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The Role of Bonds in an Investment Portfolio
Bonds are issued by governments, regional/local authorities, “supra-national” organisations, and corporations. Once issued, they are tradable without interaction with the issuing entity. The market is a virtual one, with trades conducted through a series of “market makers” using the computer and telephone. Bond brokers exist in the same way as stock brokers, but independent bond brokers, like bridport, are extremely rare, as most bond broking is conducted by the bond departments of major investment or universal banks. Trades are usually in amounts far beyond the reach of retail investors, and indeed it can be said that the bond market has not at all followed the route of the stock market in its “democratisation”. Even more than for stocks, therefore, bonds have the place in a retail investor’s portfolio as a medium to long- term placement; the cost of trading is just too high for frequent buying and selling.
As will be seen below, bonds also carry their risk, but are less volatile than equity investments. There are periods of time when bonds outperform stocks, but, over a long enough period, they have always returned less than investments in the stock market.
The place in portfolios for bonds, safe but solid investments, increases with an investor’s risk aversion, which will depend largely, but not only, on his age, or, more accurately, his time horizon and his ability/willingness to accept losses in a given year. In addition, bonds have greater attraction when stock markets are bearish and volatile (as they were in 2001and 2002 after the bursting of the “hi-tech” bubble in 2000, and now in the wake of the house bubble bursting and the credit squeeze). Inevitably, bonds have a somewhat dull image. Yet, in reality, bond markets are far from the dull image often associated with them. Sometimes bond markets can completely outperform equities, and sometimes higher-yielding bonds can take a hiding almost as severe as any stock. Bond markets are naturally more sensitive than stock markets (less prone to be “carried away” by crowd behaviour”). They respond sooner to shifts in shifts in the underlying economy than equity markets, especially when danger appears. One of the most eloquent measures of growing danger in a given sector, company or country is the interest premium (“spread”) in bond yields over the lowest risk bonds (see below).
The “dullness” of bonds means that a bondholder always receives his coupon payment during the life of a bond and his principal back at maturity. At least, that is the principle. What then are the risks?
The lowest risk bond is a loan to a government in its own currency , because, revolution apart, a government can always print more money in its own currency to pay back its debts. Inflation may eat away the purchasing power, but the borrower will have met his obligation! Government bonds in a country’s own currency therefore provide the yardstick against which all other credits are measured. Greater risk normally implies greater reward, i.e. that the borrower has to pay a premium in interest rate (the spread) over government bonds, like Treasuries, Gilts and Bunds. Five risks are associated with bonds (see box). Not even government bonds can avoid one of them (the interest risk), while the other four are present to different degrees in the corporate bond and emerging-economy market.
Traditionally, the interest risk is the driving force in adjusting a bond portfolio, and that may be a reasonable view when the investor has just one currency and sticks to government bonds. But other risks may creep up quite quickly, especially on portfolios with a large component of corporate bonds and emerging markets, for which the credit risk is considerable. Suddenly, a sector or a country that was very popular gives cause for second thoughts, as it dawns on
lenders that the amount they have lent exceeds what the company, sector or country can really
afford.
The currency risk is ever present for investors outside their home currency. The major exchange rates like between dollar, pound, euro and yen can be subject to very large swings. A given major currency may be overvalued according to “fundamentals”, but where and when will the correction take place? The debate about the real value of the dollar, pound, euro and yen against each other will never be over.
The liquidity risk comes on top of credit risk. The less creditworthy an issuer, the harder it is to find a buyer for his bond. Market makers are less prepared to hold more risky bonds and so it is the harder to buy them. Mergers in the investment banking sector have reduced the number of market makers in fixed income securities. The high-yield (or “junk bond”) market is particularly prone to liquidity declining drastically, but even the investment-grade corporate bond sector is vulnerable to liquidity crises. Structured products built around bonds are also relatively illiquid.
