Oran Hall | The COVID effect on bonds
ADVISORY COLUMN: PERSONAL FINANCIAL ADVISER
QUESTION: Corporate and sovereign bonds are getting less and less attractive to individual investors due to the inability of the issuers of bonds to honour their obligations (pay interest and close out on the maturity date) to investors. And all this when the world economy was in good shape – before COVID-19. Are bonds now less attractive as investment instruments?
FINANCIAL ADVISER: When governments and corporations issue bonds, they commit to make interest payments at a specified rate, at specified times up to maturity, and to repay the principal sum borrowed at the maturity date, but these commitments are not always honoured.
The fact is, there are bonds and there are bonds. The quality varies, and there are many factors that can adversely affect the ability of an issuer to honour these commitments.
Bonds are important in every investment portfolio, not just the portfolios of individuals. They are expected to generate income at a known rate and at pre-determined times, so they create a sense of certainty and predictability.
In many cases, the interest income they yield accounts for a significant portion of their total returns, and they do give some stability to portfolios when the capital values of other types of investment instruments decline.
Investors tend to find comfort in the promise of the issuers of bonds to repay the principal at maturity, so they invest in bonds for safety of principal. As you have observed, sometimes the reality is different. Issuers sometimes find it difficult to honour their commitments and sometimes enter into various arrangements to placate the investors and to give themselves time to right the situation.
Investors often fail to realise that they lose even when the full nominal sum is returned to them. The loss relates to the purchasing power of the principal, which erodes as a result of inflation. The loss of purchasing power is, therefore, a real risk.
Some bonds are useful in an environment like ours in which the value of the local currency declines steadily over time. In this case, bonds denominated in a strong foreign currency are useful, as interest and principal payments increase in Jamaican dollar terms, the more the value of our currency depreciates.
Sovereign bonds, bonds issued by governments, though generally regarded as safer than corporate bonds, are not immune to the inability of their issuers to make contractual payments. The primary source of income that governments use to meet these payments is taxes. There is a limit to how much governments can tax their citizens, so when tax revenues are not as robust as they should be, governments will have a problem servicing their debt. Worse, if the debt burden is heavy.
Corporations do not have the ability to levy taxes, so they must depend on their own ability to generate profit, the major element of cash flow, to service their debt. Corporations with a high debt to equity ratio are at great risk of not being able to service their debt satisfactorily.
Further, high fixed charges in the form of interest and principal repayments weaken them and compromise their ability to generate satisfactory levels of profits for their shareholders.
Net profit is the main source of the funds they generate internally, and it is important that it is able to cover the interest satisfactorily. The ratio varies depending on the type of company. The higher the level of debt and the more that new debt is incurred, the higher the risk of contractual payments not being made.
It is important to do a careful analysis of any new debt issue and also to analyse any older debt that is to be purchased on the secondary market. It is also useful to know the rating ascribed to a debt issue by international rating agencies where such a rating exists.
These ratings give an indication of the relative risk of the bond issue defaulting, that is, the issuer not making timely interest and principal payments as promised. The rating is the agency’s opinion of the credit quality of the instrument and the credit worthiness of the issuer. It is not a recommendation to buy or sell and not a guarantee that a default will not occur.
The quality of bonds varies widely at issue, but unfavourable developments may cause a significant change in the quality of a bond. The profit and cash flow of a company may decline, or it may take on additional debt, and the economy of a country may experience serious shocks and thereby cause a serious decline in tax revenues.
COVID-19 has seriously affected the revenues of governments and corporations, thus threatening their ability to make the contracted payments on the bonds they issue.
Oran A. Hall, principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.