A Key Factor When Buying Corporate Bonds
You may feel the same way I do. You loathe bond mutual funds, but if you’re going to try and build your customized bond portfolio as an alternative to a bond fund, there are a few things you should know, including one key factor that could determine the success or failure of your effort.
The headlines over the last several months have all been about the Treasury market. But the bond market is far broader than just debt issued by the Federal government. To understand what is going on, you’ll need to watch the Treasury market, along with the market for corporate debt, mortgage debt, and bonds issued by state and local governments. The pool of bond investors' choices is vast; to do a good job building a portfolio, you need to have an eye on the whole market.
In addition to the multitude of bond issuers, investors must also choose both how to structure the maturities of the bonds they buy and understand the credit risks underlying each bond considered.
Typically, the longer until the maturity date for a bond - the date the investor receives the bond's face value - the higher the yield.
In this period of historically low interest rates, going further out on the maturity spectrum with the bonds you buy has been one way to increase a bond portfolio’s yield.
The credit quality of the bond purchase will also affect the yield earned. The higher the bond’s issuer's credit rating, the higher the degree of certainty an investor has in getting paid. High-quality bond issuers can attract buyers with lower interest rates; lower-quality issuers must pay investors higher interest rates to get them to buy their bonds.
Last week I talked about the junk bond market as compared to Treasuries in 2021. While interest rates the Treasury must pay to issue new bonds have jumped this year, the same has not taken place in the junk bond market. That dichotomy reflects the market’s belief that the economy is likely to do well, benefitting companies with poorer quality credits. A good economy makes financial default less likely.
One could write a dissertation on the concepts surrounding maturities and credit quality; each has nuances affecting the yield an investor should expect. However, writing a dissertation was not my objective today. Instead, I want to highlight one factor that is key in selecting bonds for the customized bond portfolios we build. That is: we avoid the high-yield bond market.
As we’ve said in the past, we believe the most essential term in a bond contract is the obligation the bond issuer has to pay interest and ultimately repay the bond's face value when it matures. That simple promise is all that matters to our clients and us.
When we buy a bond, we expect to get paid!
What determines whether or not we are comfortable with an issuer's ability to pay is our evaluation of the issuer's ability to fund its outstanding debt. When you read a bond issuer's financial statements, you will find a section dedicated to discussing their outstanding bonds. In that section, you can learn about the amount and timing of how their bonds mature.
It is important to understand this pattern. Issuers who have large amounts of debt coming due soon, or in large blocks sometime in the future, face refinancing risk. Remember, they are obligated to repay their debt when it matures. To do so, they must either fund the refinancing out of cash flow or issue new debt. Companies have one other choice, they can sell stock to raise money to pay for debt maturities, but this is typically a last resort.
Most bond issuers will be looking to refinance maturing debt with new debt issues. This is typically how debt is repaid. However, refinancing puts the issuer at risk. If interest rates have risen or the market now views them as a riskier credit, the refinanced debt could cost them more money. In some cases, the market for their debt could be shut down if they are in financial trouble.
We avoid the high yield junk bond market because the issuers of these bonds are, by definition, already marginal credits. We do not want to expose our custom bond portfolios to the risks associated with poor credits.
You need to realize that much of the risk associated with the junk bond market is equity-like risk. For our money, we would rather be able to realize an equity return if we take equity risk. In the case of a junk bond, there is no “upside” to being right; the best we can do is collect the interest and get the face value of the bond back.
Even for higher quality investment-grade bonds, it is crucial to understand the issuer's outstanding debt maturities pattern.
Take General Electric, for example. During the financial crisis, they saw material losses in their finance division, raising concerns in the bond market. However, GE's overall debt was only 35% of capital, the maturities of their debt were evenly spread out over time, and they had mountains of cash on the balance sheet.
While the company’s credit rating slipped to Baa1 from AAA during the crisis, they were able to pay off a big chunk of their debt with cash flow, and they still had access to refinancing debt in the bond market. In light of all the problems GE faced, they still maintained their investment-grade status.
Today, the yield on GE bonds maturing in December of 2023 is 75 basis points (0.75%). That tells us investors have a high degree of confidence the bond terms will be paid.
(Nicollet Investment Management owns GE bonds in client portfolios)
Compare GE to Ford.
Like GE, Ford struggled during the financial crisis. Going into the Great Recession in 2008, Ford had a debt-to-capital ratio on the high side. They did not have much excess cash, and a slump in business had shrunk their free cash flow.
Through the crisis, Ford’s only option was to borrow more for operations and repay maturing debt. Because of that, Ford’s debt-to-capital level ballooned, which helps explain why Ford bonds are now solidly in the junk category.
Ford bonds maturing in April of 2023 yield 2.44%, according to Bloomberg. That means Ford must pay 1.69% more in interest to finance with 2-year bonds than does GE. The market considers the financial risk of repayment by Ford to be materially higher than by GE. Their financial statements show why.
That higher yield may attract some investors. Why not? Ford is a venerable old company; it has been around for more than 100 years. Clearly (they think), adding some Ford bonds to a portfolio would add to the overall return. Right?
We are not predicting the Ford Motor Company's demise, but we are cautioning you about chasing higher yields on bonds. You can’t look in the rear-view mirror to assess the risk in the issuers whose bonds you might buy. Pay attention to the fundamentals, understand the company’s capital structure and the risks they face. Always remember that the bond market does not randomly increase the interest rate a company must pay. Typically, higher rates (for similar maturities) are a clear indication of greater risk, keep that in mind and be cautious. Do your research.
If you would like to learn more about how we analyze the bonds we buy in client customized portfolios, please give me a call.