I was having a small debate recently with a financial adviser friend regarding portfolio allocation and the place of bonds in a portfolio. The main point of the debate was whether measuring the investment risk of the portfolio by the ratio of bonds to stocks/equities was at all practical.
Bonds are basically debt instruments by the issuers. In simpler words, an IOU. By buying a bond, bondholders are lending their money to the issuer, in return for interest.
Bonds vs Stocks
Most investors who buy into bonds are going after the “guaranteed static yield” that bonds provide. While it may seem many people think that bonds are thought to be safer due to this “guaranteed yield” and lessened volatility, it is nowhere near safe as people think them to be. This is in contrast to what many financial advisers and professionals will claim. In fact, it’s pretty common for advisers to measure the investment risk in a portfolio by the ratio of bonds to stocks. While it’s true that bonds are less volatile in price movements than stocks, they also have a probability of defaulting. The key point here is that volatility does not equate to risk. Bonds and stocks are as safe as the underlying assets it hold.
For stocks, you are purchasing a piece of a growing business. For bonds, you’re just getting your money back and with interest (hopefully). Imagine holding a Starbucks (NASDAQ:SBUX) stock vs holding a Starbucks bond. You’ll have missed the massive upside of owning a quality company. Besides, it’s impossible to get a multi-bagger with a bond.
The Case of Swiber Holdings
Swiber Holdings is an integrated offshore construction and support services provider for shallow water oil and gas field development which was listed in the Singapore Stock Exchange. The warning signs were there way before their bonds were defaulted. The yield of 7.1% was tempting but bonds and stocks are as only good as the companies they represent. High-yield bonds are high yield for a reason. The hidden truth is that every incremental percentage point of yield translates to potentially more risk. Investing in a bond does not mean you do not need to do some fundamental analysis on who you are lending your money too. Bond investors need to determine if the bond issuer is able to pay the coupon rates. One way is to look at the interest coverage ratio, which gives a picture of the short-term financial health of a business. The lower the interest coverage ratio, the higher the chance of the issuer defaulting.
Source: Swiber data extracted from Shareinvestor
We have been in a low interest environment for quite a number of years now. However, as interest rates start to edge higher, we should take caution on bonds, especially the high-yield ones. There is a reason why these companies are forced to pay higher yields.
In addition, bonds become more dangerous as investment time horizon increases; whereas stocks get less risky over time, assuming the stock has strong fundamentals. The inflation rate in the U.S. and Singapore has been relatively low for a number of years now, so it probably hasn’t been factored in most people’s thinking when evaluating their returns. A 3% bond yield isn’t good if inflation is at 2% – your net return is only 1%. A strong company generating with positive earnings and cash flow will always be far more valuable and be at a better position to generate returns to beat inflation.
However, in the short term, bonds may still be a useful thing in a portfolio. One has to look at the yield in relation to the interest rate environment and inflation situation to decide what’s best. One has take into account inflation eating into your return to find out your net return.
But just a final reminder, the bond is only as safe as the issuer, so do your own due diligence first…