Contrary to Popular Belief, Bonds Are Not Boring
the secret life of bonds for ETF investors
Most of today’s ETF professionals come from an equity market background, and they see today’s fixed income expansion as the industry’s less interesting second act. In Barron’s and other columns, equity authors reveal themselves when they write “bonds are/should be boring”. Similarly, the simple standstill dividend yield vs. note yield comparisons favored by columnists and bloggers are overly simplistic when so many other factors are at play.
There’s a lifetime’s worth of research and industry papers where one can learn the mathematical properties of fixed income instruments: yield curves, return decompositions, correlations, and taxation just to name a few. ETF investors usually point to these mathematical properties as the main feature distinguishing debt from equity. Similarly, for decades, equities have been labelled “the growth story” and bonds have been labelled “the yield story”, but low Treasury yields and “interesting times” have blurred this classic characterization.
More than the math, it is the operative bond documents that really distinguish debt from equity – while bond documents might seem purely administrative, investors can unlock surprising opportunities with targeted research and careful selection. Unlike equity, the terms under which new bonds are issued can change in response to a range of market conditions including, yield levels, ratings, taxation, and regulation. It is important for equity veterans to appreciate that terms may vary from bond to bond – even for a single company.
1. Management Works for Equity and not Bondholders.
Management has fiduciary duty to a company’s equity holders. Companies are managed and governed for the benefit of their equity owners, and a company’s management and board have a duty to act in the best interests of the equity owners. Equity owners have little certainty (and no legal rights) to specific share prices or specific share dividend payments - they rely on the stewardship and fiduciary obligations of management.
In contrast, a company’s management does not have a fiduciary duty to its bondholders – bondholder’s have traded (less tangible) fiduciary protections for the contractual rights and protections embedded in a bond’s offering documents and indenture. Technically, it’s the indenture trustee and not company management who is charged with preserving and protecting the interests of individual bondholders.
Management cannot disadvantage bondholders by moving or transferring assets, and management cannot execute transactions in or near insolvency. Similarly, management usually has very limited ability to alter the terms of a bond obligation. What is usually surprising to equity veterans is that management has no real duty or obligation to increase or protect an investor’s bond market value.
Of course, where there’s an expectation of future debt issuances, a company is highly motivated to avoid actions which would damage its spread levels, but bond buyers must rely primarily on their due diligence and contractual rights.
2. Bonds Change in Response to Credit Events.
One of the biggest differences between the equity and fixed income markets is the number of securities and how they’re traded. Companies typically issue only one class of public stock, and those shares trade on a public exchange; in contrast, companies may have hundreds of public bonds, bilateral loans, derivatives contracts, and other debt obligations some regularly traded and some not. Further, debt instruments are likely to vary in their features and terms which will cause them to respond differently to market conditions. Importantly, the performance of a company’s "other" debt obligations can impact your bond.
Unlike equities, debt obligations usually possess tangible and knowable (or modellable) amounts and dates. While each debt obligation comes due on one or more scheduled due dates (e.g. coupon dates, maturity dates), certain insolvency events can accelerate some or all of a company’s debt claims to become payable immediately – even where the “credit event” relates to another single instrument or claim. This acceleration (broadly referred to as “cross default” and “acceleration”) is designed to protect all claimants of the same class, ensuring that the 5-year bondholders don’t lose out while commercial paper holders drain the company of cash.
Investors often shy away from companies with complex debt arrangements, but thorough research and attention to trading prices can make these companies some of the most attractive opportunities.
3. Bonds Enjoy Life After Death.
When companies go into bankruptcy, equity shareholders get a “Q” added to their ticker and share prices and share liquidity generally go to zero.
In contrast, the bonds of a distressed issuer can take on any value (although it’s hard to imagine bonds of a liquidating company trading at a premium to par). Researchers usually point to “recovery values” as a rough valuation of bonds post-default. Recovery values usually range from 20 to 50, where “50” indicates the expectation of a $0.50 payout per $1 due. In practice, post-default market values can be very different from recovery assumptions.
Equity investors often buy dividend yielding stocks with the view that they are getting well paid to hold the stock while waiting for upside price appreciation – what would otherwise be a dead-money stock is attractive to own and wait. Similarly, bonds are often used by “special situations” investors to gain control of companies that the markets have beaten-up. The special situations debt trade is even more creative; if the bonds perform, the special situation investor is happy to collect the yield, and if the bonds fail, the special situations investor is in the best negotiating and control position to acquire the company at an attractive price – done right, it’s a win-or-win.
Even more creative, traders sometimes use distressed and discounted debt obligations to discharge their own obligations through set-off; in brief when two entities have mutual obligations (e.g. X owes Y, and Y owes X), they need not exchange gross amount due and can instead set-off the net nominal amounts owed in bankruptcy. So, if Y’s distressed debt is trading at $0.30, X can acquire Y’s debt for 0.30 on the dollar, and discharge $1.00 of its own obligations owed to Y – a 70% reduction (in brief, Y's defaulted debt is delivered back to Y in satisfaction of what X otherwise owes). For completeness, a precise fact pattern is required to achieve perfected set-off; most importantly, all of the pieces must already be in place at least ninety days before the actual credit event.
Of course none of this is legal advice, and many of the laws and legal interpretations relating to this post are subject to specific situations and jurisdictions. Additionally some bonds issued by highly regulated borrowers such as banks, may become subject to contractual or interpretative changes as regulators figure out how to balance creditor rights with newly popular “opt-in” objectives, where governments seek to convert debt claimants into equity early in a restructuring in an effort to reduce the prospect of federal bailouts.
Some summarizing points -
understanding the the unique conditions surrounding a sector, the legal landscape, and the features of bond documents can be invaluable to all bond investors including ETF investors,
having access to fixed income expertise can pay big dividends as bond ETFs become a bigger part of everyone’s portfolio,
staying informed on who’s buying which bonds in which sectors (and why) can give ETF investors a leg up on the market, and
the fixed income market rewards detail oriented investors