Last week, a reader, Jason, posted a comment regarding the attractiveness of corporate bonds vs. convertibles in the context of the US$. I’ve been pondering his comment for a week now and would like to post my thoughts on the subject. In fact, if I had heeded Jason’s previous comments regarding ACAS, I could have spared myself most of the debacle that ensued.
For background, Bill Gross (and Marc Faber and Bruce Berkowitz and Seth Klarman and others, I’m sure) think corporate bonds offer attractive returns vs. equities. Jason’s comment was that Jim Grant, in a recent issue of Grant’s Interest Rate Observer, recommends convertible bonds. Jason also expressed concern over the stability of the US$, which I share.
He makes a good point. Corporate bonds (or Treasurys or any US$ debt) offer no protection against currency risk. Regular readers know I am bearish on the dollar long-term. But I hesitate to wholeheartedly believe calls by folks like Jim Rogers to completely abandon the dollar. Rogers may be right but I think there’s a good chance it’s a ways off.
Grant’s push into convertibles is a good way to play both sides. For example, my Chesapeake preferred position will pay 8-9% per annum (in US$), which I find a satisfactory yield. If the US$ tanks again, stocks generally should go up as currency devaluation usually drives up asset prices all around (I think the Zimbabwe stock market is up some ridiculous amount). Eventually, the preferreds can be converted to equity which offer some protection against currency devaluation.
The one aspect that attracts me to bonds is they inherently have a defined catalyst for realizing their value: the maturity date. Convertible bonds, depending on the specific provisions, can offer the best of both worlds.
Using Chesapeake’s securities as an example, CHK convertible bonds, like preferred stock, offer the option to convert to equity. Like non-convertible bonds, they offer a defined catalyst for realizing value — a maturity date as well as optional redemption dates. In the case of CHK’s 2.5% 2037 convertible notes, if share prices haven’t recovered by 2017, the investor can opt to redeem the notes at par on May 15th, 2017 and every 5 year interval thereafter. The convertibles are also equal to the senior notes in the capital structure, which provides better protection than preferred or common stock in bankruptcy. Of course, the price to be paid for all this flexibility is a lower current yield which can be a substantial factor over a 10 year horizon:
- CHK 2037 2.5% convertibles: 4.66% (11% YTM if redeemed 2017 @ par)
- CHK preferred D stock: 8.82%
- CHK 2017 6.5% senior notes: 10.83% (15.5% YTM)
That said, I still think corporate bonds can be attractive, despite the currency risk. I would focus on the following factors:
- Find companies with a low likelihood of defaulting, which is tricky since the ones offering the highest yields are implicitly those are the ones most at risk. Being right (or good hedging) is absolutely essential.
- Make sure you are being paid appropriately for the risk exposure, including currency risk. 15% annual yields may or may not be enough to offset any currency devaluation risk but 6% seems paltry to me. Each investor will have to determine her own subjective risk tolerance.
- Keep maturities short. Especially with some of the junk bonds where much of the pay-off will come at maturity, the shorter duration lowers your exposure to US currency risk.
- Buy higher rate notes, if possible. Ignoring reinvestment rates, bond duration hinges on two things: maturity date and rate of interest. A higher interest rate means more of your total return is coming on the front end, not on the capital gain on principal. This allows you to take those returns, ostensibly when the US$ is worth more, and invest in non-dollar assets.
- Much of bond investing is relative — i.e. much of your risk is interest rate risk, etc. I would focus more on absolute returns and employ a buy-and-hold strategy. If a 15% yield seems attractive, focus on that. If interest rates rise and the yield is now 20%, take the opportunity cost in stride knowing that you have a defined catalyst to realize your value. Timing the bond market probably isn’t any easier than timing the stock market.
I advise all readers to do their own research to determine if bonds of any stripe (or convertibles or equities, for that matter) are suitable for their portfolios. In fact, the conventional thinking is that individual investors shouldn’t even consider individual corporate bonds unless they have a substantial amount of wealth to properly diversify their portfolio. FWIW, most people are usually advised to consider some sort of bond fund or ETF.
BTW, Jason also runs his own blog, Visinomics, which I recommend especially for his command of Microsoft Excel though his stock picking and timing skills seem superb as well (nice call on Berkshire!). I find that Excel, in conjunction with my Perl scripts (which scrape various finance sites for latest stock info), help me gather data and screen stocks quickly. Jason is pretty knowledgeable in Visual Basic and could probably embed my scripts directly into the spreadsheet for a more elegant tool. In any case, for readers who spend a fair amount of time on stocks, an efficient, automated method of viewing and screening stocks is essential.