The Corporate Bond Slight of Hand

Full disclosure: I do not have a single bond or bond fund in my portfolio. Nevertheless, there is a case to be made in some very specific circumstances to own a bond or t-bill. This article is not specifically about whether and when you should own bonds or not, but rather about whether you should own corporate bonds. There are a few kinds of major bonds: US government bonds (sold by the US government), municipal bonds (sold by local governments), and corporate bonds (sold by corporations). The corporate bond above all others works against the interest of the bond holder, in almost all respects it benefits the corporation, and often supports the higher returns of the corporation's stock holders to the detriment of the bond holder.

Lack of Compound Returns

First, let's take a look at problems common to all bonds. There is a major difference in the returns coming from investments in the stock market versus investments in a bond. When the stock market gains returns, it is always compounding that return on top of previous gains. But when a bond pays out interest, that interest is based on static principal. As an example let's compare ten years of returns from a bond with ten years of returns from the stock market. And to start things off fair, we'll assume that both the bond and the stock market return exactly 5% each year. In the first year both the bond and stock market would have a return of $500. But by the tenth year, the bond would still have a return of $500 while the stock market would have a return of $775.

Impact of Inflation on Static Returns

But the impact of non-compounding returns is not the entire problem. Because bond interest is based on a static principal, inflation actually reduces your return over time. Inflation causes the value of a dollar today to be worth more than a dollar tomorrow. Or stated another way, today it may take $1 to buy a loaf of bread but in the future, due to inflation, the cost of bread might cost $1.50. The average rate of inflation since Great Depression has been roughly 3%. 

Therefore, the returns of a bond in the second year are worth 3% less than they were last year. If we take the same ten year example of bond from above with a 5% return and we apply inflation to the return, then the inflation adjusted interest in the final year of the bond (year ten) is not 5%, it is 3.8%.

As of the writing of this article, the average coupon rate for a AAA rated corporate bond was 3.37% with an average duration of 17 years. If we experience average inflation over the next 17 years, then the inflation adjusted return of the average AAA rated corporate bond in its final year would equal 2.07%. What is worse, is that a return above inflation would only be received in four of the seventeen years, meaning that if you held the bond for the entire duration, you would have been losing ground to inflation for thirteen years in a row by buying the bond. 

In dollar terms, the average corporate bond paying a coupon of 3.37% would have paid out $337 in its first year if you bought a $10,000 bond. In the seventeenth year, the bond would have paid out $337. But because of inflation, you would need $540 to maintain the same buying power. The original $337 would have lost 36% of its value over time due to inflation. Is the security of guaranteed payments from a bond worth it? And is the security of a bond actually secure?

Danger of Calls from Corporations.

Most corporate bonds are structured to benefit the corporation and not the bond holder. Most corporate bonds have what is called a Call provision. This means that if interest rates go down, then the corporation has the right to recall the bond and issue another bond for a new lower interest rate. Re-issuing a bond at a lower interest rate further exacerbates the loss of value to inflation.

For instance, if you are able to find a bond with a high interest rate, but shortly thereafter, the Federal Reserve lowers interest rates, then the corporation could recall the bond, leaving you with two options: accept the new lower interest rate or take back your principal. All the incentives lie with the corporation and not the consumer. The consumer does not have the option to keep the bond at its original coupon rate.

The Danger of Interest Rate Increases

When interest rates go higher, the consumer does not have the option to require that the corporation begin paying a higher interest as well. Instead, the corporation again benefits by having sold a bond at a lower interest rate and continues to benefit from paying a below market rate for their debt. Whereas, the corporation has the option to reset its interest rate in a new low rate interest rate environment with a Call. The consumer does not have the option to reset the interest rate to compensate them for a higher interest rate environment. In both directions, corporations are financing their debt to the detriment of the consumer. 

