Pension funds don’t have enough junk

Junk Bonds are debt instruments issued by corporates that have relatively low credit ratings.  They pay interest at high rates as a result.

Typically viewed as risky investments, the junk bonds boom of the 80s showed that there is more to junk than just a risky investment.

Locally, our pension funds and other retirement savings money should be more heavily invested in junk bonds. I’m surprised more people aren’t talking about this. It might be due to the limited availability of junk in the SA market. On the other hand, if demand picked up, I’m sure we could see more original-issue junk bonds as yields drop and become more attractive financing vehicles.

There are always marks for considering tax

Why should pension funds be invested in junk? Tax. Approved retirement savings vehicles in South Africa don’t pay income tax. Thus, the value of securities that would attract significant tax is higher for these investors than for the market as a whole. If risk and return are balanced for the market as a whole, the extra return available to retirement vehicles through not paying tax is a bonus over and above that appropriate for the risk.

Conversely, pension funds should stay far away from tax-efficient instruments such as preference shares. The prices of these instruments have already been bid up by tax-paying investors.

Investment attractiveness from an untaxed investors perspective

Property isn’t bad from a tax perspective, since it provides taxable rental income, inflation-like growth in rental streams and an additional return given the large investment size and illiquidity of the investment.

Equities are awful for a retirement investors from a tax perspective. Tax exempt dividends and lower-taxed capital gains make up the return. Yes, this is still a source of good long-term returns and a way to earn the Equity Risk Premium over time. But more of the excess returns required by pension funds should be generated by junk bonds.

Junk Bonds provide a high return (all of it taxable in the hands of a tax-paying investor) from credit risk and illiquidity risk.

Some junk is pink, but it’s not all rosy

Pension funds should have less equity, less government bonds, more more more junk bonds. We need to work to find more and better ways of building this market so pension funds can make use of it. (Regulation 28 limits the extent of foreign exposure, another possible way to increase junk bonds investments). The added diversification of adding a different type of risk category to the investment portfolio means we will likely be able to maintain the overall level of risk (or even decrease it) while boosting returns due to the tax premium.

I’m not discounting the default risk inherent in junk bonds, and that this isn’t ideal for a pension fund. It’s a real pity pension funds can’t short the equity of the underlying companies (in moderation) to provide some protection against deterioration of illiquid junk bonds they start migrating down the credit ratings from BB towards ultimate default.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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  1. Ok, but why exactly would junk bonds give a better return for risk than normal risky equities would?

    Also, I assume you’re talking about pension funds that don’t give investment options to their members? In my fund at least, I can easily switch between stable, moderate and aggressive.

    1. Ok, let’s take 2 investments – equal payoff and equal risk (however you want to measure it). The market should price these to be the same so that they should, on average, generate the same return for investors.

      Now, let’s say one of these is tax-exempt (an exaggerated case of equities’ tax position) and the other is fully taxable (like junk bonds). Now, all the tax-paying investors in the market will strongly prefer the tax-exempt returns of the “equities”. The will buy more equities and sell junk bonds, until the after-tax yield on each is the same.

      A tax-exempt investor can now buy the junk bond much more cheaply than the equity and earn a higher return on it since they don’t have to worry about paying tax.

      Because market prices are set by the market as a whole, pensions funds with an advantage in investing in highly taxed investments should invest more heavily in just those investments.

      I was actually primarily referring to Defined Benefit schemes where the investment choice is made by the trustees. If you have the choice yourself, then you should try to find a junk bond or mezzanine debt heavy portfolio to opt into.

      1. I understand the tax logic. But in real life, do tax regulations differ for equities and bonds? If so, then all makes sense. If not, I still don’t see why junk bonds would be a better investment than risky equities, (risk , return, tax being equal).

        1. Junk Bonds: all interest is taxed. Equities: dividends not taxed and capital gains included at 25% or 50% depending on whether you’re an individual or a corporate. So yes, equities are more tax efficient than debt, therefore debt is better (from a tax perspective) for tax-exempt investors.

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