Between The Num...'s  Instablog

This article by Morningstar does a reasonable job of covering important topics relating to bond allocation in a portfolio, particularly that of a retiree looking for income over risk. One of the key ways in which bond ETFs and individual bonds are completely different (and barely mentioned in that article) is the significant diversification risk of owning only a few number of bonds. If the goal is to build a ladder, it complicates the matter further as more holdings at each maturity are required to maintain diversification. Unless it is a treasury, a longer-dated bond itself will rise and fall in value with the creditworthiness of the issuer (default or no), which can make selling for a capital loss an issue if not held to maturity. Chasing yield (at all, not just long dated) and holding individual junk bonds is a big risk for a single investor. For the average retiree, I could make a case that it would be riskier than owning individual stocks given the more opaque pricing, decreased liquidity, and concerns about the ratings agencies. "as long as the creditor remains solvent" is a tough game even for professionals (ask CalPERS, GM bondholders, etc), and picking bonds that will outperform the market is no easier than picking stocks.

Secondly, for most investors the superior liquidity of ETFs has significant advantages. Most of the bond ETFs pay nice predictable dividends, giving an opportunity to plan for income even as the underlying varies in value with interest rate changes. Some bonds have coupons that are more or less than their effective yield, and at the end of maturity the bond is paid in full. Bonds that default or undergo restructuring may be process unfamiliar to unsophisticated bond investors. If you wish to reinvest and not spend, you would incur transaction costs in reinvesting it. With the bond ETF you can sell whole or part, and use tax law to your advantage when claiming gains and losses. A reasonable portfolio of individual bonds is going have significantly higher transaction costs, while the tiny 15 basis points charged by some of the larger bond ETFs (LQD, AGG, BND,SHY) offer some of the best value of any fund. With hundreds of thousands of shares traded daily, the ETFs have tiny bid-ask spreads and never deviate in value from the underlying by more than a few basis points. Compare that to the average bond, where bid-ask spreads and quantity offered can reasonably affect returns.

In summary, if considering individual bonds, buyer beware, and consider bond ETFs a staple allocation in any portfolio looking to manage risk.

I commented earlier about how the previous restructuring offer to bondholders was both unacceptable and indicated a position of bad faith on the part of GM, using political concerns to gift unions a much larger share of the new GM. It seems that the government, having taken a deeper look at GMs books, may agree as well. From the NYT article:

It said the government, which will provide bankruptcy financing of about $50 billion, initially would hold 72.5 percent of G.M., with the United Automobile Workers union receiving 17.5 percent, and bondholders and shareholders receiving 10 percent

But the percentages held by the bondholders and the union could conceivably be larger because each are being offered warrants in the new G.M., which would be created in bankruptcy.

Under the terms of the plan, bondholders would initially receive 10 percent. They could then exercise their warrants for an additional 7.5 percent when new G.M. rises to about $15 billion in value. The second set of warrants for the final 7.5 percent would be exercisable when new G.M. rises to $30 billion in value.

The union would initially receive a 17.5 percent stake to finance a health care trust for its retirees. It has also received warrants to raise that holding to 20 percent — but as Thursday’s filing made clear, those warrants are exercisable only if new G.M.’s value hits $75 billion.

The $50B debtor-in-possession loans that the government would provide would likely not be the last credit that GM would need for the future. Unless the government was prepared to pour unlimited funds in whenever GM needed them, assuaging the fears of the credit market was necessary to enable GM to get private financing in the future.

Additionally, every dollar the government contributes causes it to become an even larger “reluctant shareholder”. This is a giant political risk for the government – if it attempts to exercise control over GM’s decision making, then GM will be quasi-nationalized and the market will view it with suspicion. On the other hand, if GM closes plants and lays off workers that are constituents of powerful political figures, there will be a cry to use government ownership to prevent GM from executing its cost and capacity reduction plan. The conflicts of interest could be quite challenging – what if what is good for GM (and the US stake as a shareholder) is not good for a city or state where the plant closures occur? A Representative or Senator cannot credibly claim that “we have no control over GM” (not with a 70% stake and a CEO firing under their belt), and would look powerless were they to allow a plant closing without at least a fight. How about a demand for gas guzzling (but higher profit) SUVs? Would the Obama administration block widespread production and sales of those vehicles due to environmental or energy dependency concerns? These examples just scratch the surface of the potential conflicts.

In order to minimize this political risk, the government needs private capital to come in and help make the tough choices required for this restructuring. By giving the debt holders a much better deal (especially when compared to the previous deal where equal status creditors got way more), there is a much better chance that future debt or stock issues by GM will be positively received by the market. The sooner the government can divest itself of majority ownership, the better it will be for everyone involved.

Disclosure: Minor indirect holdings in GM debt through various funds

I think the theme of my last three photos was "can you dig up any old photos that make you look as unqualfied as possible to discuss economics and finance?"

This new one is great - you can't tell how old I am at all. Is he 17 at his older cousin's graduation? Is he 25 at his own wedding? Is it a 35 year old at his uncle's funeral? A middle-age man watching his daughter graduate? None of the above, but with a clean shave and some movie makeup? Hard to tell.

Credit to the wife for the save.