This article was posted on Wednesday, Apr 01, 2020

As we know, stocks are equity interests. The holder of a share of stock has a partial ownership in the corporation. If the company prospers so do the shareholders, but the opposite happens as well. If a company disappoints, share prices will reflect as much. Thus, stock values are notoriously volatile. Sometimes they can soar to the sky in the manner of Icarus, who was doing well until the wax melted. Google sold stock for $85 a share at their initial public offering in 2004. In the following 16 years, it appreciated 1,400%. 

While the upside for stocks is theoretically infinite, the downside is fortunately fixed – it can only go to zero. The investor can lose only what he’s invested, which is sort of how Icarus met his doom – his entire investment just came apart. Examples of once desirable investments include airlines (Pan American, Eastern), financials (PaineWebber, Lehman Bros), and retail (Borders Books, Toys R Us), all of which have gone to zero.

Those who invest in stocks are subject to the vagarities of the market. In the five years ending 12/31/2019 Warren Buffett’s Berkshire Hathaway gained 278% on its MasterCard investment and 172% on Verisign. There were also significant losses. Berkshire lost 68% of its investment in Kraft Heinz and 55% in Teva Pharmaceuticals. Those are serious numbers. It takes a 212% gain to offset a 68% loss. It takes a 122% gain to break even after a 55% loss. If Warren Buffett couldn’t tell in advance which individual stocks would gain and which lose, there is precious little hope for the rest of us.

Buffett made his fortune buying individual stocks which, as we’ve seen, are subject to dizzying reverses. Many people today, who wish to avoid some of the risk of individual stocks simply “buy the market”, often through the purchase of index funds. An index portfolio would still cycle with the market, but hopefully less (both up and down) than individual stocks. 

Bonds are loans to the company. Bonds do not bestow partial ownership as stocks do. Bonds are evidence of the debt owed. An investor lends money to a company and gets a bond in return. Bonds provide a specified dollar amount of interest for a certain period of time, then it matures and the original principal amount is returned to the bondholder (i.e., the investor / lender). The mechanics of bonds are simple, but that doesn’t mean they are without hazard.

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Inflation.  Most quality bonds are redeemed as originally agreed, so the biggest bond risk is not default. The biggest risk is inflation, which erodes the value of every fixed income investment. At maturity a bond returns only the amount originally borrowed. A $1,000 bond due in ten years will, a decade hence, repay the $1,000 owed . . . but over those 10 years the purchasing power will have been reduced through inflation. The investor will still recover the face amount he lent the company, but it will no longer buy the same number of bananas. At 3% annual inflation a $1,000 bond purchased today will have only $744 of purchasing power in ten years.

Inflation compounds over time, so the longer the maturity the greater the inflationary losses. It would take more than $2 today to buy the same number of bananas that $1 would have bought 30 years ago. Of course, the investor assumes the risk of lost purchasing power due to inflation.

Taxes.  Interest payments are taxable. Stipulating to a 1.5% rate on a $1,000 ten year Treasury note, the gross interest received would be $15 annually. After taxes, that might be reduced to $10. 

A quickie way to estimate a bond’s net yield is to subtract first taxes, then inflation, from its interest rate. In this example, that 10 year Treasury note mentioned above would generate, net of taxes and inflation, a return of negative 2% annually. 

Then why keep bonds?  Both stocks and bonds move money into the future. Bonds give some assurance the money will actually be there when you arrive. The negative yield is the “cost” of that assurance. 

Some folks who have a pretty good track record seem to have no problem owning bonds. Berkshire Hathaway, Warren Buffett’s company, in mid-2019 had $122 billion-with-a-“B” of cash and cash equivalents on hand. It’s illuminating to relate this figure to Berkshire’s total equity of $349 billion: 35% of Berkshire’s net worth is in cash or cash equivalents. It’s equivalent to a long time real estate investor with a net worth of, say, $30 million keeping over $10 million in cash. That is so unusual that there must be a really, really good reason for it.

Capital Structure.  Each share of common stock issued by a company has an equal claim on the assets of the company. The common stock of ABC Company purchased by Ms. Eucalyptus yesterday has exactly the same claim on Company assets as the stock that Mr. Rutabaga bought in 1957. Stock is much like the common nickels cascading out of a slot machine: one coin has the same value as another. Within their classes, individual stocks are homogeneous.

Jumping to the real estate world for a moment, we note that mortgages are not one and the same. There are tiers of supremacy, such that the first deed of trust (the first “T.D”) has a greater claim to the underlying asset than the second trust deed recorded. In a foreclosure sale, the first T.D. has to be fully paid off before the second mortgage gets a dime. It’s interesting, isn’t it, to think that the second TD lender is effectively co-signing on the existing first TD?

