Impure Fixed Income
Fixed income alternatives dominate the population of well-defined markets that serve no valuable portfolio role. While default-free, noncallable, full-faith-and-credit obligations of the U.S. government play a basic, valuable, differentiable role in investor portfolios, investment grade corporate bonds, high yield bonds, foreign bonds, and asset-backed securities contain unattractive characteristics that argue against inclusion in well-constructed portfolios. Noncore fixed income asset classes command a sizable portion of the pool of investment alternatives. Many players allocate assets to corporate bonds and mortgage-backed securities, hoping to generate incremental returns without additional risk. Understanding the shortcomings of particular fixed income investment alternatives, particularly in regard to how those alternatives relate to the objectives of the fixed income asset class, helps investors to make well-informed portfolio decisions.
DOMESTIC CORPORATE BONDS
Owners of corporate bonds hold a piece of a loan to the corporation that issued the bonds to borrow the money. In a company’s capital structure, debt obligations rank higher than equity interests, causing a company’s bonds to exhibit less fundamental risk than a company’s equity. Because bonds carry less risk than equities, fixed income investors expect lower returns than do equity investors. Unfortunately for investors, corporate bonds contain a variety of unattractive characteristics, including credit risk, illiquidity, and callability. Even if corporate bond investors receive fair compensation for these unattractive characteristics, astute investors recognize that the credit risk and callability of corporate obligations undermine the fundamental diversifying power expected from fixed income holdings.
Credit Risk
Credit risk stems from the possibility that a corporation will not meet the obligation to make full and timely payments on its debt. Rating agencies, such as Standard & Poor’s and Moody’s Investor Service, publish ratings for bond issues, purporting to grade the likelihood that an issue will produce as promised. The most important factors in assessing a bond issuer’s ability to pay lie in the size of the equity cushion supporting the debt and the amount of cash flow servicing the debt. Investment grade ratings, assigned to the most creditworthy borrowers, range from triple A (the highest) to triple B. High yield or “junk” bonds carry ratings of double B and below. Lower-rated bonds embody greater credit risk and exhibit more equity-like characteristics.
Moody’s describes triple-A rated bonds as being “of the best quality” and carrying “the smallest degree of investment risk,” with interest payments “protected” and principal “secure.” Double-A bonds exhibit “high quality by all standards,” while single-A bonds “possess many favorable investment attributes.” The bottom investment grade category (triple-B) manifests adequate security “for the present,” but “lacks outstanding investment characteristics.”1 Despite the shades of gray introduced by the description of the triple-B rating category, Moody’s paints a bright picture for investment grade debt obligations.
Unfortunately, from a corporate debt investor’s perspective, triple-A rated bonds can only decline in credit quality. Sometimes bondholders experience a downward drift in quality to less exalted, albeit still investment grade ratings. Other times bondholders face a lengthy, Chinese-water-torture deterioration in credit that results in exile to the “fallen angel” realm of the junk bond world. On occasion, triple-A rated obligations maintain their standing. In no case, however, do triple-A bonds receive upgrades.
IBM illustrates the problem confronting purchasers of corporate debt. The company issued no long-term debt until the late 1970s, as prior to that time IBM consistently generated excess cash. Anticipating a need for external finance, the company came to market in the fall of 1979 with a $1 billion issue, representing the then-largest-ever corporate borrowing. IBM obtained a triple-A rating and extremely aggressive pricing on the issue, which resulted in an inconsequential yield spread over U.S. Treasuries and (from an investor’s perspective) underpriced call and sinking fund options. Bond investors spoke of the “scarcity value” of IBM paper, allowing the company to borrow below U.S. Treasury rates on an option-adjusted basis. From a credit perspective, IBM debt had nowhere to go but down. Twenty-eight years later, IBM’s senior paper carried a rating of single A, failing to justify both the ratings agencies’ initial assessment of IBM’s credit and the investors’ early enthusiasm for IBM’s bonds.
Bond investors did not face an opportunity to lend to the fast-growing, cash-generative IBM of the 1960s and 1970s. Instead, bond investors considered the option of providing funds to the IBM of the 1980s and 1990s, when the company needed enormous sums of cash. As IBM’s business matured and external financing requirements increased, the quality of the company’s credit standing slowly eroded.
Contrast the slow erosion of IBM’s credit to instances in which corporate credit quality declines dramatically. In early April 2002, WorldCom’s senior debt boasted a single-A rating from Moody’s, placing the fixed income obligations of the telecommunications company firmly in the investment grade camp. On April 23rd, Moody’s downgraded WorldCom to triple B, one notch above junk status, as the company struggled with lower demand from business customers and concerns regarding accounting issues. A little more than two weeks later, following Chief Executive Bernard Ebbers’s resignation, on May 9th Moody’s chopped WorldCom’s rating to double-B, junk-level status. According to Bloomberg, the firm thereby achieved the dubious distinction of becoming the “biggest debtor to ever be cut to junk.”2
To the dismay of WorldCom’s creditors, the rapid fire descent continued. On June 20th, Moody’s assigned a rating of single B to WorldCom’s senior debt, citing deferral of interest payments on certain of the company’s obligations. One week later, Moody’s dropped WorldCom’s rating to single C, characterized by the rating agency as “speculative in a high degree.” In the middle of the following month, on July 15th, the company defaulted on $23 billion worth of bonds. Finally, on July 21st, WorldCom filed for the largest bankruptcy in history, listing in its court filing assets in excess of $100 billion.
WorldCom’s transformation from a single-A credit, possessing “adequate factors giving security to interest and principal,” to a company in bankruptcy spanned less than three months. Most holders of bonds watched helplessly as the train wreck of WorldCom’s bankruptcy demolished billions of dollars of value in what Moody’s described as a “record-breaking default.”3
During the final stage of the firm’s death spiral, the WorldCom Senior 6.75 Percent Notes of May 2008 fell from a price of 82.34 in the week before the Moody’s downgrade to a price of 12.50 after the firm’s bankruptcy. Owners of equity fared worse. From the week before the downgrade to the date of the bankruptcy, the stock price collapsed from $5.98 per share to 14 cents per share. Measured from the respective peaks, equity investors took by far the rougher ride. The WorldCom senior notes traded as high as 104.07 on January 8, 2002, resulting in an 88.0 percent loss to the bankruptcy declaration. Stockholders saw a price of $61.99 on June 21, 1999, creating a high-water mark that allowed investors to lose 99.8 percent to the date of the corporate demise.
