Thursday, March 8, 2012

Stock or Bonds?

Which  is a better investment, Stocks or Bonds?

I wrote before about corporate bonds, and until recently, I had not invested in many of them.  Bonds are not sexy, and the financial channels and the shouting guy and the guys in the clown suits don't talk about them much.   Everything, we are told, is the almighty Dow Jones Industrial Average, and bonds are barely on the radar.

But what is the difference between stocks and bonds?  And which is a better investment?  Traditionally, we are told that corporate bonds are risky - and this is true.  But are they any riskier than stocks?  In some respects, no.

Stocks represent an ownership stake in a company.   With a stock share, you can vote for the Board of Directors, vote on Corporate resolutions, and other actions involving control.   If the company is liquidated, you will receive a pro-rated portion of the liquidated assets of the company.  And if the company makes money, you will be paid a portion of the profits as dividends from the company.

OK, re-read the last paragraph again, and this time, assume every sentence in there is a big lie.  Because it basically is.  No, really.   Let's take a look.

Stocks represent an ownership stake in a company:  While this is theoretically true, as an owner of an infinitesimal interest in the company, you really don't "own" anything.    The majority shareholders can run the place as they see fit, without your consent.  Even in a proxy battle, your pitiful investment is not going to swing votes one way or another.   While you are an "owner" in theory, the reality is, if you own 1,000 shares in a company that has millions of shares outstanding, you don't own bubkis.

With a stock share, you can vote for the Board of Directors, vote on Corporate resolutions, and other actions involving control:  This is true, again in theory.  But the fellow who owns a million shares has a million times more votes than your one share.  So often, you vote doesn't really count.  Proxy wars and shareholder resolutions sound like fine and wonderful things, but unless the really big shareholders go along with it, chances are, your vote means nothing.

The other day, representatives of the Board of Winn-Dixie called me to ask for my vote on the proposed sale to Bi-Lo.  My 200 shares are not really going to make much of a difference, but I was on the call list.  The fellow with thousands of shares or tens of thousands of shares - his vote counts.
If the company is liquidated, you will receive a pro-rated portion of the liquidated assets of the company:  Again, technically true, but in reality you get nothing.  The liquidation value of a company is often pennies on the dollar, and when most companies go belly-up, there is nothing left to sell, after creditors are paid.  Guess who those creditors are?  More on that later.  I received little or nothing from the bankruptcy of GM, Fleetwood, or Champion Auto Parts.   Just a sayonara and good-luck-Charlie.

If the company makes money, you will be paid a portion of the profits as dividends from the company:  Again, not really true.  Many companies do not pay dividends at all, but rather pay shareholders by buying back stock or retaining earnings.  And bear in mind that the dividends paid to shareholders come out of corporate profits, which are only reckoned after the company has paid the debts due and the interest on these debts.  What sort of debts are we talking about?  We're coming to that.

So the fantasy of stocks is really a fantasy - and yet we are told by the powers-that-be that investing in stocks is the only thing we should be thinking about, and all the financial channels harp on this, twenty-four hours a day.  Buy Facebook!  Buy Apple!  Buy! Buy! Buy!  Because, they tell us, the stocks can go through the roof and we can become millionaires.

But just as likely, they go through the floor and we are broke.   The financial channels and media promote the Casino Mentality of investing - that you can strike it rich by making the right investment choice, which of course, is a secret they are going to share with you and 50 million viewers.   Shhhhhh!

And of course, these same sources of poor normative cues are usually silent on Corporate Bonds.    Or, if they say anything at all, they say that bonds are risky, bonds don't pay well, and that you could lose a lot of money in bonds.  Is this really true?  Let's take a look.

Bonds are Risky:  This is true, but maybe not as true as you think.  When you buy a Corporate Bond, you are a creditor of the Corporation, and the debt instrument you hold is usually senior to other debts.    Long before shareholders see a cent of dividends, you will get paid interest on your bond.

In a Chapter 7 bankruptcy proceedings, the assets of the company are liquidated and the money used to pay off creditors first, and anything left over is paid to shareholders.  Since bondholders are creditors, they are first in line - ahead of shareholders.  So in terms of safety in liquidation, being a bondholder is better than being a shareholder.

In a Chapter 11 (reorganization) bankruptcy, or a debtor-in-possession bankruptcy, as the name implied, the shareholders are wiped out completely, and the debtors are given shares of stock in the new company.  Who are the debtors?  The bond holders.

