Part III On Asset Classes: Bonds

by: Les Nemethy
Summary

Bonds are one of the most important asset classes.

Only 2% of investment grade bonds are expected to default under a 10-year time horizon.

A diversified medium-risk bond portfolio is possible to generate a return of 6-7% per annum.

We often hear comments about how little interest banks pay, or the low yield on certain treasuries. In our business of Mergers & Acquisitions, we have seen quite a few business owners who want to sell their businesses, but hesitate to do so, because they do not know how to generate a decent return on their proceeds.

The good news is that through a diversified medium-risk bond portfolio, it should be possible to generate a return of 6-7% per annum. Rather than you working, let your money work for you!

Part I of this series provided an overview of asset classes; Part II dealt with the size and liquidity of the various public markets in which these asset classes trade. This article zeroes in on bonds, one of the most important asset classes.

On US Bond Market, Treasury Securities (government debt instrument issued by the United States Department of the Treasury) and Corporate Bonds account for 57% of the whole market, with mortgage related securities, municipal bonds, and other more exotic bonds accounting for the balance. Hence, we will focus on treasuries and corporates for the remainder of this article.

A useful tool for determining the likelihood of Government or corporate default is a credit rating. The three major rating agencies are Moody's, Standard and Poor's, and Fitch:

Exhibit 1: Credit ratings scale[1]

Each investor who decides to invest in bonds as an asset class should construct his or her own bond portfolio, with the appropriate degree of risk/return relationship. (Usually this would be in conjunction with investing in other asset classes as well).

The next two charts provide (a) a sample of 10-year Government bonds; and (b) a sample various maturities of corporate bonds, just to provide illustrate available of risk/ return relationships. Note that the least risky bonds have a negative yield!

Exhibit 2: 10-year government bond yields for the selected countries as at April 17, 2019[2]

Country

S&P Rating

10Y Yield

Spread vs Germany Bund

Spread vsTreasuryNote

Australia

AAA

1.960%

189.2 bp[3]

-63.8 bp

Austria

AA+

0.361%

29.3 bp

-223.7 bp

Canada

AAA

1.783%

171.5 bp

-81.5 bp

Chile

A+

4.130%

406.2 bp

153.2 bp

China

A+

3.429%

336.1 bp

83.1 bp

Czech Republic

AA-

1.854%

178.6 bp

-74.4 bp

Egypt

B

16.330%

1626.2 bp

1373.2 bp

France

AA

0.420%

35.2 bp

-217.8 bp

Germany

AAA

0.068%

0.0 bp

-253.0 bp

Greece

B+

3.362%

329.4 bp

76.4 bp

Hungary

BBB

3.290%

322.2 bp

69.2 bp

India

BBB-

7.390%

732.2 bp

479.2 bp

Indonesia

BBB-

7.629%

756.1 bp

503.1 bp

Italy

BBB

2.592%

252.4 bp

-0.6 bp

Japan

A+

-0.019%

-8.7 bp

-261.7 bp

Nigeria

B

14.347%

1427.9 bp

1174.9 bp

Poland

A-

2.873%

280.5 bp

27.5 bp

Russia

BBB-

8.250%

818.2 bp

565.2 bp

South Africa

BB

8.500%

843.2 bp

590.2 bp

Spain

A-

1.086%

101.8 bp

-151.2 bp

Switzerland

AAA

-0.252%

-32.0 bp

-285.0 bp

Turkey

B+

17.590%

1752.2 bp

1499.2 bp

United Kingdom

AA

1.222%

115.4 bp

-137.6 bp

United States

AA+

2.598%

253.0 bp

0.0 bp

Exhibit 3: Selected corporate bond yields as at April 17, 2019[4]

Issuer

Symbol

Coupon

Maturity

S&P Rating

Yield

Category

Microsoft Corp

MSFT4451226

4.500

02/06/2057

AAA

3.853

Prime

Berkshire Hathaway Fin Corp

BRK3677309

5.750

01/15/2040

AA

4.065

High Grade

Apple Inc

AAPL4336433

4.650

02/23/2046

AA+

3.943

High Grade

Cargill Inc

CARG.HY

6.125

04/19/2034

A

4.651

Upper Medium Grade

Boeing Company

BA.IS

7.875

04/15/2043

A

4.520

Upper Medium Grade

AT&T Inc

T4621935

5.300

08/15/2058

BBB

5.942

Lower Medium Grade

Delta Air Lines Inc

DAL4277696

4.250

01/30/2025

BBB+

3.835

Lower Medium Grade

Dell Inc

DELL.GR

6.500

04/15/2038

BB-

6.414

Speculative

Netflix Inc

NFLX4556816

4.875

04/15/2028

BB-

5.756

Speculative

Frontier Communications Corp

FTR4609188

8.500

04/01/2026

B

9.784

Highly Speculative

Mattel Inc

MAT.HG

5.450

11/01/2041

B+

7.978

Highly Speculative

Tesla Inc

TSLA4530906

5.300

08/15/2025

-

(Moody's Caa1)

8.318

Substantial Risk

Bombardier

BDRB3705506

7.450

05/01/2034

-

(Moody's Caa1)

7.088

Substantial Risk

So how often do bonds default? A summary overview is provided by the following chart:

Exhibit 4: Global Average Cumulative Default Rates[5]

In other words, higher grade and shorter-term bonds default quite seldom. Only 2% of investment grade bonds (e.g. credit rating of Baa3/BBB- and higher) are expected to default under a 10 year time horizon.

As the following chart indicates, yields fluctuate over time:

Exhibit 5: Moody's Seasoned Aaa and Baa Corporate Bond Yields[6]

Since the end of the last financial crises, yields on Aaa bonds have fluctuated between 3-5% and Baa bonds between 4-7%.

We are not suggesting an investment in bonds is for everyone. (For example, it takes a fair amount of resources to build a balanced portfolio when bonds are typically sold in denominations of USD 100,000). However, we trust we have illustrated the principle that a 6-7% overall yield even in today's low yield market should be achievable with relatively modest risk, and that bonds of various types should be seriously considered by most investors.

[1] Learn Bonds, Bond Credit Ratings Table

[2] World Government Bonds, World Government Bonds - Daily updated yields

[3] Basis point. One basis point is equal to 1/100th of 1%, or 0.01%

[4] Finra - Bonds, Bonds Home

[5] S&P, 2017 Annual Global Corporate Default Study

[6] Fred Economic Data

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only, not to be construed as investment advice. It is very important to do your own investigation and analysis before making any investments based on your own personal circumstances.