Clearly, on a security-specific basis WorldCom’s collapse hurt equity holders more than it hurt debt holders, consistent with the notion that equity carries more risk than bonds. Yet, ironically, equity owners likely found it easier to recover from the WorldCom debacle than bondholders. The key to this apparent contradiction lies in the superior ability of a portfolio of equities to absorb the impact of single-security-induced adversity. Because individual stocks contain the potential to double, triple, quadruple, or more, a portfolio of equities holds any number of positions that could more than offset one particular loser. In contrast, high quality bonds provide little opportunity for substantial appreciation. The left tail of the negatively skewed distribution of outcomes hurts bond investors in dramatic fashion.
The deterioration in IBM’s ability to pay over nearly three decades and the much more compressed collapse of WorldCom’s credit standing mirrored a broader trend in the corporate debt markets. In recent times, corporate debt downgrades far outnumbered upgrades, forcing bond investors to manage against substantial headwinds. For the two decades ending December 31, 2006, Moody’s Investors Service downgraded 6,907 debt issues while the firm upgraded 4,087. In the last decade alone, $7,003 billion of debt deteriorated in quality relative to the $3,931 billion of debt that improved.4
The across-the-board decline in credit standards stems in part from the past two decade’s relentless increase in leverage in corporate America. On June 30, 1987, the debt-equity ratio of S&P 500 companies stood at 0.6, signaling that the constituent companies of the S&P 500 carried 60 cents of debt for every dollar of equity. As leverage increased in popularity, on June 30, 1997, the ratio reached 0.90. By June 30, 2007, the S&P 500 posted a debt-equity ratio of 1.03, indicating that debt levels exceeded the equity base by three percent. As the level of corporate borrowings increased, the security of corporate lenders decreased.
Not surprisingly, the increase in debt placed stress on the income statement. Consider the ratio between the cash flow available to service debt and a firm’s interest expense. At June 30, 1987, the constituent companies of the S&P 500 boasted $4.70 of cash flow for every $1.00 of interest expense. By June 30, 2007, the ratio decreased to $3.80 of cash flow per $1.00 of interest expense, representing a dramatic impairment. Obviously, as cash flows decreased relative to fixed charges, the security of the bondholders decreased commensurately.
Balance sheets and income statements tell the same story. Debt-equity ratios increased markedly over the past two decades, signaling deterioration in corporate credit. Cash flow coverage ratios deteriorated significantly over the same twenty years, suggesting a decline in corporate financial health. Both factors contribute to rating agency downgrades far outnumbering upgrades.
In addition to fundamental factors, the particular nature of companies that issue corporate debt may contribute to the surplus of downgrades over upgrades. The universe of corporate debt issuers consists of generally mature companies. Relatively young, faster growing companies tend to be underrepresented in the ranks of corporate bond issuers, in many cases because they have no need for external financing. Bond investors cannot purchase debt of Microsoft, because the company sees no need to tap the debt markets for funds. Bond investors can purchase debt of Ford Motor Company, because the firm requires enormous amounts of external finance. If the group of corporate debt issuers excludes fast-growing, cash-generative companies and includes more-mature, cash-consuming companies, perhaps bond investors should expect to see more credit deterioration than credit improvement. Regardless of the cause, if history provides a guide to the future, bond investors can expect more bad news than good on credit conditions.
Liquidity
Liquidity of corporate bond issues pales in comparison to the liquidity of U.S. Treasuries which trade in the broadest, deepest, most liquid market in the world. Most corporate issues tend to trade infrequently, as many holders buy bonds at the initial offering and sock them away, pursuing buy-and-hold strategies.
Yet bond investors value liquidity highly. Compare U.S. Treasury issues and Private Export Funding Corporation (PEFCO) bonds. Even though both bonds enjoy full-faith-and-credit backing of the U.S. government, the less liquid PEFCO bonds trade at prices that produce yields of as much as 0.6 percent per annum higher than comparable-maturity Treasuries. The difference in yield stems entirely from the value that the market places on liquidity. Liquidity of most corporate bonds tends to stand closer to the PEFCOs than to the Treasuries, suggesting that lack of liquidity explains a significant portion of the corporate bond yield spread.
Callability
Callability poses a particularly vexing problem for corporate bond investors. Corporations frequently issue bonds with a call provision, allowing the issuer to redeem (or call) the bonds after a certain date at a fixed price. If interest rates decline, companies call existing bonds that bear higher-than-market rates, refunding the issue at lower rates and generating debt service savings.
The holder of corporate bonds faces a “heads you win, tails I lose” situation. If rates decline, the investor loses the now-high-coupon bond through a call at a fixed price. If rates rise, the investor holds a now-low-coupon bond that shows mark-to-market losses. The lack of parallelism in a callable bond’s response to rising and falling rates favors the corporate issuer over the bond investor.
The asymmetry implicit in the corporate bond call provision prompts questions regarding relative market power and sophistication. Why do many bonds incorporate call provisions? Why do put provisions appear rarely?* Surely, if interest rate increases prompt bond price decreases, investors would like to put the now-underwater bonds to corporate issuers at a fixed price. The answer to the asymmetry no doubt lies in the superior sophistication of issuers of debt relative to the limited market savvy of purchasers of debt.
In point of fact, fixed income markets attract analysts several notches below the quality and sophistication of equity analysts, even though the complexity of the task facing the fixed income analyst arguably exceeds the difficulty of the equity analyst’s job. Corporate bond investors need familiarity not only with the complexities of fixed income markets, but also with the full range of issues involved in equity valuation. Since understanding the cushion provided by a company’s equity proves essential in evaluating a corporation’s ability to service debt, bond analysts require a full assessment of a company’s stock price. Ironically, because financial rewards for successful equity analysis far outstrip the rewards for successful fixed income analysis, the talent gravitates to the easier job of simply analyzing equity securities.
