Wednesday 26 June 2019 by Jonathan Sheridan Education (advanced)

The lifecycle of a bond – what can I expect?

A bond is like any other investment that can trade after it is first issued – the market price can move up and down.

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Depending on the expectation of the repayment of the bond relative to the performance of the company, the price may move by more or less as the company’s fortunes wax and wane, noting that the company’s obligation in relation to the final repayment never changes.

In general, bonds are much less volatile than the equity (shares) in the same company, as bonds are higher in the capital structure and as such are less risky than the shares given the performance of the company itself.

It is important in bond investing to think about the downside.  As bond returns are usually in a relatively low single digit percentage, the worst case scenario is that we don’t get our capital back when we expect, and at the amount expected.

Shares, which can offer upside of multiples of the initial capital, can sometimes compensate for volatility with large returns – but of course this can also work the other way with losses as well!

We can see this in two examples – one current and one historical.  It is important to consider a time when the investing world was under stress, as well as in today’s markets where everything is (currently) performing strongly.  It is the stressed markets where the security selection becomes absolutely key, as that is often when you can’t sell when you might otherwise want to…

Historical – showing CBA senior unsecured bond vs hybrid security vs equity through the GFC

CBA_value
Source: FIIG Securities, Bloomberg

It is clear that the senior bond (from a very large, solid company that benefitted from a government guarantee on deposits at the lows) shows a level of stability that is not matched by either the hybrid security or the equity.

This is to be expected when the issuer has a very strong investment grade rating from the ratings agencies.  The short term performance of the company does not influence the market’s view on its ability to repay the bonds, and as such their pricing remains very stable.

In the most stressful time, the bond actually goes up in price as investors sought this kind of safety when other assets (such as their equity and hybrids) were selling off.  This is an important counter-cyclical advantage of owning high grade bonds.

Current – showing Hertz senior secured and unsecured bond vs equity

Hertz

Hertz is a sub-investment grade (or “junk”) issuer. It is considered by the market to be of a much lower quality than CBA for example.

This chart demonstrates that despite the significant volatility in the share price, reflecting the changing fortunes of the business, since the issuance of the secured bond on the 31st of May 2017, its price has remained within a small range around par (100 or the issue price).

The unsecured bond, which ranks below the secured bond and would therefore be paid out after the secured bond holders, shows a higher volatility, but still significantly less than the equity, which is at the bottom of the capital structure ranking.

In conclusion, it can be seen that bonds in general are less volatile than shares.  Generally, the safer the issuer of the bond, the less the volatility of the bond relative to the underlying performance of the business.

Even in lower rated, riskier issuers, bonds show less volatility than the shares of the same company.

Bonds can therefore provide a valuable smoothing effect to an overall portfolio which is otherwise made up of riskier, more volatile assets.


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