Oran Hall | Bonds are not risk-free

Bonds have a place in balanced investment portfolios but are particularly attractive to conservative investors because they are confident about the certainty of their principal and the interest they expect to earn.

Although they tend to be safer than some other types of investment instruments, bonds are not risk-free.

Bonds are debt instruments: the issuer borrows and makes a promise to the lender to pay interest at a prescribed rate at pre-determined times – usually at six-month intervals, although it is becoming common for interest to be paid quarterly – and to repay the principal sum on the agreed maturity date.

The loan is secured by specific assets, thereby giving the lender protection in the event that the borrower defaults – is unable to meet the commitment to pay.

A bond listed on a stock exchange is more visible and trades more easily and with a greater level of transparency than one that trades on the over-the-counter market. Generally, the higher the quality of the bond, the easier it is to trade, and investors are able to benefit from the ability of financial and investment professionals to use various tools to evaluate its investment quality.

In evaluating the investment quality of bonds, analysts look at the following:

• if the earnings of the company are sufficient to make the contractual interest payments;

• if the cash flow of the company is sufficient to retire the debt at maturity;

• if the debt is reasonable relative to its equity;

• if the debt is backed by an adequate amount of assets; and

• the ratings that independent ratings agencies give them.

The above are quantitative tests based on historical performance.

To give a fuller analysis, analysts also use the qualitative approach by focusing on the intangible aspects of a company’s operations, such as the quality of management and major diversification into new areas, as well as future developments in the industry, and changes in the government’s regulatory environment – which, to varying degrees, have implications for the future performance of the company and translate into quantitative data.

Debentures are another type of debt instrument but they are backed by the good name, or creditworthiness, of the issuer and not by specific assets. They, too, are appraised against the earnings and financial strength of the borrowing company.

A corporate debt instrument that is a good investment instrument is not guaranteed to retain its positive ranking at the same level, or at all, for the duration of its life. The company can become less profitable for many reasons.

Changes in the local and international economies can affect its profits. Substitutes for its products can cause it to lose market share, and changes in management can affect how well it performs.

Because the various aspects of a company are related, lower profits or a reduction in the rate of growth of profit can make cash flow and shareholder’s funds less robust, and a drag on shareholder’s equity can affect the debt-to-equity ratio negatively, for example. Such negative developments can cause independent ratings agencies to ascribe a lower rating of the debt of the company.

In our own market, we have seen the challenges Digicel has had servicing its bonds. A major challenge it faced was strong competition in some of its markets, which had a negative impact on its profitability against the background of its high debt.

Corporate debt is not the only type of debt that carries risk. Governments also borrow by issuing instruments with varying maturities. It is clear from the significant variations in the ratings the independent rating agencies give these sovereign debt issues that the debt of some governments is deemed superior to others, meaning that some are riskier than others.

Although bonds and debentures generate a flow of income at a known date, they do not generate capital gains unless they are bought at a discount, but this does not give a significant advantage as it is factored into the yield-to-maturity. Nevertheless, they have a place in a balanced portfolio.

Even when the investor is satisfied that a bond is of acceptable investment quality, there are certain considerations to be made during the life of the security. If the bond is held to maturity, the natural expectation is that its face value will be paid to the investor, although it will be worth less in real terms because of inflation.

Additionally, selling before the maturity date could mean a capital loss or gain, if interest rates increase or decrease during its life. It is thus useful to monitor market prices and yields.

There should also be continuous monitoring of the company issuing the stock, focusing on its overall financial position, as well as on general business conditions and the economic environment, including the outlook for interest rates.

There is no need to be wedded to an investment instrument, particularly if it no longer aligns with the investor’s objectives or seems likely to face unfriendly market conditions.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com