Negatively Skewed Distribution of Outcomes
Atop the perils facing investors in the corporate bond market stands a further handicap. The expected distribution of corporate bond returns exhibits a negative skew. The best outcome for holding bonds to maturity consists of receiving regular payments of interest and return of principal. The worst outcome represents default without recovery. The asymmetry of limited upside and substantial downside produces a distribution of outcomes that contains a disadvantageous bias for investors.
Shorter holding periods manifest the same distributional problem. Return of principal at maturity (or prematurely upon corporate exercise of a call provision) limits appreciation potential. The nearer the date of expected repayment, the greater the dampening effect. In the case of credit deterioration, bondholders experience an attenuated dampening effect. When corporate prospects deteriorate, bond prices decline as purchasers require greater returns for the now-riskier issue. In a worst-case default scenario, bond investors may face a total wipeout. Both when holding bonds to maturity and for shorter terms, bond investors deal with a decidedly unattractive, limited-upside, substantial downside, negatively skewed distribution of returns.
Investors prefer positively skewed distributions by a wide margin. Active equity investors prize positions with limited downside, perhaps supported by readily ascertained asset values, and substantial potential upside, perhaps driven by anticipated operational improvements. Under such circumstances, investors see a high likelihood of preserving capital with a considerable possibility of significant gains. Positively skewed distributions of expected investment results definitively trump negatively skewed distributions, creating yet another hurdle for fixed income investors.
Alignment of Interests
Interests of stockholders and bondholders diverge dramatically. Equity owners benefit by reducing the value of debt obligations. Equity owners suffer as the cost of debt finance increases. To the extent that corporate management serves shareholder interests, bondholders beware.
Consider the enterprise value of a corporate entity. Analysts assess company values by evaluating either the left side or the right side of the balance sheet. The left side of the balance sheet contains difficult-to-value physical assets. What price reflects the fair market value of the various and sundry facilities owned by Ford Motor Company? What value accrues to Ford from its world famous trademark? Even the most diligent analysts recoil at the thought of conducting the asset-by-asset inventory required to value the left side of a company’s balance sheet.
The right side of the balance sheet contains easier-to-value liabilities. Summing the market value of a company’s debt and the market value of a company’s equity provides the enterprise value of a corporation. The enterprise value reflects the price an investor would pay to buy the entire company. If all equity were purchased at the market price and all debt and other liabilities were purchased at market prices, the purchaser would own the entire corporation (debt free!).
From this description of a firm’s debt and equity positions follows the fundamental corporate finance principle that a firm’s value stands independent of a firm’s capital structure. Because an investor holds the power to undo what a firm has done with its capital structure or to do what a firm has not done with its capital structure, the enterprise value of a company must be independent of its financing. For example, an investor might undo a firm’s leverage by purchasing that firm’s bonds, thereby negating the effect of corporate leverage. Conversely, an investor might create a leveraged position in a firm by borrowing to buy the firm’s stock, thereby creating leverage where none existed. Since investors can destroy or create leverage independent of a company’s actions, the enterprise value must be independent of the company’s capital structure.*
The description of enterprise value highlights the clear, direct trade-off between the interests of stockholders and bondholders. The value of the enterprise lies in the sum of the value of the debt and the value of the equity. To the extent that owners of a company reduce the value of the bondholders’ position, the equity owners benefit. Stockholders gain by imposing losses on bondholders.
Because interests of corporate management align with equity investors, bondholders find themselves sitting across the table from corporate management. Recognizing the vulnerability created by relying on corporate management to protect lender interests, bond investors employ complicated contracts, called indentures, that seek to cause corporate issuers of debt to serve bondholder needs. Unfortunately for bondholders, even contracts drafted by the most able lawyers prove insufficient to influence corporate behavior in the desired manner, particularly when the hoped-for actions run against the economic interests of management.
At times, the transfer of wealth from bondholders to stockholders occurs in dramatic fashion. When companies engage in leveraged buyout or leveraged recapitalization transactions, the debt levels of the corporations increase substantially. The increase in debt heightens the risk for existing lenders, leading directly to a decrease in the value of existing debt positions. KKR’s 1989 RJR Nabisco buyout exemplifies the pain suffered by bondholders when debt levels balloon. During the bidding war for RJR, as the price offered for the company increased to ever-more-absurd levels, so did the prospective debt burden. Before the buyout, RJR Nabisco’s liabilities amounted to something less than $12 billion. Post-buyout fixed obligations exceeded a staggering $35 billion. As a direct result of the dramatic change in capital structure, pre-buyout bondholders lost an estimated $1 billion of value while equity owners enjoyed a $10 billion windfall. The bondholder losses went directly to the equity owners’ pockets.
In other situations, management employs more subtle methods to disadvantage bondholders. Simply by seeking to borrow at the lowest possible costs and on the most flexible terms, management acts to lessen the position of bondholders. Aside from working to achieve low borrowing rates, bond issuers might include favorably priced call options or attractively structured sinking fund provisions. Upon exercise of a call option, bondholders suffer and equity owners gain. Companies may negotiate indenture terms that grant wide operating latitude for management, including the flexibility to take actions that impair bondholders’ interests.
The ultimate check on management’s actions to disadvantage bondholders comes from a desire to retain access to the debt financing markets. Repeated, egregious actions that hurt bondholders may lead to a temporary hiatus in a company’s ability to borrow on favorable terms. Yet the transactions most likely to raise bondholders’ ire, buyouts and leveraged recapitalizations, occur infrequently, allowing the market’s memory to fade before a company needs to borrow again. More subtle actions taken by management to pick bondholders’ pockets seldom receive much notice. By taking a seat across the table from corporate management, bondholders expose their position to potential impairment.
Market Characteristics
At December 31, 2006, the market value of investment-grade corporate bonds totaled $1.7 trillion. Yield to maturity stood at 5.7 percent, with the proviso that future changes in credit quality contain the possibility of decreasing the forecasted yield. Average maturity and duration stood at 10.1 years and 6.1 years, respectively.5
Summary
Many investors purchase corporate bonds, hoping to get something for nothing by earning an incremental yield over that available from U.S. Treasury bonds. If investors received a sufficient premium above the default-free U.S. Treasury rate to compensate for credit risk, illiquidity, and callability, then corporate bonds might earn a place in investor portfolios. Unfortunately, under normal circumstances investors receive scant compensation for the disadvantageous traits of corporate debt. At the end of the day, excess returns prove illusory as credit risk, illiquidity, and optionality work against the holder of corporate obligations, providing less than nothing to the corporate bond investor.