As you would expect, the bond market shares much of the structure of the mortgage market. Corporate debentures (unsecured debt) are tiered, such that senior debt has greater claim to corporate assets than subordinated debt. Thus, when buying bonds, it’s generally considered prudent to explore the issuer’s credit rating through referencing the appropriate agencies (Moody’s, S&P, Fitch). 

High-Yield Bonds.  Any bonds that do not have an investment grade rating are, by default, considered non-investment grade. These bonds are known as “non-investment grade”, “high-yield”, or even “junk bonds, depending on who is speaking and how much he’s recently lost. Companies that issue these might be promising start-ups, existing but struggling businesses, or established but highly leveraged issuers. Their common thread is that repayment of the bond is less than certain. This risk is reflected in a higher interest rate, a shorter maturity date, or both.

Occupying the middle ground, under certain conditions high-yield bonds can gain or lose value during the investor’s holding period. Actually all bonds, including investment grades, can fluctuate in value prior to maturity, but high-yield bonds seem to make a career of it. If interest rates go up, the value of the bond (when sold before maturity) goes down. Vice versa. This is especially notable with high-yields. They are, after all, non-investment grade speculative investments. Consider that the reason high-yields offer the higher interest rates they do is because there’s a distinct possibility of default. But credit ratings are not fixed in stone. If the company’s situation improves, it’s possible for their high-yield bonds to get an upgrade from one of the rating agencies. Getting an upgrade means that the yield on the bond goes down which benefits the (then) current holder because the value of the bond would naturally go up. Remember the teeter-totter effect: when net income goes up, value goes down.

A word about changing yields. The bond has a contractual interest payment printed on its face. For the purpose of discussion, let’s consider a hypothetical $1,000 bond with a face rate of 12%. Clearly, in the current uber-low interest rate market that would very much be a high-yield bond. Math: 12% of $1,000 is $120 annual debt service. Excluding default, that payment will not change during the life of the bond. 

But after the initial purchase, during the holding period, the bond may be resold on the secondary market (secondary market: where existing assets are bought and sold). If something happens that makes the bond riskier, the new buyer may require a higher yield just to compensate him for accepting the steeper risk profile. That would affect the price of the bond. Assume the new required yield would be 15%. Math: $120 divided by 0.15 equals a (revised) bond value of $800. That bond just lost 20% of its value. Teeter-totter.

Benefit to Individual investor.  There is the possibility that rating companies might upgrade the credit rating of a bond, indicating a reduced risk. In that event, it’s likely the bond may gain value. Again, risk went down so we’re back on the teeter-totter. The bond gains value because some of the risk of the investment has been lifted. A subsequent buyer on the secondary market would reasonably require a lower risk premium, bringing the required yield down, perhaps to a 10% yield. In that case the value of the bond may rise to $1,200. Math: $120 divided by 0.10 equals $1,200.

To review, the bond that was purchased originally for $1,000; subsequently lost value and was resold at $800 (a loss of 20%). It has now rebounded to $1,200 (a gain of 50%). Speculative, indeed!

Overview: Benefit to Company.  A reduction in interest rate would benefit the company in two ways: (a) the company could borrow more money (the same debt payments would service a higher loan at the lower interest rate) or (b) if the amount of the new borrowing remained unchanged, the cost of servicing the new bonds would be lower.

Example: Benefit to Company. Using different numbers . . . a $400 million issue of 10-year bonds from a “C” issuer at 11% would have an annual interest expense of $44,000,000. If that company received a ratings upgrade to “CC”, the bond might have to carry only a 9% interest rate. Interest expense reduced from $44 million to $36 million. That’s a yearly savings of $8 million. Over ten years it comes to $80,000,000. 

Alternatively, the example company may choose to continue their $44,000,000 in annual interest, but since the cost of that money has now dropped to $36,000,000, that same $44 million would service more debt.

Either way – less interest expense or more money borrowed – the company’s future brightens as its credit rating improves. 

Current credit ratings are so significant to a company’s future that two rating agencies (Moody’s and S&P) offer clues that sometimes foreshadow a company’s outlook. They might announce a company’s rating is Under Review (Moody’s) or on CreditWatch (S&P). Then an amendment might be made to the current rating: it is assigned a positive, negative, stable or developing outlook. A positive or negative bias suggests that an upgrade or downgrade is being considered. Some investors (speculators?) might get excited and act on this new information, but there is no certainty that those amendments will actually result in a changed rating. Besides, rating changes can happen with no prior amendments. Making investment decisions on only the hint of a credit amendment is chancy.

 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]