The concentration risk reflects the fact that entire sectors tend to move as one. A rating change for one telecom company might bring others into trouble. If one consumer company looks less attractive, its rival will go the same way. If one emerging market looks sick, other countries soon suffer contagion. Sectors may have half-hidden links, too. The dangers of telecom bonds are widely known, but the fact that many banks may be holding large quantities of these bonds is not so obvious. Should telecom bonds suffer, so do some of those banks.
In principle the price of a bond changes so that the yield always reflects prevailing
market conditions for that bond within the universe of comparable bonds. To allow an investor to see clearly the performance of the bond and its class beyond the general movements of prevailing interest rates, it is usual to consider spreads (the difference in bond yields) rather than absolute yields. The most widely used spread is that between the bond or class of bond and the swap of the same maturity. (See our note on swap curves.)
As yields vary in the opposite direction to bond prices. Likewise when spread and prices move in opposite directions, but spread is the better measure of the perceived risk of a bond versus risk free investments.
Swap Curve as Benchmark
It may be thought that the “obvious” benchmark for the nearest thing to risk-free lending would be based on bonds issued by a government in its own currency. Indeed, notwithstanding differences in the credit ratings of even the most developed countries, default of government bonds has been extremely rare. Nevertheless, government bonds do not provide a perfect benchmark as they are themselves subject to volatility linked to supply, and are not strictly comparable from one currency to another (since government regulations vary). A move has therefore taken place in recent years to return to a private sector benchmark, one based on “swap rates”.
Definition: swap rates are used between banks with high credit ratings (which gives them a very low credit risk). They are the fixed interest side of an interest-rate swap of six- monthly fixed coupon payments to the specified maturity versus variable-rate coupon payments also paid every six months. The latter is fixed as the six-month LIBOR rate at the beginning of each payment period.
Because the swap agreement is between very solid banks, each acting on behalf of an unnamed corporate client, it is the banks credit worthiness that is at stake, not the corporate client’s.
The Swap Curve is constructed by plotting the prevailing swap rates against maturity.
The analyses conducted by bridport investor services are almost entirely based on spreads versus the swap curve, in particular in the “Keox” portfolio management system. For example, Keox calculates the differential to the swap rate of the yield to maturity (D/ Swap) of each bond, and then calculates the average of all these differentials in a given portfolio to a complete (or source) list (M/Diff).
Convertible Bonds
Conversion ratio (parité) is the number of shares that are received for each bond
converted.
Conversion price is the par value of the bond divided by the conversion price.
Conversion value is the conversion ratio multiplied by the current market price of the stock: the bond’s “value as stock”.
Conversion premium is the bond’s current market value minus the conversion value, expressed as a percentage of the conversion value: 15-30% at issuance.
Investment value or bond floor (plancher actuarial) is the estimated value of the bond without the conversion feature; the bonds “value as a straight bond”.
A call provision means that the issuer may also force conversion. The bond has a call price and the issue would only call when the conversion value exceeds the call price, which would make the bondholder choose to convert.
Thus a convertible bond is at least a straight bond with a call option. Since so many convertible bonds are callable, a second option, in the hands of the issuer, affects price in the opposite direction.
The hedge ratio is the change in the value of an option for a unit change in the price of the underlying stock. It is equal to the number of shares in the equivalent portfolio of “long stock, short bonds” under the BOPM.
Remember option terminology chosen to be applicable to both call and put option:
In the money Out of the money at the money.
The naked value or bond floor of a convertible is its value without convertible features. If the bond were risk free its value would be that of a risk-free bond (a Treasury). The lower the value of the underlying equity, the greater the risk of the bond and the lower its value. This explains the asymptotic shape of the “Naked value” curve on page ch5/4 of the ISAM course.
Be careful, “naked” usually refers to writing options with no offsetting underlying securities.
The conversion value is the straight line (45 degree slope). The actual value will be above the two “curves”.
It looks tempting to say that the value is that of the higher of the naked value or conversion value plus the value of a conversion option a la Black and Scholes.
However, binomial models seem more appropriate. A certain Ingersoll suggests that conversion is worth it only when the dividend stream exceeds the coupon payments. However, the callable factor may interfere with that statement.
