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.