If investors invest in a fashion that exceeds their own risk tolerance, so that when things go awry (as they inevitably will from time to time) they must abandon their strategy, they have done themselves a disservice by engaging in the strategy in thefirstplace.
—Robert Arnott, president and chief financial officer of First Quadrant
In this chapter we will cover various types of corporate fixed-income securities. We will begin with investment-grade corporate bonds. Before we do so, however, we point out that the securities of the two GSEs (discussed in chapter 5) are corporate bonds, as both Fannie Mae and Freddie Mac are public corporations. Thus most of the issues that we discussed that are related to the securities of the GSEs (e.g., credit risk, event risk, call risk) generally apply to corporate bonds as well. We will also cover the world of high-yield (junk) bonds, preferred stocks, and convertible bonds.
The market for corporate bonds can be divided into the two broad categories of investment grade and noninvestment grade. Investment-grade bonds are those that carry a Moody’s rating of AAA, Aa, A, or Baa, or an S&P rating of AAA, AA, A, or BBB. Issues with ratings below these levels are speculative, and are categorized as high-yield bonds.
Investors also must be careful to check the rating of each individual security because they are independently rated. For example, just as General Motors has many different types of cars (e.g., Chevrolets, Pontiacs, Cadillacs) with unique characteristics, General Motors has also issued many different debt instruments, each with its own unique rating. The specific rating assigned to a security will depend on the terms contained in the indenture. Thus one issuer can have securities that trade with different credit ratings. Factors that impact the credit rating of a specific issue include whether the bond is collateralized (and the quality of the collateral), whether the bond is subordinated (other debt has preference in terms of repayment in the event of a default), the potential for event risk, and even its maturity.
Investors should also be aware that the ratings of corporate bonds can and do change frequently due to changes in the economic climate or to event risk appearing. An example of how changing economic conditions can impact asset values would be when oil prices fell in the mid-1980s from above $30 a barrel to about $10 a barrel. The prices of homes collapsed in many parts of the oil belt (i.e., Texas, Louisiana, Colorado, Oklahoma). They fell so sharply that many homeowners mailed in their keys to their mortgage lender. Similarly, in the pre-Microsoft days Seattle was basically a one-company town. Whenever the aircraft manufacturing industry, especially Boeing, got into serious trouble (as it did in the 1970s), the prices of homes in Seattle came under serious pressure. Other good examples of how events can lead to changes in credit ratings are Merck’s downgrading from AAA to AA- due to the problems caused by the recall of its popular drug Vioxx and the downgrading of many bonds of the state of California in 2003 due to the state’s fiscal problems.
Because ratings can change frequently they must constantly be monitored. In addition, as was discussed earlier, not all AAA bonds are created equal—corporate bonds are significantly riskier than municipal bonds of the same rating. Finally, the call provisions of corporate debt instruments can be far more complex than they are for municipal bonds. The bottom line is that corporate bonds are far trickier investments than Treasuries or municipal bonds. Investors need to tread carefully if they wish to invest in this sector of the market, especially if they are going to do so on their own.
The attraction of corporate bonds is the higher yield they provide over Treasuries. As we have discussed, part of the yield premium is a result of the exemption from state and local taxes that applies to the interest on Treasury debt, but not to corporate debt. This is a consideration for investments held in taxable accounts. The other factors are their greater exposure to economic risk and their lower level of liquidity (resulting in greater trading costs). And the lower the credit rating the greater the economic risks and the lower the level of liquidity.
The question for investors is the following: Given the role of fixed-income investing in a portfolio, is the higher yield sufficient to justify all of the risks? Given that a high (if not the highest) priority for investors, whether in the accumulation or withdrawal stage, is safety or stability of principal, the prudent choice is to restrict holdings to only the two highest investment grades, AAA and A A. One of the major reasons is that as the credit rating de-creases, the correlation with equity returns increases. This is a strong negative feature of lower-rated bonds—they are more likely than higher-rated bonds to perform poorly at the same time that stocks are performing poorly. Another compelling reason is that the historical evidence (as presented in chapter 2) suggests that investors simply have not been sufficiently rewarded for taking incremental credit risk. The reasons are related not only to the credit losses incurred, but also to features (i.e., calls) that can negatively impact returns.
