The path to gain in bonds is strewn with hopes of high yields: How not to get taken in

By Andrew Allentuck
Globeinvestor Magazine Online, Aug. 13, 2008

As omens go, the yield curve is about as good as it gets. A line that connects interest rates paid for bonds, it starts off withIn finance, there is a law that every experienced investor ought to know: You don’t get something for nothing. In fixed income, that means promises of high yields and low risks. In truth, they seldom go together.

The most important rules are just five in number. Remember them and you’ll not be led astray.

1. Don’t be a yield pig.

You can be sure that if the yield offered on a bond or other fixed income asset is far above what government debt pays, the risks are much higher too.

“Retail investors are caught in the environment of low returns,” says Edward Jong, senior vice-president at Mak Allen & Day Capital Partners Inc. and portfolio manager of the FrontierAlt Opportunistic Bond Fund in Toronto. “Today, investors can hide safely in GICs, but they can too easily fall into products that they do not understand.”

The problem is that the riskless return on 90 day Treasury-bills, about 2.75 per cent if you are an insurance company with millions to park and 2.35 per cent if you want to put $10,000 into a safe place, is less than the current headline rate of inflation, which Scotiabank’s economics department has predicted to be 2.8 per cent for all of 2008. And that is before tax on interest income.

There is a temptation to buy higher risk investments that offer more interest. But enhanced yield comes with higher risk or reduced liquidity – think of the debacle with non-bank asset backed commercial paper – IOUs that froze up in a dysfunctional secondary market and became uncashable.

You need to know the risks you are buying. They can be the ordinary risk of interest rates rising and creating better opportunities elsewhere – and driving down the prices of existing bonds with fixed coupons. Or the risks can reach into default on corporate bonds, dividend non-payment on preferred shares, or market collapse as in the case of derivatives.

2. Don’t dismiss warnings.

Currently, General Motors Acceptance Corp. three-year notes pay 2,040 basis points (there are 100 basis points in one percentage point) over U.S. Treasuries of the same term, Mr. Jong notes.

“The market is expressing a lot of doubt that GMAC will be able to honour the notes when they are due,” he explained. “The risk is clear. After all, GM’s second-quarter loss per share, $27.33 (U.S.) reported on Aug. 1, was more than twice its closing share price that day, $10.23 (U.S.). That’s not a good sign,” he adds.

3. Don’t ignore counterparty risk – the chance that a company with which you are dealing – may be unable or even unwilling to pay you back.

If you are buying U.S. Treasury or Government of Canada bonds or provincial bonds, you can be confident that they’ll be around to refund principal on bonds and pay interest when due. But if you are putting money into some of the companies that post classified ads that offer double digit returns in a couple of months, you are at substantial risk.

A lot of these ads are come-ons that offer repeat performances of the scheme of Charles Ponzi, a U.S. entrepreneur who convinced investors in 1920 that an anomaly in the pricing of international postal coupons could generate returns of 50 per cent in just 45 days. The plan did not work as well as intended. To keep it going, Mr. Ponzi, whose name now covers a wide range of quick buck schemes, used fresh money from new investors to pay off earlier investors. Therefore know the company that gets your loan and know how it makes money to pay you back.

4. Don’t assume that what was will be.

Case in point: contractual promises called covenants attached to bonds in the wake of the Supreme Court of Canada decision on June 20 regarding the fate of the debt of BCE Inc.

Covenants are printed in the prospectuses that accompany new bond issues. They can also can be found at regulatory websites like www.sedar.com for Canadian bonds and at http://www.sec.gov/edgar.shtml for U.S. bonds. Covenants weakened in the period of low interest rates after 2004. At the time, it did not seem to matter to investors who were less worried about fineprint than just boosting their bond yields. That process led to erosion of protection of investors’ money by bond issuers, says Craig Allardyce, vice- president for fixed income at Mavrix Fund Management Inc. in Toronto.

In 2001, long before the BCE Inc. case, typical bond covenants promised that if a company were taken over by another, the successor company would take over the obligations of the corporation. That was the idea in a Great-West Lifeco 6.74-per-cent bond issued in November, 2001, and due November, 2031.

On buyouts of one company by another, the covenants said, “the corporation will not merge, amalgamate or consolidate with or into any other corporation or sell, convey or dispose of all or substantially all of its assets to any other person unless the successor company…assumes all of [its] obligations….”

Recently, bonds like the Thomson Reuters Corp. 5.7 per cent issued on the eve of the BCE decision and due July, 2015, have been crafted with covenants that say that no implied agreement, representation or warranty will be part of the bond contract. Even if bond holders can find an omission or other inconsistency, investors cannot use it against the bond issuer.

“Holders may wish to assert that we have obligations to them which extend beyond our covenants and agreements but [this covenant] precludes holders from making such assertions,” wrote the legalists who crafted the passage. This is tough language, but it is all that companies have to give in the post-BCE Inc. world of bond undertakings.

“If you don’t like the covenants, then don’t invest in the first place,” suggested Tom Czitron, managing director and head of income and structured products at Sceptre Investment Counsel Ltd. in Toronto. “You can’t go crying to the referee when you are losing because you didn’t like the rules.”

5. Don’t ignore liquidity.

Unlike the stock market where one share of a company’s common stock is just like another, corporate bonds are custom-crafted affairs. When issued, bonds are said to be “on the run” and can be traded very easily with relatively low costs (bonds are sold by spread, the difference between what a dealer pays and what the client pays). After a few weeks – or months for long bonds – they may no longer trade very much.

When bonds are not on the run, spreads widen and some bonds and other fixed income products become relatively illiquid. That may not matter if you have some time to dispose of the bonds, but if prices start to crash for any reason and you want to unload, you can wind up like the Nobel prizewinning investors in Long-Term Capital Management, a Connecticut-based hedge fund that managed to hold $1.2-trillion (U.S.) of debt it could not unload.

“There was no exit door for the amount of bonds LTCM held,” explains bond portfolio manager, Richard Gluck, principal at Trilogy Global Advisors LLC in New York. “The Fed orchestrated an orderly wind down of LTCM’s business and ensured that its bills got paid. An individual investor would not be so lucky.”