- Bonds issued that do not mature for 10 or even 20 years, with provisions after 5 years to reset the interest rate, and sometimes can repay early too.
- Some are perpetual, reset the rate annually or every 5 years, and never mature.
We like “vanilla” bonds since they are simple, you know the interest rate in advance, it is fixed for 5 years, and then you get your money back (in most cases).
The simplicity is the key issue.
Over the past few years we bought some “vanilla” bonds such as ;
Telecom A rated paying 8.5% maturing 2015
Tower BBB rated paying 8.5% maturing 2104
Fonterra A rated @ 7.75% maturing 2015
Plain and simple !! The problem is you cannot get much more than 5% from good bonds today (June 2012).
Long bonds with 10 & 20 year maturities
Bonds with long maturities are always a worry, so much can happen over 10 or 20 years, they may or may not benefit from rising interest rates. Best avoided unless you really know what you are doing. e.g. Genesis 2036 and IAG 2041.
It is interesting our favoured bond fund (DFA) does not go past 5 year maturities – never.
Perpetual bonds reset the interest rate every year, or every five years, according to a preset formula.
It is most important to know the reset provisions as they will have a big impact on the future market value of a perpetual bond
Around 2002 to 2007 several perpetual bonds were issued that reset the rate annually. The reset provision was commonly the one year rate plus about 1%.
After 2007, money was hard to borrow , and so a lot of bonds were issued with much better reset provisions. The older perpetual bonds are now much less popular, and so trade at a big discount.
If you bought Rabobank (ROBHA) perpetual bonds at issue, you were getting over 7% from an AAA rated bank, but now you are now getting 3.8% pa.
If you invested $10,000 at issue and want to sell out today, you will get about $8,000.
This is just one example; some other big name issues are similar and are down to $7,000.
If you know when interest rates will rise, a perpetual with good reset provisions would be desirable, as its price will rise in anticipation of an interest rate rise. But who can accurately forecast an interest rate rise ?
However you could build a bond portfolio that is in part insulated against rises and falls in interest rates.
But unless you really know what you are doing, you would be well advised to avoid perpetuals.
Senior or Subordinated
In simple terms if a company gets into trouble, it will pay back (if it can) senior bonds first, subordinated bonds second, third, or even fourth* in some cases, and shareholders last.
*Some companies have done a lot of bond issues and may have several levels of subordinated bonds.
As a general rule you want bonds that are senior, or not too far down the list.
For example an big bond offer from a big company some years ago was paying 10% but was deeply subordinated – there was a $1 billion of existing bonds that ranked above the issue. That does not necessarily mean the offer was either good or bad – it would need to be analysed, and compared to other offers that were also available.
Tower 2014 bonds issued 2009 are senior and they have very low debt (only 13% debt to equity ratio). However they had to pay a higher 8.5% as their rating is lower than some at BBB.
There are dozens of these funds available, and they add diversification which is always good.
Offshore our preferred bond fund is the DFA 5 Year Fixed Interest trust which is spread across 80 to 90 AAA and AA rated global bonds, and is very low risk. It is hedged into NZ dollars so is unaffected by the exchange rate.
The fund was designed by Eugene Fama, a DFA director, who won the inaugural 2009 global Onassis award for services to global finance (no one in financial circles in NZ has won such a high award) .
In keeping with the DFA philosophy, this is a low cost fund, the average return has been around 7.25% pa since inception in 2004, and money can be withdrawn anytime.