As we have discussed, transparency of pricing is a critical issue for investors. Transparency provides at least some protection against exploitation by Wall Street. Unfortunately, most corporate bonds are not even listed on the major exchanges, making it difficult to obtain true market pricing; investors are prevented from learning how much markup was added by the broker to the wholesale price. Even among listed bonds the financial press reports on the prices of very few issues. For example, the Wall Street Journal reports daily on the prices of just forty corporate bonds, and many of them are from the same few issuers. Given the lack of transparency, individual do-it-yourself investors considering purchasing corporate bonds should only buy new issues (which are all offered at the same price to every investor). In addition, they should only buy them if they intend to buy and hold them.
As we have discussed, diversification is one of the most important concepts of prudent investing. Because Treasury securities en-tail no credit risk, there is no need for diversification. However, as we move beyond Treasuries the need for diversification increases in direct relationship to the credit rating—the lower the rating, the greater the need. Since government agency and government-sponsored enterprise securities entail little credit risk, very little diversification is required. Investors might, for example, own some Treasury debt and also allocate some of their assets to each of the GSEs and agencies. Once we move to corporate debt the risks become much greater. Since it is not economical to buy or sell less than $50,000 per corporate bond, only investors with a fixed-income allocation of at least $500,000 should even consider buying individual corporate bonds. That would allow them to limit their exposure to any one issuer to a maximum of 10 percent of theirfixed-incomeallocation. In addition, because of the relatively low level of liquidity in the corporate bond market, individuals acting on their own should only make purchases if the expectation is to buy and hold. Investors with less than $500,000 offixed-incomeassets who are seeking to capture the incremental yield of corporate bonds should use either low-cost mutual funds, like those of Vanguard, or exchange-traded funds.
While we have discussed why prudent investors should consider purchasing only corporate bonds of the two highest grades, high-yield bonds have received so much attention that we need to discuss their attributes and why they are appropriate only for speculators, not investors.
Well-informed investors avoid the no-win consequences of high-yield fixed-income investing.
—David Swensen, chief investment officer of the Yale endowment, Unconventional Success
As we have discussed, the riskier the credit of the issuer is perceived to be, the greater the risk premium, in the form of a higher interest rate, the market will require.
A study, “Explaining the Rate Spread on Corporate Bonds,” sought the answers to the following questions: 1
The following is a summary of the study’s conclusions regarding these questions:
It is logical that compensation for risk changes over time as economic conditions change. If changes in the required risk premium affect both corporate bond and stock prices, corporate bonds contain risk that cannot be diversified away. The study found that such a relationship does exist—corporate bond returns were positively related to the equity market factor as well as the size and value factors. This is only logical: “If common equity receives a risk premium for this systematic risk, then corporate bonds must also earn a risk premium.” Very importantly, the authors found that the longer the maturity and the lower the credit risk, the stronger the correlation is to the risk factors.
The findings of this study have significant implications for investors. We begin with an understanding that high-yield bonds are hybrid securities.
High-yield bonds are often recommended to investors because of their greater yield and because they have a nonperfect correlation with both equities and U.S. government securities and the securities of corporate bonds with the highest credit ratings (AAA and AA). Investors considering, for example, a 60 percent equity and 40 percent fixed-income portfolio (based upon their risk tolerance) might be counseled to allocate one-fourth of their fixed-income holdings to high-yield debt (10 percent of the portfolio). A problem is created because high-yield debt is really a hybrid instrument; while it is called debt, as we have seen, it has equity-like risk characteristics. This is why it has nonperfect correlation with both equities and debt. Since high-yield debt is really taking on equity risk, the investor will actually be holding a portfolio that has more equity risk than a 60 percent-40 percent portfolio would hold. And as the results of the aforementioned study show, the lower the credit rating, and the longer the maturity of the debt, the more equity-like the high-yield security becomes.
The main purpose of fixed-income securities for most investors is to provide stability to their portfolio, allowing them to take equity risk. While it is true that high-yield debt has nonperfect correlation with equities, the correlation may increase at just the wrong time—when the distress risk of equities shows up. Therefore, investors should always remember that correlations are not static values.
There are several other issues that impact the decision on whether or not high-yield securities should play a role in the portfolio. They include liquidity, asset location, and the distribution of returns.