Corporate bond investors find the deck stacked against them as corporate management’s interests align much more closely with equity investors’ aspirations than with bond investors’ goals. A further handicap to bond investors lies in the negative skew of the potential distribution of outcomes, limiting the upside potential without dampening the downside possibility.
Safe-haven attributes justify inclusion of fixed income in well-diversified portfolios. Unfortunately, in times of duress, credit risk and optionality serve to undermine the ability of corporate bonds to protect portfolios from the influences of financial crisis or deflation. In troubled economic times, a corporation’s ability to meet contractual obligations diminishes, causing bond prices to decline. In declining rate environments, caused by flight to quality or by deflation, bond call provisions increase in value, heightening the probability that companies call high-coupon debt securities away from bondholders. Sensible investors avoid corporate debt, because credit risk and callability undermine the ability of fixed income holdings to provide portfolio protection in times of financial or economic disruption.
Historical returns confirm that investors received insufficient compensation for the array of risks inherent in corporate debt. For the ten years ending December 31, 2006, Lehman Brothers reports annualized returns of 6.0 percent for U.S. Treasury bonds and 6.5 percent for investment-grade corporate bonds. While index-specific differences in market characteristics and period-specific influences on market returns cause the comparison to fall short of a perfect apples-to-apples standard, the 0.5 percent per annum difference between Treasury and corporate returns fails to compensate corporate bond investors for default risk, illiquidity, and optionality. U.S. government bonds provide a superior alternative.
HIGH YIELD BONDS
High yield bonds consist of corporate debt obligations that fail to meet blue chip standards, falling in rating categories below investment grade. The highest category of junk bonds carries a double-B rating, described by Moody’s as having “speculative elements,” leading to a future that “cannot be considered as well assured.” Moving down the ratings rungs, single-B bonds “lack characteristics of the desirable investment,” triple-C bonds “are of poor standing,” double-C bonds “are speculative in high degree,” and the lowest class of bonds (single-C) has “extremely poor prospects of ever attaining any real investment standing.”6
High yield bonds suffer from a concentrated version of the unattractive traits of high-grade corporate debt. Credit risk in the junk-bond market far exceeds risk levels in the investment-grade market. Illiquidity abounds, with the lowest-rated credits trading by appointment only. Callability poses the familiar “heads you win, tails I lose” proposition for owners of junk bonds with an added twist.
Holders of both investment-grade and junk bonds face callability concerns in declining rate environments. Lower rates prompt refunding calls in which the issuer pays a fixed price to the bondholders and reissues debt at lower cost. Holders of high quality paper and junk bonds face interest-rate-induced refunding risks of similar nature.
Above and beyond the possibility that junk bondholders lose bonds in a declining rate environment, callability potentially thwarts the junk bondholder’s ability to benefit from an improving credit. One of the goals of junk-bond purchasers involves identifying companies that face a brighter future, leading to greater ability to service debt, improved marks from the rating agencies, and higher prices in the market. Fixed-price call options serve to limit the ability of junk-bond investors to benefit from improving credit fundamentals, marking yet another means by which equity holders benefit at the expense of bondholders.
Packaging Corporation of America
Consider the fate of investors in Packaging Corporation of America (PCA) 9.625 percent Series B Senior Subordinated Notes of April 1,2009. Issued by a highly leveraged manufacturer of containerboard and corrugated cartons, at the initial offering in April 1999, the bonds carried a coupon rate approximately 500 basis points above comparable maturity Treasury notes and boasted a rating at the bottom of the single-B category. According to Moody’s Investors Service, the single-B rating indicated that “[a]ssurance of interest and principal payments or of maintenance of other terms in the contract over any long period of time may be small.”7 Purchasers of the bonds no doubt hoped for a better future, one in which the likelihood of maintenance of contract terms might be larger rather than smaller. Perhaps investors foresaw a future characterized by an improvement in corporate fundamentals, a bull market in bonds, or both.
The PCA 9.625s of April 2009 provided more than $530 million of proceeds to help finance private-equity-firm Madison Dearborn’s leveraged buyout of Tenneco’s packaging business. The single-B rating flowed naturally from the highly leveraged nature of the buyout transaction. At the time of the bond issuance in the second quarter of 1999, PCA carried net debt of $1,639 million, representing a borrowing level equal to 4.9 times the company’s equity base.
In January 2000, PCA floated equity shares in an initial public offering conducted near the peak of a two-decade-long bull market. Underwritten by Goldman Sachs, the 46.25 million shares offered at $12 each raised a total of $555 million in proceeds for the company. As for the bondholders, the 9.625s of April 2009 retained a single-B rating and a price near par.
Shortly after the company’s IPO, the hoped-for improvement in PCA’s credit picture began. Second quarter 2000 net debt declined to $1,271 million, improving the debt-equity ratio to 2.2. In April 2000, Moody’s increased the company’s senior subordinated note rating from single B3, the lowest rung of the single-B category, to single B2, the middle-rung rating. More good news followed in September 2000, when Moody’s boosted the rating of the PCA 9.625s of April 2009 to B1, the top of the single-B category. In a mere eighteen months, the quality of the senior subordinated securities showed significant improvement.
Positive momentum in PCA’s financial situation continued. By the third quarter of 2001, the company paid down enough debt to bring outstanding borrowings to $751 million, resulting in a debt-equity ratio of 1.1. Moody’s Investors Service recognized the improvement by assigning a mid-range double-B rating to PCA’s senior subordinated debt, moving investors from the “small assurance” of single-B paper to the far-more-exalted “uncertainty of position” of double-B obligations.
By the second quarter of 2003, bondholders faced far better circumstances than they confronted in January 2000. Over that period, net debt declined from $1,292 million to $607 million. The debt-equity ratio decreased from 2.4 to 0.9. Credit fundamentals moved dramatically in favor of PCA’s junk-bond investors.
Not only did the PCA 9.625s of 2009 benefit from the company’s ability to pay down debt, thereby improving the credit standing of the remaining obligations, but the bonds also profited from a dramatic decline in interest rates. In January 2000, ten-year U.S. Treasury rates stood at 6.7 percent. By June 2003, ten-year Treasury yields halved, promising investors only 3.3 percent. The powerful bond market rally and the dramatic credit improvement combined to move the price of the PCA 9.625s of 2009 from approximately par in early 2000 to around 108 in June 2003.
