Friday, April 1, 2011

Corporate Bonds

Are corporate bonds a good investment?

As I have noted in other posts, corporations can raise money (capital) to pay for research and development, new equipment, or just to pay operating expenses, in a number of ways:

1. They can sell stock, which is an "equity stake" in the company.

2. They can go to a bank like you and I do, and borrow money in a loan.

3. The can sell corporate bonds and raise cash that way.

Since you and I are not banks, the only way we can participate in making money from a corporation is in buying stock or in buying corporate bonds.  What is the difference between the two?  And which has more risk?  Interesting question, and the answers may surprise you, or at least they did me.

For example, you would think that being a shareholder was a better deal.  After all, you are a part owner of a company and have a say in how it works, in terms of your proxy votes at annual meetings - so you can "elect" the corporate officers and make decisions that affect the company.

A nice fiction, I think.  In reality, most companies are dominated by a few large shareholders who own millions of shares of stock, while you may own hundreds or thousands at best.  As a result, your voice is drowned out by the big players, who make all the real decisions.

The biggest difference, of course, is in terms of payback.  A share price can skyrocket in value sometimes, and some shares pay dividends.  Corporate bonds, in contrast, pay only interest based on the assessed risk  of the company - with the irony being that the better shape the company is in (and the more likely it is to pay off) the less they actually pay.  Potentially, you could make a lot more money from "equities" than you could from corporate bonds, which are usually paying only a few percentage points in interest.

But what about risk?  At first, it would seem that the Corporate Bond holders are taking more risk than you, the shareholder, is.  After all, your investment is backed up by the equity in the corporation, and if they go bankrupt and liquidate, you get a "share" of the liquidation assets, right?

Well, get in line, because, guess what?  The Bondholders, who are debtors, are in line ahead of you.

So, for example, with GM stock, my investment of about $3000 went down to $8.00 and I am now proud owners of something called "Motors Liquidation Corporation".    You know, you'd think they'd give me a rebate on a car, at least.

But what about GM's bondholders?  Well, they took a hit, to be sure, but when the entire thing went bust, they ended up in better shape than the shareholders:

"According to the trustee, the bondholders who technically own all the assets of the old GM Corp. (Motors Liquidation Company) will receive 10% equity in the new GM along with warrants for an additional 15%."
"On the morning the IPO was released to trade, the GM benchmark 8 3/8% bonds were trading at 34 to 35 cents on the dollar, a far cry from May of 2009, when they hit bottom at approximately 1.5 cents."

 Now this may still sound like a crappy deal, but consider this:

1.  10% is a lot more than I got out of the deal.  I got maybe 0.26% of my money back.  Actually, I got nothing, as the trading cost of selling "Motors Liquidation" stock for me exceeds its market value ($9.99 for the cost of the trade, compared to $8 value).

2. Many bondholders no doubt sold their bonds, while others bought in at a far lower price.  Thus, for example, the smart guy who bought GM debt at 1.5 cents on the dollar is now poised to have that converted to new GM stock, or at least sell out at 34 cents on the dollar.  Shareholders, on the other hand, were wiped out, with no recourse or chance to make even a small fraction of their money back.
So, as we can see, the "risk" to corporate bond holders can actually be less than for shareholders.  They are debtors, and as such, have greater priority in bankruptcy proceedings than shareholders do.

Does this mean I recommend buying corporate bonds?  Yes and No.  As part of a diversified portfolio, some corporate debt might not be a good idea.  But investing all or even a substantial part of your portfolio in corporate debt makes little or no sense.

1.  To being with, the rates of return on most corporate bonds are not very high.   And the higher the rate of return, the greater the risk.   GE, for example, is offering 5% on a 10-year corporate bond.   This is not a great rate of return - you could do almost as well with long-term Treasury notes.  If you really want to grow your portfolio for retirement, you need a greater rate of return than this, particularly early on in your career.

2.  The higher the rate of return, the riskier the bond.  GE has a lot of debt issues and is struggling financially right now.  So there is some risk you will end up like a GM bond holder and end up with only part of your money back.  Still, you might make out better than a GE shareholder.  But in terms of risk, this could be a fairly risky bet, particularly if you are approaching retirement age.  If they went bust, you could lose half or more of your investment.
So, it might not be a bad idea to buy some Corporate debt, but I would not make a habit of it.

And note that Corporate debt may be callable.  I bought some Ford Debt back in the day, when Ford offered this to shareholders through their "Ford Money Market" accounts.  The rate of return was pretty modest, but it seemed like a good way to invest in a different investment vehicle, if you'll pardon the pun.  But Ford "bought back" much of this debt, and as a result, you could find yourself being paid back early.  But given the risks involved with Corporate debt instruments, this seems like the least of your worries.

You can buy corporate bonds (as well as municipal bonds, treasury notes, etc.) through etrade or ameritrade online.  Treasury debt can be purchased directly through TreasuryDirect online.