High-yield bonds are generally highly illiquid instruments (and the lower the credit rating, the more illiquid the instrument is likely to be). For example, a typical U.S. high-yield index includes about 1,500 securities, with only about 25 percent of them trading even at least once per month. 2 The less liquid an asset class, the greater will be trading costs, including not only bid-offer spreads, but market-impact costs as well. In addition, in times of crises the markets for illiquid assets can virtually dry up—buyers disappear and sales can only be made if the seller is willing to accept a severe discount. (It is like trying to sell a condominium apartment in a glutted market where prices are falling.) As a result, investors in high-yield bonds demand an incremental risk premium. Thus a liquidity premium must explain part of the differential in yields between high-yield bonds and Treasuries. Unfortunately, this liquidity risk rears its head in times of crisis, just when equity prices are under pressure, leading to high correlation with equity prices just when we need low correlation— again illustrating that correlations are not static values.
Another negative feature of high-yield bonds is that they often have call provisions. Investors generally think of the call feature in terms of the risk that the bond will be called if interest rates fall. This is true for high-grade bonds. However, for lower-rated bonds, there is an additional risk created by the call feature. The risk is that the credit rating of the issue will improve sufficiently for the issuer to call the bond and issue a new bond with a higher rating, lowering interest costs. A similar risk is created by what is known as a “clawback” provision. Some high-yield securities allow the issuer to call a predetermined amount of the bond if the issuer is able to do an equity offering. The good news for investors in general is that the investment risk is reduced. That, however, doesn’t do you any good if your bond is called.
There is another often overlooked issue related to illiquid assets—illiquidity artificially induces what is known as positive serial correlation (also known as autocorrelation) of returns. Serial correlation is the correlation of a variable with itself over successive time intervals. An example will clarify the issue.
Imagine that you have to sell your home in order to take a job in another town. How would you determine the price at which you should list your home? Typically you would look at the sale prices of similar properties. But what if no sales had occurred in the past year? And what if economic conditions had changed dramatically during that period? Would the last sales price be truly reflective of current valuations? Would those prices correctly reflect current valuations for the homes in your neighborhood? If you believed those prices were accurate, then you would be assuming that prices had been stable. Of course, both assumptions are likely to be incorrect.
The calculation of the value of an index (or the value of the assets in a portfolio) that prices bonds for which there has been no active market will include prices that are either outdated or are based on what is known as “matrix pricing.” The latter is an attempt to estimate the market price by evaluating the prices of bonds that have similar risk characteristics but have traded more recently. If estimates are based on prices that are outdated, then the true price is probably different. Thus the price may be over-stated or understated. Both outdated prices and matrix pricing tend to give the appearance of greater price stability than is actually being experienced (if the securities had actually traded). Thus illiquidity and the resulting autocorrelation leads to an underestimation of volatility and of the real risks of an asset class. The result is that for portfolios of illiquid securities, reported returns will tend to be smoother than true economic returns, under-stating volatility and overstating risk-adjusted performance measures such as the Sharpe ratio. The issue of serial correlation and its implication is important to keep in mind when considering any illiquid investment (e.g., emerging-market bonds, venture capital, hedge funds).
There is another risk-related issue that should be considered before investing in high-yield bonds. Risky or illiquid assets tend to have a distribution of returns that exhibits what is called skewness and excess kurtosis. We will first define these terms and then explain why it is necessary to understand their implications.
Skewness measures the asymmetry of a distribution. In other words, the historical pattern of returns does not resemble a normal (bell-curve) distribution. Negative skewness occurs when the values to the left of the mean (less than) are fewer but farther from the mean than are values to the right of the mean. For example: the return series of -30 percent, 5 percent, 10 percent, and 15 percent has a mean of 0 percent. There is only one return less than 0 percent, and three higher; but the one that is negative is much farther from zero than the positive ones. Positive skewness occurs when the values to the right of the mean (more than) are fewer but farther from the mean than are values to the left of the mean.
Behavioral finance studies have found that, in general, people like assets with positive skewness. This is evidenced by their willingness to accept low, or even negative, expected returns for assets that exhibit positive skewness. The classic example is a lottery ticket, which has negative expected returns. As we all know, there are precious few who win the lottery (positive out-come) and an enormous number who lose (negative outcome). However, the benefit of a positive outcome is much greater than the cost of a negative one. On the other hand, most people do not like assets with negative skewness. This explains why people generally purchase insurance against low-frequency events, such as disability or fires. While these events are unlikely to occur, they carry the potential for large losses. The problem for investors is that high-yield debt exhibits negative skewness.