Unfortunately for bondholders, call provisions of the PCA 9.625s of April 2009 dampened the security’s appreciation potential. On April 1, 2004, the company enjoyed the right to purchase the outstanding bonds at a fixed price of 104.81. Because of improved credit standing and lower interest rates, PCA would almost certainly exercise its right to call the bonds and refinance at lower rates. Investors evaluating the bonds in mid 2003 knew they would almost certainly lose the bonds at a price of 104.81 on April Fool’s Day in 2004, placing a limit on the amount they would reasonably pay for the securities.
In fact, holders of the PCA 9.625s of April 2009 did not need to wait until April 2004 to relinquish their bonds. On June 23, 2003, the company announced a tender offer for the securities at a price of 110.24, representing somewhat more than a two-point premium to the pre-tender market price. The company opted to pay 110.24 for the bonds on July 21, 2003 instead of waiting to pay 104.81 on April 1, 2004, because the combination of the firm’s improved credit condition and the market’s decreased interest rates made it too expensive for PCA to leave the bonds outstanding. The tender proved successful, as holders of 99.3 percent of the notes surrendered their bonds to the company.
PCA issued new bonds to refund the PCA 9.625s of April 2009, paying much lower rates of 4.5 percent on the five-year tranche and 5.9 percent on the ten-year tranche. The dramatically reduced coupons saved PCA tens of millions of dollars of interest expense over the remaining term of the original financing. Both refinancing bond issues eschewed fixed-price call provisions, as the junk-bond investors firmly demanded that the company close the barn door after the stalls had emptied.
From an investor’s perspective, accepting the company’s tender maximized returns. Based on the bond’s coupon, the tender price, and the call price, if investors held the securities until the call date, they faced an expected return of only 60 to 65 basis points over comparable-maturity Treasuries. Rational holders of the PCA 9.625s of 2009 had no choice but to tender their holdings.
The call provision proved costly to PCA’s senior subordinated bondholders. In June 2003, the bonds traded in a close range, from a low of 108.2 to a high of 108.6 averaging approximately 108.4. Based on lower interest rates and PCA’s improved credit standing, had the PCA 9.625s of 2009 not had a call provision, the price would have been in excess of 125. The company’s fixed-price call option dramatically reduced the potential for junk bondholder gains.
In spite of the dampening effect of the PCA 9.625s call provision, bondholders received handsome holding-period returns. Buoyed by improving credit fundamentals and declining interest rates, the junk-bond investors garnered a return of 49.2 percent from January 28, 2000, the date of the company’s IPO, to July 21, 2003, the date of the completion of the tender offer. Junk-bond investors could not hope for better circumstances or better results.
How did the PCA junk bond returns compare to results from closely related alternative investments? Strikingly, a comparable-maturity U.S. Treasury note produced a holding period return of 45.8 percent, as the noncallable nature of the government issue allowed investors to benefit fully from the bond market rally. The 3.4 percent holding period increment, realized by PCA bondholders over the three-and-one-half years, represents scant compensation for accepting a high degree of credit risk. U.S. Treasuries produced risk-adjusted returns significantly higher than those realized by holders of the PCA 9.625s.
Holders of PCA stock faced a tough set of circumstances. In contrast to the strong market enjoyed by bondholders, equity owners faced a dismal market environment. From the date of PCA’s IPO, which took place near the peak of one of the greatest stock market bubbles ever, to the bond tender-offer date, the S&P 500 declined a cumulative 24.3 percent. Bucking a decidedly adverse market trend, PCA’s equity rose from the initial offering price of $12.00 in January 2000 to $18.05 on July 21, 2003, representing a holding period gain of 50.4 percent. Even in the worst of worlds for equity holders and the best of worlds for bondholders, the equity owners of PCA eked out a victory.
Upon reflection, the superior returns garnered by PCA’s equity holders might be expected. Improving credit fundamentals for junk bond positions necessarily correspond to an increase in the equity cushion supporting the company’s fixed liabilities. An increase in the stock price provides one means of enhancing the underlying support for the firm’s debt burden. Since improving credit fundamentals frequently go hand in hand with rallying stock prices, investors face better odds by owning unlimited-upside stocks as opposed to constrained-potential bonds.
In the case of deteriorating credit fundamentals, junk bond investors attain little or no edge relative to equity investors. Recall that the PCA 9.625s of April 2009 entered the markets in 1999 at the bottom of the single-B rating category, precariously positioned with a “small assurance of maintenance of contract terms.” Credit deterioration would likely damage the investments of bondholders and stockholders alike.
Junk bond investors cannot win. When fundamentals improve, stock returns dominate bond returns. When rates decline, noncallable bonds provide superior risk-adjusted returns. When fundamentals deteriorate, junk bond investors fall along with equity investors. Well-informed investors avoid the no-win consequences of high yield fixed income investing.
Alignment of Interests
Junk bond owners face misalignment of interest problems even more severe than those faced by investment-grade bondholders. In the case of fallen-angel junk issues that began life as high quaility bonds and suffered a fall from grace, declines in credit quality correspond to reductions in equity values. In distressed situations, corporate managements usually work hard to prevent further erosion in the company’s equity base. Tools available to management include revenue enhancement and cost reduction. Obviously, reducing interest expense and otherwise decreasing the value of debt obligations represents one important means by which management can improve the equity position. Holders of fallen angels find their interests at odds with the interests of corporate management.
In the case of new-issue junk bonds, particularly those employed to finance leveraged buyout deals or leveraged recapitalization transactions, bondholders confront even more highly motivated, adversarial management groups. Sophisticated, equity-oriented financial engineers bring numerous tools to bear on the problem of increasing equity values substantially and rapidly. As the financial operators work to limit the cost of debt, the bondholders realize the mirror image of cost reduction in the form of return diminution.
Market Characteristics
At December 31, 2006, the market value of high yield corporate bonds totaled $657 billion. Yield to maturity amounted to 7.9 percent, with the market showing an average maturity of 7.9 years and an average duration of 4.4 years.