How Corporate Bond Holders Subsidize Stock Holders

The kicker to all of this is that by taking advantage of the consumer both in lower and higher interest rate environments, the bond holder is in fact, subsidizing the increased stock price of a person holding the stock of the company. How do you ask? 

When a company calls a bond and reissues new bonds with lower interest rates, it is lowering its interest obligations. This lower interest obligation increases its available cash on hand, which adds value to the company and in turn increases the price of its stock. When a bond holder is forced to continue holding a bond or sell at a discount when interest rates are rising, the company is benefiting from a static interest rate and inflation. Meaning, as the company maintains a reduced debt cost from inflation, its cash reserves are increased, adding to the value of the company and increasing its stock value.  

In a proof positive way, corporations finance the their stock price on the backs of those that choose to own corporate bonds. While bond holders lose in every way, the stock holder gains from each kind of the bondholder's loss. As the saying goes, "head I win, tails you lose".

Danger From Loss of Credit Worthiness

You may think, well, I can find a good corporate bond that is not a callable bond (some do exist) and I am okay with a lower inflation adjusted return over time because I am willing to trade the security of a AAA rated bond for some returns. It may very well be that buying such a bond could be a safe investment. But consider the possible options for a AAA rated bond. When you buy a AAA rated bond, there is no where for the bond's credit rating to go but down increasing its risk of default. In fact, this happens often and when it does it means that the bond suffers a loss of value with a downgrade in credit rating. Now, if you continued to hold the bond, then the downgrade would not affect you, but if there was a need to sell the bond, you would not get the same return on principal as you initially paid. And, either way, you have added risk, which is what you were trying to avoid by accepting a lower return. 

And even in this scenario, the corporation, not the consumer owns all the advantages. A business that gains the status of a AAA rating, is able to issue bonds at the lowest possible price. But if their creditworthiness decreases and they are downgraded, then there is no protection for the consumer. The consumer must suffer all the downside of a credit rating downgrade while the corporation continues to receive the benefit of low interest even though it has lost its top rating. In essence, a downgrade means that the bondholder now has added risk (exactly what he was trying to avoid) but he is not compensated with a higher coupon rate (interest). All this while the corporation continues to reap the benefit of an old AAA rating.

Bonds With Upgraded Credit Ratings

The next question may then be legitimately asked: isn't the consumer able to take advantage of a bond whose credit rating is upgraded? While this may be the case for some bonds, an increase in credit rating makes it possible for a corporation to issue bonds at a lower interest rate which means that the chances that a corporation will exercise their right to Call the bond go up dramatically. On balance, a corporation whose credit rating improves, benefits the corporation, not the consumer.

High Yield Bonds 

High yield corporate bonds are the riskiest of all. The reason they have such high coupon rates is exactly because the corporation is in danger of bankruptcy. Some think that the high interest rate is compensation for the risk. But is it enough? Most people fail to consider that a corporation that does go bankrupt is under no obligation to pay back the initial principal invested into the bond if the corporation has no liquid assets. This means that although a bond holder received a high interest rate for a time, they may end up losing most or all of their principal investment.

Oddly enough, even when a company goes through bankruptcy the bond holders may be helping stock holders. In the case of the stock holder, the stock price will drop significantly but they do not lose the stock. They still own as many shares as they had to begin with whereas the bond holder must take whatever principal payment the corporation can actually pay. Neither is in a good position, but by forcing bond holders to accept less principal then they invested, the debt is magically removed from the books putting the company in a better financial position (though not an enviable one). At this point, the stock holder is the one most likely to recoup his loses in the future, not the bond holder who was forced to accept a loss. 

Summary

If knowledge and understanding is power, then understanding the relationship of corporate bond owners to corporate bond issuers and stock holders is essential to knowing where to invest your money and the risks involved. Corporate bonds may appear to be risk free, but they not. Stocks may seem to be risky, but they reap all the benefits from the risk that the bond holder takes on. Be very careful when investing in corporate bonds.