High-yield debt returns also exhibit high kurtosis. Kurtosis measures the degree to which exceptional values, much larger or smaller than the average, occur more frequently (high kurtosis) or less frequently (low kurtosis) than in a normal (bell-shaped) distribution. High kurtosis results in exceptional values that are called “fat tails.” Fat tails indicate a higher percentage of very low and very high returns than would be expected with a normal distribution. Low kurtosis results in “thin tails.”
It is important for investors to understand that when skewness and kurtosis are present (the distribution of returns is not normal), investors looking only at the standard deviation of returns (the most commonly used measure of risk) receive a misleading picture of the riskiness of the asset class—understating the risks. This creates problems for investors and advisors using efficient frontier models (see glossary) to help them determine the “correct,” or most efficient, asset allocation from a universe of risky assets. The reason is that efficient frontier models are based on mean-variance analysis, which assumes that investors care only about expected returns and the standard deviation. In other words, they do not care whether an asset exhibits skewness or kurtosis. If that assumption is correct (investors are not bothered by skewness and fat tails), then indeed, the use of mean-variance analysis is appropriate. However, this assumption is too simplistic, as many, if not most, investors do care about skewness (especially negative skewness) and kurtosis. If an asset exhibits nonnormal distribution (as do high-yield bonds), mean-variance analysis (using the standard deviation as the measure of risk) is only a good first approximation of risk, but does not completely reflect investors’ true preferences. Mean-variance analysis will underesti-mate risk, and the result will be an overallocation to the asset class.
Investors holding high-yield securities in taxable accounts receive their incremental risk premium in the form of interest payments that are taxed at ordinary rates. If an investor holds that same distress risk in the form of equities, the return will be in the form of capital gains, which are taxed at lower long-term rates (or dividends which are now taxed at the same rate as long-term capital gains). On the other hand, because they have equity risks, holding high-yield securities in a tax-deferred account has negative implications.
It is preferable to hold equity risk in a taxable account for the following reasons.
These benefits are lost when you hold equity risks inside of a tax-deferred account, whether the equity risk is in the form of a bond or a stock.
In his wonderful book Deep Survival, Laurence Gonzales described the following situation. Eight snowmobilers had just completed a search-and-rescue mission. On their way back, they stopped at the base of a hill well known as great for climbing and hammerheading, a competitive game to see who can reach the highest point. The idea is to race up the hill until gravity stops you or you turn back downhill. This particular hill had a reputation for being especially dangerous and was prone to avalanches. Hammerheading was out of the question. Still, one of the snowmobilers could not resist temptation, and then a second could not resist the thrill of the hunt. An avalanche occurred and, tragically, two members of the team died. 3 This story reminds us that some risks are just not worth taking.
In summary, investing in high-yield bonds is a risk that is just not worth taking—the benefit of the higher yield is more than offset by the risks and other negatives that we have discussed. If investors seek greater returns than offered by investment-grade securities, they should do so by increasing either their equity allocation or their allocations to the riskier asset classes of small-cap stocks and value stocks. At the very least, if investors decide to hold high-yield debt, then they should be sure to adjust their allocations to include the recognition that they are taking some incremental equity risk. Finally, since diversification takes on greater significance as we move to lower-rated credits, investors who want to speculate with high-yield bonds should only consider doing so through a low-cost mutual fund like that offered by Vanguard. There is no other way to obtain sufficient diversification.
Preferred stocks are technically equity investments, standing behind debt holders in the credit lineup. While preferred shareholders receive preference over common equity holders (hence the term “preferred”), in the case of a Chapter XI bankruptcy all debt holders would have to be paid off before any payment could be made to the preferred shareholders. If the company were to be liquidated, both preferred and common stockholders would generally receive nothing. Unlike with shares of common stock, which may benefit from the potential growth in the value of a company, the investment return on preferred stocks is a function of the fixed dividend yield (most preferred stocks carry a fixed yield). The difference is that conventional bonds have a fixed maturity date while preferred stocks may not.
