Concentrate in equities, not bonds

Tracey McNaughton

Escala Partners

One of the questions I’m often asked is why should I invest in a corporate bond fund when I can buy individual bonds directly? We do it with shares all the time, why not with bonds? The simple answer is because there is no prize for getting your bond pick right, but get it wrong and the consequences could be significant. So why would you risk it? A second, no less important, reason is that every bond is different and comes with several inches worth of documentation within which risks can lurk for the unsuspecting investor.

Risk is biased to the downside – so stay diversified

In the equity world, risk is symmetric. A concentrated portfolio of 30 names makes sense because an Apple or an Amazon can save your fund if one or two of your stock picks go wrong. 

Source: Wilsons

In the bond world there is no such safety net. In credit, returns are asymmetric. This means that the best you can hope for with a corporate debt portfolio is that the loan or bond matures and you get your principal back plus interest. If you lend $100 for one year at 6% the best you can hope for is you will get $100 back plus $6 in interest. This will be the case even if the borrower is Apple or Amazon. There are no prizes for getting it right. If the borrower is GE, however, your return in a concentrated 30 name portfolio is significantly reduced. The penalties for getting it wrong can be big.

Source: Wilsons

So it doesn’t make any sense to try and pick winners in a bond fund because the risk profile is asymmetric. In fact, bond investing is often described as a “negative art”.

“Since the chief emphasis must be placed on the avoidance of loss, bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance. An investor may reject any number of good bonds with virtually no penalty at all, provided he does not eventually accept an unsound one.” Security Analysis, 1934, Ben Graham and David Dodd

The corollary of there being no benefit to picking winners is there is no cost to diversification. If all that matters is protecting the downside, why wouldn’t you be as diversified as you possibly can? A bad bond in a portfolio of 300 names will have less impact on overall returns than it would in a portfolio of 30 names.

Source: Wilsons

Active management can help to weed out the problem bonds. But if there is one thing that the Lehman crisis in 2008 taught us it is that unforecastable surprises do happen. In March 2008, the US Government rescued Bear Sterns, the fifth largest bank in the US at the time. Credit analysts then assumed that a line had been drawn under Bear Sterns. Any bank larger than Bear would be rescued. Lehman was the third largest bank. Up until midnight on September 14 2008, Lehman was going to be rescued. But the arranged deal with Barclays fell through and we know what happened next.

The world of corporate debt is littered with such surprises – Enron, Parmalat, Washington Mutual, Worldcom just to name a few of the bigger, global names. Some Australian companies that have defaulted in the past decade were BIS Industries (2018), Atlas Iron (2016) and Mirabela Nickel (2013). All were companies in the energy and natural resources industries. Other industries are not immune, however. Babcock and Brown was the biggest Australian financial institution to default during the GFC and Midwest Vanadium was in the aerospace/auto industry when it defaulted in 2014.

Know your doc’s, understand your risk

The public offer document made available to potential buyers of Telstra shares when they floated was 11 pages. The information memorandum to buy a Telstra bond is over 100 pages. Unlike equities, bonds are not homogenous. They differ according to a number of factors embedded within the documentation including maturity profile, position in the capital structure, embedded options, covenants, events of default, and legal jurisdiction. All of which affect the performance of the bond. While it is prudent to read the offer docs for each share you purchase, it is even more prudent to do so for bonds given these embedded differences can affect its risk profile.

A well-known Australian example of how dangerous it can be to invest without “knowing your docs” occurred in 2012. Banksia Financial Group was a non-bank lender based in Victoria that collapsed owing $660m to 16,000 retail investors in its mortgage debentures. Given Banksia was not an authorised deposit-taking institution, and so was not supervised by APRA, the funds in the debentures were not backed by a deposit guarantee. This was in the documentation of course but many investors chose to invest anyway.

Just because you got away with it doesn’t mean you didn’t take risk

For the vast majority of the time, most bonds will mature without an issue. According to S&P, the speculative grade default rate in 2018 was 2.1%. But if it doesn’t cost anything to diversify (remember there is no upside) why would you take the risk? For an individual investor thinking about an investment in bonds, it makes much more sense to invest in a diversified fund where there are in excess of 150-200 bonds across regions, countries, sectors and rating rather than attempting to pick a handful of bonds hoping nothing goes wrong but not getting rewarded if it doesn’t. 

Tracey McNaughton
Tracey McNaughton
Chief Investment Officer
Escala Partners

Tracey was appointed Chief Investment Officer at Escala Partners in November 2019. In this role she has responsibility for strategic and tactical asset allocation and manager selection across all multi-asset funds, and is Chair of the Escala...

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