High-yield corporate bonds can provide the income investors are seeking but there is substantial risk involved. A recent Moody’s Investors Service report on corporate bond defaults underlines the fact that sometimes companies go bankrupt and bondholders get little or nothing.
Between 1989 and 2004, 64 Canadian corporate issuers have defaulted on a total of $32 billion in bonds, according to the Moody’s report.
The two Canadian public bond defaults in 2004, says Moody’s, were Hollinger Inc., which temporarily missed the interest payment on $161 million of its senior secured notes, and Stelco Inc., which had $240 million of bonds outstanding when it filed for bankruptcy protection.
Moody’s predicts that the global default rate for corporate bonds is likely to rise over the next year and this trend will probably hold true in Canada as well where two companies have already defaulted in 2005.
The dangers in holding corporate bonds is something investors should keep in mind as they eye the current high yields of around 11 per cent available on 5-year General Motors bonds. This is a substantial premium to 5-year Government of Canada bonds yielding around 3.5 per cent.
The same GM bonds also looked good when they were quoted at yields of around 6 per cent a few months ago.
But those who had bought then are now sitting with substantial capital losses as the price of the bonds has adjusted downward in response to recent rating downgrades; Standard & Poor’s, concerned with management’s inability to handle the company’s competitive disadvantages, cut the credit rating on GM bonds to a ‘speculative’ BB from the lowest investment-grade rating of BBB minus.
Bonds rated BBB, A, AA, and AAA (the highest) are all considered to be investment grade. But an investment-grade rating doesn’t always mean investors are protected because problems can develop at anytime in the fast-changing world of business and rating agencies aren’t always good forecasters of the future.
For those attracted to the 11-per-cent yield on 5-year GM bonds, a key question is whether GM will be around to pay the bonds in full when they mature.
In Canada, most of the GM bonds are issued by a subsidiary, General Motors Acceptance Corp., which many analysts claim is in better financial shape than its parent in the United States.
But is the GMAC Canadian subsidiary really separate from its U.S.-based parent? Would GMAC bondholders effectively escape damage if General Motors succumbed to its major health care and pension liabilities and went bankrupt?
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These questions are obviously difficult to answer for individual investors who may not have the time or knowledge to research the matter in depth.
To come up with an informed judgment, one would need to dig into the details of GM’s financial situation, make a forecast on its ability to keep market share in the car and truck market, and, furthermore, read the prospectuses and other detailed documents related to the bond issues to gauge how real the protections are.
What this all boils down to is that individual investors are ill-equipped to make knowledgeable investments in riskier corporate bonds.
Those seeking income from this sector would be wise to allow a fund manager to do the research and make the investment decisions. There are several mutual funds specializing in high-yield corporate bonds.
This is not to say that professional bond managers have a perfect score in this regard. Some have made mistakes, ending up with bankrupt-company bonds in their portfolios.
But that raises another reason why investing in a fund makes sense. Given that corporate bonds defaults do occur, it is best to be diversified in at least 20 different issuers in a portfolio, so that if one company goes bankrupt, only 5 per cent of the portfolio would be affected. It’s pretty difficult for average individual investors, given the size of their portfolios, to achieve such a diversification on their own.
For investors seeking income, an attractive alternative is an investment in business income trusts where cash distribution yields are often as high as the interest paid by high-yield corporate bonds. Given that corporate bonds aren’t completely safe, there is really no additional risk in going this route and, unlike bonds, there is the added potential of growth if the business does well and raises distributions.
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
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©2005 Wayne Cheveldayoff