E-mail:    

FOREX MARKET

How to choose an appropriate bond: balancing risk & reward

market watch bond risk reward

Bonds, in the sense of financial instruments, have been in circulation virtually ever since people began to accumulate wealth. The term “bond” in its literal sense means “that with or by which a thing is bound” (source: Oxford English Dictionary) and also means an obligation, a duty, or a covenant between two parties. In the technical and legal sense, it is a deed by which one party agrees to pay an amount of money (or transfer property) to another party under certain conditions and usually within a certain timeframe.

As markets have evolved and become fully internationalized, it is quite impossible for investors to have a personal knowledge of the other party that is being “bound” through the issue of debt instruments such as bonds. Even when the most sophisticated fund managers in the world employ analysts and accountants to quantify the risks involved in purchasing bonds, there are regularly nasty surprises. Investors are expected to make rational risk assessments for the bonds in which they invest, but for all but the most highly-informed investors, this is an extremely difficult task. “Argentina is a sovereign nation and will always repay its debts, right?” Wrong. “The government is supervising the financial system and would never let a bank fail, would it?” Hah. “With so many bankers, accountants and lawyers working with borrowers, everything should have been taken into account so that my money is protected, no?” Wishful thinking.

In addition to ingraining the concept of a balanced portfolio in the mind of every investor, there is one other phrase that needs repeating at every turn: no reward without risk. In the simplest of terms, the higher the return on an investment, the greater the risk. If there was no chance whatsoever that a borrower could default on its obligations, the real interest rate that it would pay on its bonds would theoretically be zero (real interest rate being defined as nominal interest rate less inflation). I would hope that after the events of the last 2 years, no one out there still believes that financiers are alchemists who can turn lead into gold. Except for a miniscule number of financial geniuses, anyone who consistently beats average returns is consistently taking above average risk with their investments. Retail investors always want to think there is a way of “beating the odds” without taking extra risk, but whether it be an insurance policy, an equity portfolio, a bond or a structured product, this simply isn’t a long-term truism.

In terms of traditional risk assessment for bonds, an approximate “hierarchy of risk” would look something like the following, with the entities at the top of the drawing representing the “greatest” amount of risk, and those at the bottom representing the “least” amount of risk:

market watch bond risk reward

One has to be very careful in these days of “stress-tested” banks to say that there aren’t a lot of corporations that seem less risky than many banks, even governments for that matter, but over time this grid offers a fairly consistent basis for assessing risk. Within each of these boxes, however, there are subgroups that have higher or lower levels of risk: a municipal government is likely to be riskier than a national government, and local savings bank is likely to be riskier than a global bank, a local company is likely to be riskier than a multinational corporation, etc. As most are aware, global ratings agencies do extensive research on nearly every borrower in the world and assign their own risk assessment ratings (Moody’s, Standard & Poors, Fitch, DBRS, etc). The point being made is that your investment choices come down to a fairly simple risk-reward calculation.

Here are some bonds in EUR that give matter for thought in relation to the above descriptions and comments:

 

Issuer

Ratings

Maturity

Coupon

Current Yield

Comment

EIB

Aaa/AAA

15/10/2025

4.50%

4.60%

Sleep at night and get a decent coupon for going longer; easy to sell if need be

KfW

Aaa/AAA

16/01/2012

3.375%

2.00%

Still better than a bank account

Denmark

Aaa/AAA

17/03/2014

3.125%

3.08%

Recent sovereign issue mid maturity

Italy

Aa2/A+

01/08/2016

3.75%

3.95%

Bit better yield for going down the sovereign credit curve

Rabobank

Aaa/AAA

05/05/2016

4.375%

4.45%

Highest rated bank left standing

Bank of America

A2/A

23/03/2015

4.00%

6.75%

This is a test of your risk-reward skills

Shell

Aa1/AA+

14/05/2013

3.00%

3.00%

Solid company, solid business sector

BASF

A1/A+

09/06/2015

5.125%

4.20%

Good corp story but now a bit expensive

Telecom Italia

Baa2/BBB

01/02/2012

6.25%

4.05%

This one will keep getting more expensive as the year goes by

Daimler

A3/A-

10/06/2011

6.875%

4.00%

Will they go bust? Is 4% a decent return for this risk? Are they really single A?

 

Roy Fraser