Bonds are getting more and more complex. To reduce risk you must diversify on and offshore.
Unrated bonds are harder to assess. Perpetual bonds and bonds with longer maturities can be more risky.
Subordinated bonds can be more risky. Remember NZ (Inc) is not without risk -never put all your money into NZ bonds. A lot of global companies/corporates are in much better shape than is commonly known. Promoters who receive commissions may make a new bond issue look better than it really is.
Most bond issues are rated, and start from being AAA which is the lowest risk, way down to DDD like the Greek govt. Bonds rated BBB and above are investment grade.
Some unrated bonds that have been issued in NZ are Fletcher Building, GPG, Infratil, Sky City, Sky TV, Trustpower, Quayside, Works, and Z-energy.
They may or may not be good but only the very experienced can analyse them sufficiently. The average investor may do well to avoid them.
Senior or subordinated
If a company gets into trouble, it will pay back (if it can) senior bonds first, subordinated bonds (if any) second, and shareholders last.
Some companies have done a lot of bond issues and may have several levels of subordinated bonds. This is common with bank bonds in NZ that are in theory AA-, but they may have 2, 3, or even 4 levels of subordination and this needs to be taken into account.
By contrast Tower bonds are BBB, are senior, and the company has very low debt to equity ratios. This is not a recommendation for Tower, rather an example of a company with low debt and a company that has not issued subordinated bonds.
Risks – company failure
Any company can fail and while it is rare, you can lose money on bonds. Risk can be reduced by diversifying widely, and a good rule of thumb is not to invest in more than 5% of your money into any one bond. Risk can be further reduced by being patient and waiting for the better issues.
Commissions – who is selling a bond to you?
Be aware that a sharebroker or a bank or other institution may be promoting a bond for their own benefit – to make commissions. This is good for them but will it be good for you? Commissions can distort investment advice negatively.
Always ask for a disclosure, which should show if they receive commissions. They are not independent under new adviser laws if they receive commissions.
Independent advice from a fee based adviser should be a better way to go.
More risky – perpetual’s and long maturities
Perpetual bonds and longer dated bonds reset the interest rate every year, or every five years, according to a according to a preset formula.
It is most important to know the reset provisions as they will as they will have a big impact on the future market value of a bond. Around 2002 to 2007 several perpetual bonds were issued by a leading bank that reset the rate annually at a less-than-generous formula. They are now trading at $7,000 per $10,000 invested – a 30% loss if you need to get out.
Long maturities are also of concern as so much can happen over 10 or 20 years, and a long bond may or may not sell well until maturity. If you need the money sooner you may be in line for a nasty loss.
It is best to avoid perpetual’s and longer dated maturities unless you really know what you are doing.
Our preferred DFA global bond fund does not go past five year maturities, with good reason.
NZ is a tiny country and is highly exposed to major catastrophes such as earthquakes, foot-and-mouth disease, and various other risks. A major negative economic event limited to NZ could have devastating effects on investors who have all their money in NZ.
Reduce overall risk by investing in offshore bonds
There are literally thousands of bonds available offshore but they do present all sorts of complications such as taxes, exchange rates, and so on.
It is easier to use a managed fund for offshore bonds but all too often the manager’s fees and costs outweigh any benefits.
We have found an exception from DFA – a low-cost fund with a simple yet sophisticated strategy that holds mainly AAA rated bond global bonds. The DFA bond fund is widely diversified, hedged into NZ dollars, and has averaged 7.22% pa.for the past five years. It is liquid too, so funds can be withdrawn at any time.
This fund can be included in most portfolios as it adds diversification and is very low risk.
Many global corporate are in good shape
The global economic infrastructure is in much better shape than it was in 2008 and since the global financial crisis. Many companies/corporates have restructured and become as “lean and mean” as they can, and now many are very profitable. In addition many have been very prudent and in the US are holding on an estimated $2 trillion (trillions !! not billions ) in cash reserves.
Fund managers such as DFA are already tilting their bond portfolios away from shaky governments and investing more in corporate bonds, which makes a lot of sense.