I heard someone talking on Classic Business tonight. Pity I didn’t catch his name so I can avoid his advice in future.
He was saying that he doesn’t see the point in investing in debt instruments. He explained that the return is low and the risk high since if the company gets into trouble, you’ll likely only get a few cents on the dollar back.
Well, he’s wrong.
Risk and asset-liability matching
Fixed Interest investments are often the only investment that makes sense when you need to match or hedge fixed liabilities. Naively consdering expected return only and not asset-liability risks gives naive results.
Credit risk premia more than compensate for default experience over time
It’s worth exploring risk a little further. The caller stated that if the company gets into trouble, it’s likely the bondholders will also be hurt, and will likely only get a few cents on the dollar. Well he’s wrong here too.
The historical default frequency for investment great bonds (BBB and above) has been hardly more than a few single digit percent. The Loss Given Default (how much an investor will typically lose if the bond issuer does default) is anywhere from 35% to 80%, depending on the seniority of the instrument, which estimate you trust, how it is measured and when the estimate was made. It’s because there are so few investment grade defaults that the data is so sparse and the estimates so wide. However, it’s clear that the likely return won’t be “a few cents on the dollar”.
I’m going to hunt round for some references here so you’re not just trusting my word.
Illiquidity premia = higher returns for some
Given the illiquidity of many corporate bonds, the expected returns are even higher if you as an investors are not considered with easy liquidation of your investment. This is a “pure risk premium” that you will earn over time without expected loss. You could purchase extremely high quality, well-collateralised debt and earn a good return above risk-free as long as you have the patience and resources to hold it for long periods or until maturity.