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Do not buy corporate bonds

Alvin Chow
Alvin Chow

Everyone is familiar with Government Bonds and Treasury Bills. How about corporate bonds? A company needs cash and capital to run or expand the business. There are several ways for the company to raise money. It can borrow from the bank, getting listed, execute rights issues (if listed), take in private investments or issue corporate bonds.

Out of these methods, the company will likely choose the least cost of borrowing. So if the company decided to issue bonds, it means that it is the cheapest the way to borrow. More often than not, corporate bonds will give out a higher interest rate (or coupon payment) higher than what the government would offer.

In year 2010, we can see some of the big organizations like Temasek Holdings and SIA issuing bonds to the public. Retail investors can only buy and sell bonds listed on the Singapore Stock Exchange. For over the counter bonds, only accredited investors are allowed to invest in corporate bonds with minimum investment of S$250,000. So are they good deals? Here’s my opinion:

#1 – Misalignment of Interest between Share Holders and Bond Holders

As a bond holder, you want to receive a high rate of interest as much as possible, while the share holders want to borrow as cheaply as possible. The management has to answer to the share holders and not the bond holders, and in fact, most of the management are shareholders of the company as well. Hence, your interest as a bond holder is not in the same interest of the management. The management can always use other forms of borrowing as mentioned above to undo the debt obligation to you.

#2 – Callable bonds

Callable bonds give the issuer the rights to buy back the bonds from you after a certain date and at a fixed price. This gives the power and flexibility to the issuer, who can refinance with a cheaper loan when interest rate falls and terminate the debt relationship. As a bond holder, you are under the mercy of the issuer.

#3 – Limited upside

Bonds always promises a fixed interest rate and to me, this is leveraging on the weakness of man – the desire for certainty. There is a price for certainty, which is limiting your upside. When a bond gives you a promised rate of 3%, you will get 3% and nothing more. Even when the company is earning 20%, you will still be paid 3%. On the contrary, the shareholder can reap a gain as high as the company’s profits can grow. Nobody can get rich with a limited upside.

#4 – Unlimited downside

Companies can go bankrupt. During the claim for bankruptcies, bond holders take precedence of share holders. But it does not mean bond holders will always get back the full amount. When the company is badly insolvent, bond holders may not even get a single cent back. A good example would be Lehman Brothers. The distributors (banks) have to pay part of the debt obligations to the mini-bond holders, and this was after the pressure from the public and government. In my opinion, both bond holders and share holders are equally helpless when a company goes bankrupt. The belief that bond holders are in a better position is not true at all.

To me, these are 4 good reasons why one should not buy corporate bonds. Especially for #3 and #4, this is a wrong way to make an investment decision. We want to limit the downside and enjoy an unlimited upside. Doing the opposite is a sure way to be poor. Why are there still people who want to buy bonds? I believe the main reason is similar to buying endowment policies.

These people are not financial savvy and they do not know how to get a return better than the promised interest rate of 3% or less. And since it is greater than what the fixed deposit rate, it makes sense to go for corporate bonds.

The key is they should work on improving their financial literacy and not take the easy way out (there isn’t any). They think that big famous companies like SIA are credible, but time and time again, history has shown us the demise of great companies.

They may be fine today, but it takes much lesser time for a bad management to screw it up than to build the company to great heights. This black swan event is often underestimated by investors.

Alvin Chow
Alvin Chow
CEO of Dr Wealth. Built a business to empower DIY investors to make better investments. A believer of the Factor-based Investing approach and runs a Multi-Factor Portfolio that taps on the Value, Size, and Profitability Factors. Conducts the flagship Intelligent Investor Immersive program under Dr Wealth. An author of Secrets of Singapore Trading Gurus and Singapore Permanent Portfolio. Featured on various media such as MoneyFM 89.3, Kiss92, Straits Times and Lianhe Zaobao. Given talks at events organised by SGX, DBS, CPF and many others.
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6 thoughts on “Do not buy corporate bonds”

  1. Hi Alvin,

    A bit extreme don’t you think? What if there’s a global bank like standard chartered or HSBC issuing a bond with say returns of 6-8% pa?