Summary
Junk bond investors face a concentrated combination of the factors that make high-grade corporate bonds a poor choice for investors. Magnified credit risk, greater illiquidity, and more valuable call options pose a triple threat to bondholders seeking high risk-adjusted returns. The relatively high cost of junk bond financing provides incentives to stock-price-driven corporate managements to diminish the value of the bond positions in order to enhance the standing of share owners.
As protection against financial accidents or deflationary periods, junk bonds prove even less useful than investment-grade bonds. The factors that promise incremental yield—credit risk, illiquidity, and callability—work against junk bond owners in times of crisis, undermining the ability of junk bonds to provide portfolio protection.
The recent historical experience of junk investors confirms the inadvisability of owning debt positions in highly leveraged corporations. For the ten years ending December 31, 2006, Lehman Brothers High-Yield Index produced annualized returns of 6.6 percent relative to 6.0 percent for U.S. Treasuries and 6.5 percent for investment-grade corporates. While structural differences in the indices (most notably differences in duration) make the comparison less than perfect, the fact that junk bond investors took far greater risk for insignificant incremental return comes through loud and clear.
ASSET-BACKED SECURITIES
Asset-backed securities consist of fixed income instruments that rely on a broad range of underlying assets (the backing in asset-backed) to provide cash flows and security for payments to bondholders. While the most commonly used asset in asset-backed securities consists of home mortgages, bankers employ assets ranging from credit card receivables to commercial lease payments to automobile finance obligations as collateral for asset-backed deals.
Asset-backed transactions exhibit a high degree of sophisticated financial structuring. Driven by a security issuer’s desire to remove assets from the balance sheet and obtain low costs for the financing, the asset-backed security purchaser sits across the table from a formidable adversary.
In the case of mortgage-backed securities—financial instruments that pass through mortgage payments from homeowners to security holders—investors face an unappealing set of responses to changes in interest rates. If interest rates decline, homeowners enjoy the opportunity to prepay and refinance the mortgage. Just as discharging a high-rate mortgage favors the borrower, it hurts the holder of a mortgage-backed security by extinguishing an attractive stream of high interest payments. Similarly, if rates rise, homeowners tend to pay only the minimum required principal and interest payment. Holders of mortgage-backed paper lose high-return assets in a low-rate environment and retain low-return assets in a high-rate environment.
In exchange for accepting a security that shortens when investors prefer lengthening and lengthens when investors prefer shortening, holders of mortgage-backed securities receive a premium rate of return. Whether the premium constitutes fair compensation for the complex options embedded in mortgage securities poses an extremely difficult question. Wall Street’s version of rocket scientists employ complicated computer models in a quest to determine the fair value of mortgage-backed securities. Sometimes the models work, sometimes not. If financial engineers face challenges in getting the option pricing right, what chance do individual investors have?
Optionality proves even more difficult to assess than credit risk. In the case of fixed income instruments with credit risk, sensible investors look at bond yields with skepticism, knowing that part of the return may be lost to corporate downgrades or defaults. In the case of fixed income instruments with high degrees of optionality, everyday investors hold no clue as to the appropriate amount by which to discount stated yields to adjust for the possible costs of the options. In fact, many professionals fail to understand the difficult dynamics of fixed income options.
Piper Capital’s Worth Bruntjen
In a celebrated case of the early 1990s, Worth Bruntjen, a fixed income specialist at Piper Capital in Minneapolis, built an enormous reputation as a manager of mortgage-backed securities. Based on stellar results in the early years of the decade, Bruntjen attracted significant amounts of capital from retail and institutional investors alike.
Bruntjen managed the Piper Jaffray American Government Securities Fund (AGF), one of a group of mortgage-bond investment vehicles for retail investors. Driven by a powerful bull market in bonds and a portfolio highly sensitive to interest rates, for the five years ending December 31, 1993, the fund returned 19.3 percent per annum, representing a substantial increment over the 11.2 percent annual return of the Salomon Brothers Mortgage Index. Bruntjen’s top-of-the-charts returns prompted Morningstar to name this “visionary and guiding force” runner-up in its portfolio-manager-of-the-year competition.8
Public records indicate that Bruntjen counted the State of Florida among his institutional separate account clients. In fact, Florida pursued a perverse investment strategy with its conservative operating funds, taking assets from poorly performing managers and adding assets to market-beating accounts. As a result of Bruntjen’s stellar results, by January 1994, the State of Florida’s account with Bruntjen totaled in excess of $430 million, more than double that of the nearest competitor.9
Bruntjen explained his strategy: “We buy government-agency paper that has a higher interest rate than the 30-year bond, but has an average life of only three to five years.”10 The fund manager’s “paper” included mortgages and mortgage derivatives with a bull market bias. Nonetheless, Bruntjen’s something-for-nothing explanation of his investment approach found a receptive audience. Funds under Bruntjen’s management rose rapidly until early 1994.
Unfortunately for fixed income investors, the fall of 1993 marked a high point of the bond market rally, with ten-year U.S. Treasury yields reaching a twenty-six-year low of 5.3 percent. Within a few short months, by May 1994, a wrenching decline in bond prices drove yields to 7.4 percent. The Wall Street Journal described the spring meltdown in the mortgage market: “The bloodbath in mortgage derivatives is claiming new casualties as investors and dealers continue to rush for the exits, feeding a vicious cycle of falling prices and evaporating demand.”11 The bear market that rocked bond portfolios laid waste to Bruntjen’s approach.
During calendar year 1994, Bruntjen’s individual investors in AGF experienced losses of nearly 29 percent. In contrast, the Salomon Brothers Mortgage Index posted a modest 1.4 percent loss. Between January and September, the Bruntjen’s State of Florida account incurred losses of $90 million, an entirely unacceptable result for supposedly conservatively invested operating funds. Frustrated by the dismal returns, Florida announced that it would pull nearly $120 million from Bruntjen’s account. Retail and institutional investors suffered side by side.
The bond market carnage turned Bruntjen’s strategy on its head. When rates rose, the mortgage specialist’s use of “significant investments in volatile derivatives like inverse floating-rate bonds and principal-only strips” caused his funds to behave like long-term, thirty-year bonds, not like the shorter-term bonds he cited in his strategy description.12 Heightened sensitivity to interest rates in a rising rate environment doomed Bruntjen’s investors.