Preferred stocks are either perpetual (have no maturity) or they are generally long-term, typically with a maturity of between thirty and fifty years. In addition, many issues with a stated maturity of thirty years include an issuer option to extend for an additional nineteen years. Investors considering purchasing a perpetual preferred should ask themselves the following question: Would a prudent investor purchase a bond from the same company paying the same interest rate with a hundred-year maturity? The answer is almost certainly no. Why not? Because the credit risk on a bond of such long maturity is likely to be too great. The very long term of preferred stocks with a stated maturity also creates a problem. As we discussed, the historical evidence on the risk and rewards of fixed-income investing is that longer maturities have the poorest risk-reward characteristics—the lowest return for a given level of risk.
The long maturity typical of preferred stocks is not the only problem with these securities; they typically also carry a call provision. With very few exceptions, U.S. Treasury debt has no call provision. Thus almost all U.S. government debt (as well as all noncallable debt instruments) has what is called symmetric price risk. If interest rates rise, bond prices will fall. If rates fall, bond prices will rise. A one percent rise or fall in interest rates will result in approximately a one percent change in the price of the bond for each year of duration. This is not the case with callable preferred stock. If rates rise, the price of the preferred will fall. However, if rates fall, and the issuer is able to do so, they will call the preferred and replace it with either a new preferred issue at lower rates, less expensive conventional debt, or perhaps even equity. Thus you have asymmetric risk: You get the risk of a long-duration product when rates rise, but because of the call feature when rates fall the gains are limited to the gains that would be realized from an instrument of shorter maturity. Thus preferred stocks rarely trade much above their issue price.
It is important to note that almost all callable preferred stocks are callable at par, thus there is an extremely limited upside potential (virtually none if the call date is near) if the security is purchased at par. Having protection from calls is vital to income-oriented investors because callable instruments present reinvestment risk, the risk of having to reinvest the proceeds of a called investment at lower rates. Through calls investors lose access to relatively higher income streams. Thus part of the incremental yield of preferred stocks relative to a noncallable debt issuance of the same company is compensation for giving the issuer the right to call the debt should the rate environment prove favorable. The other source of the incremental yield of preferred stocks is the credit risk.
To begin, as is the case with corporate bonds, preferred stocks are rated by the four major credit-rating agencies. This makes it easy to check the credit quality, although, as is also the case with corporate bonds, the rating needs to be constantly monitored. While all preferred stocks are not in the junk bond category, they seldom are highly rated credits (though there are exceptions). Given the lower cost of tax-deductible conventional debt (as equity preferred dividends are not deductible for the issuer) one has to ask why companies issue preferred stock, especially when traditionally preferred shares are rated two notches below the issuer’s rating on unsecured debt (the lower credit rating increases the cost). The answer is often not very reassuring to investors; they may issue preferred stocks because they have already loaded their balance sheet with a large amount of debt and risk a downgrade if they pile on even more.
Some companies issue preferred stock for regulatory reasons. For example, regulators might limit the amount of debt a company is allowed to have outstanding. There might also exist other regulatory reasons. In October 1996 the Federal Reserve allowed U.S. bank holding companies to treat certain types of preferred stocks (what are called hybrid preferred stocks) as Tier 1 capital for capital adequacy purposes. An additional reason for issuing preferred stock is that it can be structured to look like debt from a tax perspective and equity from a balance sheet perspective. Instruments structured in this manner are called trust preferreds. Finally, investors should be aware that preferred dividends are paid at the discretion of the company. Thus in times of financial distress preferred dividends could be deferred. On the other hand, bond interest payments represent a contractual obligation, and failure to pay sets the wheels in motion for reorganization or bankruptcy and liquidation.
There is another risk associated with buying preferred stocks that is related to the call feature. The call feature is not only related, as most investors think, to interest rate risk, but also to changes in the company’s credit rating. An issuer with a low-rated credit and a high-yielding preferred will likely call the preferred if their credit status improves—and replace the preferred with a now higher-rated conventional corporate bond (and its tax deductibility). Of course, if the company’s credit deteriorates, it will not call the preferred (but the price of the preferred will fall due to the deteriorated credit). Again, an asymmetric risk for the investor—one of the reasons for the higher yield. Risk and ex-antereward are always related. Whether the higher yield eventually translates into higher returns, and for how long, is a question to which only a clear crystal ball could provide the answer.
Investors can benefit from learning to think of things from the company’s perspective. Most companies with solid credit ratings generally will not issue preferred stocks (except for regulatory reasons) since the dividend payments are not tax-deductible like bond interest. Thus preferred stocks are generally too expensive a form of capital for strong credits. Thus before buying a preferred an investor might ask why a company would issue preferred stock paying a generous dividend when they could presumably issue debt securities with more favorable tax consequences. Investors seeking safe returns are generally not going to like the answer.