    1) The bank wants to satisfy certain capital requirements, hence they give you sell you the bonds. I don’t see a misalignment in interest. Similarly, there are many many things out there which are not aligned in interest to shareholders, like placements, like dual listing etc etc. Doesn’t mean we can’t make money out of it.

    2) The fixed price is both good and bad. Bonds will be bought back at par value. If you buy the bond below the par value, then there’ll be a fixed capital gain after a certain period of time. If you’re talking about a bond giving you 6-8% pa PLUS a fixed capital, everyone should be getting excited.

    3) limited upside or not depends on your price. As mentioned, if you get a bond which is callable, as long as you purchase below the par value, you can calculate your returns straight away and ignore the price. It’s good for certain purpose.

    4) This point is not valid because it works the same for everything, be it shares or bonds. So, there’s no real disadvantage of bonds when compared against shares.

    I think you’re talking about bonds in local context. If you look around, I think there are some good buys around the world.

    Reply
  2. There are only 2 primary reasons to invest:

    1. To preserve Wealth,
    2. To build Wealth.

    There is a saying that the RICH invest to preserve wealth, if they don’t lose it, it is considered successful investment. However, the not so rich invest to build wealth and you can’t afford to lose it..

    So are you building wealth or preserving wealth? Each requires totally different strategy.

    Read? https://createwealth8888.blogspot.com/2009/08/when-you-have-money-what-would-you-do.html

    Reply
  3. Thanks all for your valuable views.

    Personally, I am uncomfortable with the limited upside and unlimited downside that comes with corporate bonds. Sharing the same risk with a shareholder, but getting less upside does not appeal to me.

    There are many ways to grow wealth like createwealth8888 mentioned, at the end of the day, it must be something that the investor believes in and comfortable with.

    Reply
  4. Interesting view. At the end of the day, if it is such bad product, accredited investors would not bought in.

    On your points:-

    “#1 – Misalignment of Interest between Share Holders and Bond Holders”
    – Not necessarily. Both would need the company to do well and be able to pay its interest to bondholders and dividends to shareholders. Yes, shareholders do want the company to borrow at the lowest possible rate, but it would be at a reasonable level for the risk that bondholders will be willing to undertake. Otherwise, without funding, the company may collapse or be unable to grow. Other ways of fundraising, e.g. issuance of new shares will dilute shareholders’ value and may not be something that the shareholders support.

    “#2 – Callable bonds”
    – Not all bonds are callable. “At the mercy of the company” made it sound arbitrary – bondholders who want to fix the maturity date can always opt for non-callable bonds. Non-callable bonds of course are likely to come with lower interest rates – this is a free market, there may be pundits and extremists with money to burn, but in general prices are adjusted based on supply and demand, and institutional and accredited investors who form the bulk of those investing in such products are likely to be able to work out the values.

    “#3 – Limited upside”
    Are you aware that bond prices can move up? So on top of the coupons paid, you could sell the bonds even if they’re less liquid than common equities. In times of great market uncertainty, highly-rated bonds can be a lot more valuable as people are willing to pay a premium over them.

    “#4 – Unlimited downside”

    I am not sure how you can derive at the conclusion of bondholders and shareholders being “equally helpless” in the event of a default if in your assessment you’ve already mentioned that bondholders have precedence over shareholders.

    At the end of the day, a balanced portfolio needs different kinds of exposure, to be tweaked in accordance to investors’ needs and market conditions. Your conclusion of why people invest in bonds is hasty at best. The fact that corporate bonds are often offered in private placement and popular with institutional and accredited investors do not support your hypothesis that only people who are not financially savvy buy bonds.

    Reply
    • Thanks hw for your point of view.

      It was my fault not writing it clearer.

      Indeed, creditors have the first claim to the company before shareholders. But there is also a packing order among the creditors. My point is, corporate bonds are not as safe as what most people think it is.

      La Papillon and CreateWealth888 are right. I was thinking more like a retail investor. A rich man is likely to construct a portfolio to preserve wealth, not take more risks.

      Hence you are right in a sense that corporate bonds have a place in some portfolios.

      Reply

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