Are Bonds Really Safe?
25 January 2019
Earlier this week, The Straits Times reported on Hyflux’s town hall meeting with holders of its perpetual bonds. Many of them were grey-haired retirees desperate to know how much money they would get from their investments. They received no definitive answer, and were informed that in a liquidation scenario, holders of perpetual bonds would get back nothing.
In the search for higher yields than what bank fixed deposits provide, many investors found themselves attracted to the 6% coupons Hyflux offered for holding their perpetual bonds. They were a fast-growing Singaporean company, and seemed like a good investment. Yet what many investors forget to ask in these situations is why a company would be offering such high coupon rates in the first place.
Why do companies pay high coupons?
No company would willingly pay out higher than necessary coupons just to secure financing unless they had no choice. That is, the reason why those coupons were so high is that they were meant as compensation for the significant risk investors would be taking on in buying and holding that company’s bonds. In contrast, companies deemed safer, i.e. ‘investment grade’, can get away with offering much lower coupons and still find a ready pool of buyers.
Higher returns always come with a higher risk. Investors always say (or think) that they can afford the higher risk, until it blows up.
But I can take the risk!
Being able to accept a higher risk is not just a matter of mental strength. It is one thing to be able to remain calm in the face of tremendous loss, but even that calmness would not be able to save you from bankruptcy or restore your retirement savings. Should the worst happen to your investment, how badly would your life be affected? How many plans would be derailed?
For many of the retiree investors in Hyflux, their loss would have affected their ability to retire peacefully. Without funds they may have been depending on, they may have had to find other sources of income, or to cut back on daily expenses.
When deciding on what level of risk you can afford to take, you should therefore not just consider your risk tolerance level but your present financial circumstances. You may have a high risk tolerance but find that losing an investment could severely cripple your retirement savings. If so, you’ll have to fight your natural instincts and be more conservative in investing so as to avoid potential disaster.
How to take a higher risk safely
Conversely, you may be risk-avoidant and want nothing to do with the investment world. So you may choose to stick to fixed deposits and bank savings, but fail to realise that these instruments may not be enough to meet your financial goals. As such, you might have to consider higher risk investments in order to get the rate of returns you need.
You can still take measures to mitigate the risk – such as by starting early and having a long time horizon that will give you enough time to recoup any losses you may suffer. Historically, those who have invested money in a 100% equity portfolio of globally diversified stocks have never seen any losses after a 15-year holding period.
What do I get when my bonds default?
In Singapore, corporate bonds are typically offered in lots of $250,000 each. So, even if you have a million to invest, you can only get exposure to 4 bond issues. Each bond issue is tied to the fortunes of just one company, which means that if that company goes belly up, your entire bond investment could drop to zero in a flash.
Of course, you may hopefully get some recovery value, but it’s unlikely to be anywhere near your original investment. In the case of Hyflux, their senior unsecured creditors (bank lenders, noteholders and contingent creditors) were told they could only expect a recovery rate of between 3.8% to 8.7% in a liquidation scenario. The junior creditors holding the perpetual securities would get nothing.
Contrast this with holding units in a bond fund, where you could get exposed to over 300 global bond issues. This law of large numbers also helps you statistically, because high yield bonds (like Hyflux) have a default rate of 4% on average. So, in the event that a crisis hits, your bond fund would suffer a 4% loss – much less than the potential 100% loss you could expect if that single bond you had imploded. This is where diversification can help make a difference in your overall investment risk. The only downside is that you might get a lower than 6% coupon.
How else can I get a 6% return?
If you would still like a 6% average rate of return in the long term for an investment of $250,000 (i.e. what you would pay for a single bond issue), you could instead invest in an enhanced indexing portfolio of 70% global equities (comprising 10,000 stocks) and 30% global bonds (comprising 300 issues). At any one time, the value of your portfolio will certainly fluctuate more than a single bond issue would. However, it would be almost impossible for such a portfolio to ever reach a 0% value the way a single bond might.
In the event you find that your portfolio value has since fallen below your original invested capital, all you would need to do is ride out the investment cycle and let time help your portfolio recover. With a singular bond, that would not be possible – once the bond has defaulted or the company has liquidated, that money would be gone for good.
So, are bonds really the safer investment?
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