There is another point we need to cover. Longer-term maturities with fixed yields do provide a hedge against deflationary environments. The problem with long-maturity preferred stocks is that the call feature negates the benefits of the longer maturity in a falling rate environment. Thus the holder does not benefit from a rise in price that would occur with a noncallable fixed-rate security in a falling rate environment. If the issuer is unable to call the preferred, the reason is likely to be a deteriorating credit rating, putting the investor’s principal at risk. Given that preferred issuers are generally companies with weaker credit ratings, and distressed companies are the very ones most likely to default in deflationary environments, the benefit of the high-yielding longer maturity (which should rise in price in a falling rate environment) is unlikely to be realized by the holders of these callable instruments.
Are there any good reasons to buy a preferred stock? Corporate buyers of preferred stock receive favorable tax treatment on the dividends of preferred stock, with most of the dividend not subject to taxes. U.S. corporate holders can exclude up to 70 percent of the dividend from their taxable income provided they hold the shares at least forty-five days. This favorable tax treatment creates demand for the product. Individuals get no such favorable tax treatment.
The bottom line is that investors buying preferred stocks because of the higher yield, possibly combined with the fear of equity investing, are taking on additional risk. Since the market is very efficient at pricing risk, significantly higher yields must en-tail significantly greater risk (something fixed-income investors were likely seeking to avoid in the first place). These risks include perpetual life (or very long maturity), a call feature, low credit standing, deferrable dividends, and a depressed yield due to demand from corporations that receive favorable tax treatment.
There are some other reasons to consider avoiding preferred stocks. First, there are no low-cost index or passive asset-class funds that provide investors with the most effective way to diversify the risks of individual issuers. Second, if you buy individual issues you have the trading costs involved, the lack of diversification, and the need to constantly monitor credit ratings. Third, the typical lengthy maturity of preferred issues increases credit risk. Many companies might present modest credit risk in the near term, but their credit risk increases over time. Finally, while fixed-rate noncallable debt makes an excellent diversifier for stock portfolios because a weak economy (which usually has a negative impact on stock prices) generally leads to falling interest rates and rising bond prices, due to their call feature preferred shares will not benefit as much.
The risks incurred when investing in preferred stocks make them inappropriate investments for individual investors. As we have discussed, fixed-income investors should stick with U.S. government debt and debt in the two highest credit-rating brackets, AAA and AA. If investors have the ability, willingness, or need to take more risk, that risk is best taken in the equity market, where it can be earned in a low-cost and highly tax-efficient manner.
The same issues that apply to preferred securities also apply to convertible debt. Like preferreds (and high-yield bonds), convertible bonds are also often touted because of their nonperfect correlation with equities. However, as we have seen with high-yield bonds, low correlation is only a necessary condition for investors to consider a security. The sufficient condition is that the security provides the appropriate risk-adjusted expected returns given its role in the portfolio.
With convertible bonds you have the issue of equity risk being present and you also have a shifting asset allocation depending on where the stock price is trading relative to the conversion rate stated in the bond. If the current stock price is well above the con-version price, then you are basically holding an equity security— the convertible bond will move virtually in tandem with the stock price. On the other hand, if the price is well below the conversion price, then you are basically holding a debt instrument—the convertible will trade more like a bond than a stock.
The remaining maturity and the credit rating are also important factors in determining just how much equity and fixed-income risk you really are holding when owning a convertible bond. As these factors shift, your asset allocation will be shifting, causing you to lose control over the most significant determinant of the risk and expected reward of your portfolio. In addition, all of the negative tax implications (for individual investors) we discussed in connection with high-yield bonds and preferred stocks apply to convertible securities as well. Thus, once again, prudent investors should avoid including convertible securities (or any hybrid security) in a portfolio. As we have said, if investors want to seek, or need to seek, higher returns, then they should take the risk in the equity portion of their portfolios.
Having completed our review of corporate fixed-income securities, we next turn our attention to international bonds. We will first discuss them as a broad asset class and then move on to discuss the specific asset class of emerging-market bonds. When considering these asset classes we need to keep in mind the general principles of prudent fixed-income investing regarding term risk, credit risk, and the need for, and benefits of, diversification that we have already discussed.