Worth Bruntjen, Morningstar’s “visionary,” failed to understand the risks of his strategy as did his superiors at Piper Capital. Supposedly sophisticated institutional investors at the State of Florida failed to understand the risks of his strategy. Mutual-fund consulting firm Morningstar failed to understand the risk of his strategy. The complexity inherent in understanding and evaluating mortgage-related securities argues for avoiding exposure to the potentially harmful options imbedded in mortgage instruments.
Florida’s Sub-Prime Folly
In 2007, after clearly failing to learn from the Piper Capital debacle, the State of Florida once again embarrassed itself in mishandling a short-term investment portfolio. This time, Florida’s Local Government Investment Pool (LGIP) produced the dismal results by exposing the fund to highly structured investment in low quality, sub-prime investments.
Prior to the mishap, at the end of 2007’s third quarter, the fund contained $27.3 billion13 in 2,168 individual accounts maintained by 995 local government participants.14 In the words of the Florida State Board of Administration (SBA), the pool sought “to provide stable returns for participants with an emphasis on safety and liquidity of principal.”15
Belying its conservative mandate, the LGIP pursued a yield chasing strategy, characterized by Bloomberg Markets as “more aggressive than most states.” In October 2007, Florida’s 5.63 percent yield represented the “highest return of any public fund in the U.S.”16 The next month, in November, Florida’s high posted yield appeared less promising. Dogged by rumors of impaired holdings, Florida responded with a November 9th “Update on Sub-Prime Mortgage Meltdown and State Board of Administration Investments.” The report begins to address the acute problems with the LGIP on Chapter 2 with the Pollyannaish observation that “[w]e are pleased to report that none of the SBA’s short-term portfolios have any direct exposure to sub-prime residential mortgages.” Talk about a distinction without a difference. As LGIP participants were about to find out, indirect exposure holds the potential to harm as much as direct exposure.
Prompted by concerns over holdings of downgraded and defaulted debt, in November participants began leaving the fund, ultimately withdrawing $12 billion, or 46 percent of the fund’s assets. Closing the chicken coop door after losing a substantial portion of the flock, on November 29 the state froze withdrawals. The once-largest and once-highest-yielding fund stood in disarray.17
Florida hired BlackRock to deal with the mess. BlackRock separated the pool into a prime pool, Fund A, with approximately $12 billion, and a less-than-prime pool, Fund B, with approximately $2 billion. Fund B contained a variety of toxic waste, including structured finance company paper issued by KKR Atlantic Fund Trust and KKR Pacific Fund Trust (sponsored by buyout firm KKR), Axon Financial Fund (sponsored by buyout firm TPG), and Ottimo Fund (registered in the Cayman Islands). On top of the asset-backed commercial paper, Fund B included substantial holdings in CDs issued by Countrywide Bank, the troubled (and downgraded) mortgage lender, due to the CDs’ “significant” credit risk.
Fund A, with its high quality asset pool, allowed limited withdrawals a week after the freeze, beginning on December 6th. Participants promptly withdrew nearly $2 billion. The State of Florida made a mess of its short-term fund pool. Florida erred first, just as in the Piper Capital case, by aggressively chasing yield without regard to risk. Florida erred second by allowing a run on the bank, paying out $12 billion to early movers at par and leaving all of the impaired assets with the laggards. Florida needs to rethink its approach to investment management.
Clearly, many investors lack the capacity to understand the options in mortgage-backed securities. From a broader portfolio perspective, option-related and credit-related issues in mortgage-backed securities work against investors who wish to use the bonds to hedge against deflation or financial distress. The prepayment option held by the homeowner works like a call option on a corporate bond. If rates fall, prompted by deflationary forces or financial distress, the holder of mortgage-backed securities may lose the investment, along with protection against unfavorable circumstances. Similarly, defaults on mortgages, most likely in times of distress, undermine the value of fixed income’s crisis hedging attributes.
Alignment of Interests
Holders of asset-backed securities stand opposite some of the marketable securities world’s most sophisticated financial engineers. At best, asset-backed security investors buying newly minted securities should anticipate low returns from the issuer’s use of a complex structure to further the corporate objective of generating low-cost debt. At worst, the complexity of asset-backed securities leads to an opacity that prevents investors from understanding the intrinsic character of investment positions. In extreme situations, the Rube Goldberg nature of asset-backed security arrangements causes serious damage to investor portfolios.
Market Characteristics
At December 31, 2006, the market value of asset-backed securities totaled $105 billion. Yield to maturity amounted to 5.3 percent, with the market exhibiting an average maturity of 3.2 years and an average duration of 2.8 years.18
Summary
Asset-backed securities involve a high degree of financial engineering. As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run. At times, the creators and issuers of complex securities fail to understand how the securities might behave under various circumstances. What chance does the nonprofessional investor have?
Many mortgage-backed securities enjoy the support of government-sponsored enterprises, causing investors to assume that the securities carry low levels of risk. Investor assumptions may prove false on two counts. First, the credit risk may ultimately prove greater than market participants assume. Second, the GSE-induced investor complacency may mask significant risk of exposure to hard-to-understand options. Investors beware.
Just as with other forms of fixed income, the issuer of asset-backed securities seeks cheap financing. Cheap financing for issuers translates into low returns for investors. Combine low expected returns with high complexity and investor interests suffer.
As with many other segments of the fixed income markets, investors in asset-backed securities appear not to have reaped rewards for accepting credit and call risk. For the ten years ending December 31, 2006, the Lehman Brothers Asset-Backed Security Index returned 6.0 percent per annum, essentially matching the Lehman Brothers U.S. Treasury Index return of 6.0 percent per annum. Like other comparisons of bond index returns, the numbers do not account for differences in index composition. Nonetheless, over the past decade asset-backed bond investors appear to have fallen short in the quest to generate risk-adjusted excess returns.
FOREIGN BONDS
By asset size, foreign-currency-denominated bonds represent a formidable market, falling just short of the aggregate market value of U.S.-dollar-denominated debt. Yet, in spite of the market’s size, foreign bonds offer little of value to U.S. investors.
