Eight ways to spell risk in bonds

Yields rise in lockstep with risk, helping investors calculate their odds of losing money

By Andrew Allentuck
Globe Investor Magazine Online, September 10, 2008

For investors who consider risk a four-letter word, bonds are often synonymous with safety.

But they have been a byword for danger over the past year, when the $330-billion (U.S.) market for auction-rate securities in the U.S. and the $32-billion asset-backed commercial paper market in Canada collapsed.

With bonds, investors have a unique but simple tool to measure their odds of losing money – yields, which rise in lockstep with risk.

The lowest yields are always found on bonds issued by federal governments, which can repay debt by raising taxes or printing money.

But risk comes in many forms. Here are eight types of risk that bond investors should keep in mind:

Interest-rate risk

This shows up in federal bonds that are due after a year. If investors think that there is a risk that bond yields will be higher in the future, they will want to be compensated for owning bonds today. As a result, current five-year Canada bonds pay 2.95 per cent to maturity, 10-years carry 3.45 per cent to maturity and 30-years 3.95 per cent to maturity.

Similarly, treasury bills due in less than a year are least affected by changes in interest rates in the future. They currently yield 2.40 per cent for 365 days - the least risky deal in the bond market.

Credit risk

This arises when an issuer cannot print money the way a federal government can. Provincial bonds carry more risk than federal bonds because taxes are the only way to generate income to cover bond interest.

Thus, an Ontario five-year 4.75 per cent issue due June 2, 2013 has recently been priced to yield 3.60 per cent to maturity, which is 65 basis points more than a Government of Canada of the same term. (There are 100 basis points in one percentage point.)

Credit risk becomes more serious when bonds are issued by companies.

“With credit products other than government bonds, you are taking on the chance of default,” says Chris Kresic, senior vice president and head of fixed income at Mackenzie Financial Corporation.

“GE Capital Canada, which is one of the few AAA credits left in Canada, adds 220 basis points to the six-year Canada bond yield to maturity for a net yield of 5.15 per cent, compared to 2.95 per cent for a six-year Canada,” he explains. Chartered bank bonds pay as much as 5.30 per cent on a five-year issue, such as the CIBC 5.15 per cent bond callable June 6, 2013.

Chartered bank bonds’ yields have soared because of fear of loss. A bank with $100-billion in capital and $1-trillion in loans can be wiped out if just 10 per cent of the loans go bad.

“You buy the yield, you take the risk,” says Tom Czitron, managing director for income and structured products at Sceptre Investment Counsel Ltd. in Toronto.

Liquidity risk

This is the ability to sell a bond to another investor or to cash it in. It used to be a minor concern, but after the markets evaporated for “alphabet bonds,” like asset-backed commercial paper (ABCP) in Canada and U.S. auction-rate securities (ARS), liquidity has become a huge concern.

Even auction-rate securities from government-backed corporations like the Port Authority of New York are viewed by investors as very risky. As their prices have fallen, their yields, calculated as coupon interest divided by price, have soared. In March, ARS issues were discounted so deeply that they yielded 20 per cent.

Today, fearful of breakdowns in liquidity, bond buyers are shunning all but the most familiar, most frequently traded issues. “How can you be sure that there will be a resale market for alphabet bonds?” Mr. Kresic says. “You can’t.”

Conversion risk

When stock prices enter the equation, as they do with convertible bonds that can be turned into shares, risks rise. Convertible bonds tend to be issued by small or unfamiliar companies and can have the volatility of small cap stocks. The conversion ratio, which is part of the bond offering, is specified in the prospectus for the bond. Typically, convertibles are low-rated or even unrated bonds that are sweetened with the conversion feature. They carry all the risks of high-yield bonds and all the uncertainty of owning stocks as well.

Counterparty risk

This is the chance that the company or entity that has your money will be unable or unwilling to pay it back. Counterparty risk is common in sovereign loans to other countries. Over the years, nations such as Argentina and Russia have been serial defaulters. As a result, a Republic of Argentina bond due Feb. 21, 2012 that pays in U.S. dollars has recently been priced to yield 12.375 per cent.

Subordination risk

This reflects how far down the food chain the bondholders are in case of insolvency. A deeply subordinated bond will add as much as 125 basis points to the yield compared to one at the top. For example, a senior note from the Bank of Montreal with 10 years to maturity has recently been priced to yield 5.72 per cent while deeply subordinate a BMO Tier 1 Capital Trust issue with 10 years to maturity yields 6.76 per cent.

Currency risk

It exists in any bond that pays in a currency other than loonies. If the foreign money becomes worth less against the Canadian dollar, the holder loses.

Residual risk

It is the chance of loss inherent in what one does not know. Statisticians call this tail risk, that is, the chance that some unexpected risk can emerge and devastate a security.

For example, rogue trader Nick Leeson gambled in Japanese stock futures and lost. His trades bankrupted Barings Bank, his employer, in 1995 and wrecked its bonds.

“[Residual risk] is always present, but it emerges only when a crisis that nobody expected shows up,” says Edward Jong, senior vice present at Mak Allen & Day Capital Partners Inc. and portfolio manager of the FrontierAlt Opportunistic Bond Fund in Toronto.

“You can’t quantify this risk, but the stronger the balance sheet of a company, the better it can withstand an unexpected bad event.”

Special to The Globe and Mail