way out of the forest of risks is to check bond ratings before you spend any money.

Risk and return

You can skip the research by leaving bond picking to mutual fund managers or you can buy an exchange traded fund (ETF) that is invested in bonds. The mutual fund path involves fees usually that average 1.5 per cent, which eats up most of the interest on government bonds and much of the interest on corporate bonds. The ETF path tends to select bonds by category such as five-year corporates. The research you need to do on ETFs and mutual funds can be as demanding as what you have to do to pick good bonds.

But pick you must, for in the tough economic times that have gripped the world, the number of global corporate defaults for this year up to August 23, 2012 matched the number for all of 2011, Standard and Poors reports. By region, 29 of 53 defaulters were based in the U.S., 14 were in emerging markets, seven were in Europe, three were in Australasia (excluding Japan) and one, technically not a default but a suspension of interest payments looming as company finances were reorganized, was in Canada.

You have to judge risk by what it offers in return. The shrewd way to have your cake in the form of enhanced corporate bond yield and to balance risk is to spread default risk as bonds’ credit ratings fall.

For a Government of Canada or a provincial bond issue, one bond, perhaps a short bond for liquidity, will do. There is no risk of default. For AAA corporate bonds, hard to find these days, two or three bonds will do. For an AA level, three or four bonds. When you get down to single B, which is junk, you need perhaps 20 bonds to average out the risk. And at C level, which is how the agencies rate speculative debt, you are betting in a game of Russian roulette with three bullets in your six shooter. Even if you have 50 bonds, the odds are not good that you will walk away uninjured. Leave this game to junk bond fund managers. †

Each bond rating service has a website with free access after you go through a little bother to register:

DBRS: www.dbrs.com, Can-adian, free, and abundantly informative.

Standard and Poors: www.standardandpoors.com, all that and a vast global database.

Moody’s Investor Service: www.moodys.com, data superb, slight tilt to the U.S.

Fitch Ratings: www.fitchratings.com, French base, European and global focus. †

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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