This is, by the way, how people can "hollow out" a company, make money, and then take over.   You get control of a company, load it up with debt (that you hold the notes for) declare bankruptcy, strip off obligations like pension plans, and then as debtor-in-possession, take over the new company as majority shareholder.  See, e.g., Friendly's Ice Cream.  Edna the waitress gets a screw-job, while the guy running the place gets total control and all those pesky debts stripped off.  See also, Bain Capital, and Romney, Mitt.

So yes, there is risk in bonds.  But when a company goes belly-up (these days, often by design) you might be more protected as a debtor than as a shareholder.

By the way, this was Mitt Romney's beef with the GM Bankruptcy.  The shareholders were wiped out, which was fine with him.  But the bondholders (the Bain Capitals of the world) were not protected as in a usual bankruptcy.   Instead of screwing the pension plan, they protected it, and that just isn't American!  Or Morman, anyway.  Everyone knows the folks with all the money are supposed to win!

Bonds Don't Pay Well:   Many folks look at the paltry rates of return on bonds, and think they are a dead-end.  5-6% rate of return?  When you can make 10% in the market?  A bad bet, right?  Well, it depends.

For example, you buy  $5000 of ACME Corporate Bonds, which are paying 6%.  You also buy $5000 of ACME Stock, which is paying an annual dividend of 6%.  Which is a better deal?   At first, they seem the same.

But, the stock can soar in price, which it likely will, if ACME is paying a 6% dividend and the products take off and the company is profitable.  Stock prices soar when companies do well, and profits go up with companies do well.

But bonds are traded just like stocks, and here is where it gets weird.  Bond prices don't go up when the company does well - at least not far beyond their face value.  But when a company runs into trouble, the effective yield on a bond can skyrocket.  Of course, this is a reflection of the perceived risk in the company, as investors believe (often correctly) that the company might not be able to pay off the debt, and go bankrupt.

So bonds can have an effective yield rate far above their stated "coupon" value.  Of course, this increased effective rate reflects an increase in perceived risk.    But the idea that bonds are a fixed investment that pays out X% in terms of the coupon rate, is false.

You Could  Lose a Lot of Money in Bonds:  Holders of Greek Debt are finding this to be true.  But you can also lose a lot of money in stocks as well - in fact all of it, for example, if you bought GM a few years ago.  Even the Greeks are offering 50 cents on the dollar, which is a lot more than I got out of GM.

Oftentimes, debts are "worked out" this way.  For example, I discussed the Mohegan Sun, whose bonds fell so far in value that the effective rate of return skyrocketed to 240%.  The dust is still settling on that one, but the Casino is not defaulting just yet - but is offering the bondholders new bonds, when the old ones come due, at an even higher interest rate.  The interest payments would still be made, but the principal would not be paid back until 2016 (at which point, it might be extended yet again).

If the plan is approved, the bond holders are not wiped out, but continue to hold debt and collect interest.  Things could be worse.  That scenario, however, is unique, as by law, only Indian Tribe members can hold stock, so bondholders are not protected if they decide to declare bankruptcy.

But for most situations, even if the company goes bankrupt, as bond holder, you are first in line for the pickin's - and often this means stock in the new company.  Even in the GM bankruptcy, which some claim screwed the bondholders, the bondholders got 30 cents on the dollar.   And while that might sound like a screw-job on the bondholders, bear in mind that just prior to bankruptcy, you could buy GM Corporate Debt pretty cheaply - for less than 30 cents on the dollar.  Some people made out in that deal.

So are bond a good or bad deal and should you invest in them?  Yes, No, and Maybe.  First of all, they are deceptively complex.   They appear to be simple interest-bearing notes, but since they are traded like stocks, they have a market price, just like stocks, and an effective rate of return that can vary from the face value of the bond (the so-called "coupon rate" although most bonds today do not have detachable coupons).  And if you don't understand any of what I just said, you probably have no business buying bonds in the first place.

Diversification is important in any investment strategy.  And while corporate or municipal bonds, as well as U.S. Treasury debt instruments are a good adjunct to any investment portfolio, putting all of your money into them is probably a bad idea, particularly when you don't know what you are doing.

What started me on this thread was the fact that I own some GE stock and some GE corporate bonds.  The stock is in the tank right now (down 46%) while the bonds are worth 6% more than I paid for them.  GE is struggling right now (and yet, people criticize it for not paying corporate taxes!) and its huge debt load is part of that problem.   But if they did go out of business (which I obviously am betting won't happen) which do you think will be worth more - my GE stock or my GE bonds?