Consider bonds of similar maturity and similar credit quality, with one denominated in U.S. dollars and the other denominated in foreign currency. Because monetary conditions differ from country to country, the two bonds would likely promise different interest rates. An investor might expect that different interest rates and different economic conditions in different countries would lead to different investment results. If, however, the investor hedges each of the foreign bond’s cash flows by selling sufficient foreign currency in the forward markets to match the anticipated receipt of interest and principal payments, then the U.S. dollar cash flows of the dollar-denominated bond match exactly the U.S. dollar cash flows of the foreign-currency-denominated bond hedged into U.S. dollars. In other words, an unhedged foreign currency bond consists of a U.S. dollar bond plus some foreign exchange exposure.
Foreign currencies, in and of themselves, provide no expected return. Some market players, as part of so-called macro strategies, speculate on the direction of foreign exchange rates. Foreign bond mutual funds provide a vehicle through which investment managers sometimes take speculative positions. Top-down bets on currencies fail to generate a reliable source of excess returns, because the factors influencing economic conditions, in general, and interest rates, in particular, prove far too complex to predict with consistency. Sensible investors avoid currency speculation.
In a portfolio context, foreign exchange exposure may produce the benefit of additional diversification. Even with no expected return, the lack of full correlation between currency movements and other asset class fluctuations reduces portfolio risk. However, investors should obtain foreign exchange exposure not through foreign bond positions, but in connection with an asset class expected to produce superior returns, namely foreign equities.
Since foreign currency positions, per se, promise a zero expected return, investors in foreign bonds expect returns similar to returns from U.S. dollar bonds. Yet, unhedged foreign bonds fail to provide the same protection against financial crisis or deflation enjoyed by holders of U.S. Treasury securities. In the event of a market trauma, U.S. investors have no idea what impact foreign exchange rates will have on the value of foreign bond positions. The unknown influence of foreign currency translation forces investors hoping to benefit from fixed income’s special diversifying characteristics to avoid unhedged foreign bond exposure.
Alignment of Interests
Holders of domestic Treasury bonds expect fair treatment from their government. Unlike the inherently adversarial relationship between corporate issuers and corporate creditors, governments find no reason to disadvantage their citizens. If investors purchase foreign-currency-denominated bond issues held largely by citizens of the country of issue, those investors may well benefit from a reasonable alignment of interests.
However, if a foreign government debt issue resides primarily in the hands of external owners, the alignment of interests breaks down. In fact, if political considerations trump contractual obligations, external holders of foreign government paper may suffer worse consequences than owners of troubled corporate debt. When international politics enter the picture, foreign bondholders may suffer.
Market Characteristics
At December 31, 2006, foreign-currency-denominated bonds totaled a substantial $14.5 trillion, of which $9.2 trillion represented issuance by foreign governments and $1.9 trillion represented investment grade issues of corporations. Foreign-currency-denominated, high yield corporate issues totaled a paltry $114 billion, reflecting the market’s relative immaturity.
Yield to maturity for foreign-currency-denominated government paper amounted to 3.2 percent, with an average maturity of 8.2 years and duration of 6.2 years. Foreign-currency-denominated investment-grade corporate bonds promised yields of 4.3 percent with average maturity of 7.0 years and duration of 5.3 years.
Summary
Foreign-currency-denominated bonds share domestic bonds’ burden of low expected returns without the benefit of domestic fixed income’s special diversifying power. Fully hedged foreign bonds mimic U.S. bonds (with the disadvantage of added complexity and costs stemming from the hedging process). Unhedged foreign bonds supply investors with U.S. dollar bond exposure plus (perhaps unwanted) foreign exchange exposure. Foreign-currency-denominated bonds play no role in well-constructed investment portfolios.
2007 PERFORMANCE UPDATE
Based on data presented in the summary section for each of the fixed income alternatives, Treasury bonds appear to provide superior risk-adjusted returns. The return comparisons fail to provide a completely fair test, however, because differences in duration throughout the ten-year measurement period cause the comparisons to fall short of the apples-to-apples standard.
Domestic corporate and high yield returns for the ten years ending December 31, 2006 produced inadequate margins over Treasuries to compensate for illiquidity, credit risk, and call risk. Asset-backed securities actually show a small deficit relative to Treasuries. Although the shorter duration of asset-backed instruments explains part of the return deficit, even after adjusting for the shorter duration, investors received insufficient compensation for straying from the full faith and credit of the U.S. government.
Table A.1 Treasury Bonds Trump Riskier Alternatives
Ten-Year Returns of Fixed Income Indices
Source: Lehman Brothers
|
|
Period Ending December 31, |
Index Duration (Years) | |
|
|
2006 (%) |
2007 (%) |
December 31, 2007 |
|
U.S. treasuries |
5.97 |
5.91 |
5.2 |
|
Domestic corporate |
6.52 |
5.96 |
6.3 |
|
High yield |
6.59 |
5.51 |
4.6 |
|
Asset-backed securities |
5.95 |
5.43 |
3.4 |
The credit crisis during the second half of 2007 emphatically reinforced the superiority of Treasury bonds. Trailing Treasury returns scarcely moved as the ten-year measurement period advanced from the end of 2006 to the end of 2007. In contrast, corporate bond returns declined by 56 basis points to a level of only five basis points above Treasuries. High yield bond returns dropped by 108 basis points per annum for the ten-year period, falling a full 40 basis points below the Treasury return. Similarly, asset-backed securities lost 52 basis points per annum, increasing the deficit relative to Treasuries to 48 basis points.
One lesson of the 2007 credit crisis concerns the fact that investors in bonds with the unattractive characteristics of illiquidity, credit risk, and call risk underperformed Treasuries for the year ending December 31, 2007. The other lesson concerns the timing of the dramatic short-term underperformance of corporate, high yield, and asset-backed securities during the second half of 2007. Just when investors most needed protection provided by bond positions, non-Treasury holdings disappointed.
CONCLUSION
A host of fixed income markets fall short of the diversifying power inherent in default-free, full-faith-and-credit obligations of the U.S. government. Factors including credit risk, call options, illiquidity, and foreign exchange limit the attractiveness of investment-grade corporate bonds, high yield bonds, asset-backed securities, and foreign bonds. Sensible investors avoid the sirens’ song that promises something (in the form of hoped-for incremental return) for nothing (in the form of ignored incremental risk).