Bond investing and financial advisers

Brent Sheather wrote an interesting article in the NZ Herald on Thursday. As usual it was insightful and provocative and made some useful points.

One of Brent’s major arguments is that in the bond part of their portfolio NZ investors should stick with low risk bonds like those issued by government, SOEs or city councils, and should stay away from the higher risk types, like finance company debentures. He criticises financial advisers who persist in recommending finance company debentures. His major reasoning for focusing on low-risk bond is the classic portfolio theory that the role of bonds is to anchor the low risk end of an investor’s portfolio and act as a counter-weight to riskier elements, as bonds are seen as moving counter-cyclically to shares. Junk-debentures do no fulfil that role, as they tend to co-move with shares during market stress.

Brent’s argument is fine at an AFA (non-complex) level but current portfolio theory argues things are not that simple. Current theory argues that junk bonds should be treated as similar to shares and, as such, have a valid part in a diversified portfolio. They should be appraised based on their return/risk characteristics and regarded as analogous to shares, with debentures from large finance companies being bluer chip, and smaller ones being clearly junk. Any counter-cyclical benefits should be ignored. Note that the put-like return characteristics of debentures would argue for higher returns than comparative equities. The research trick is then being able to differentiate traditional bonds from equity-like junk bonds on something other than a B+ rating.

The key words here were ‘diversified portfolio’, so they would be the 30th security, not the 2nd. My major problem with debentures prior to the naughties crisis is not that they were used but that finance company debentures were under-priced – given the lack of dividends and risk level, the riskier ones should have being returning at least 16%. That would have compensated investors for the coming bankruptcy and given investors a clear idea of risk level. At that return, I’m sure Brent could see a role for a few being included at the riskier end of the portfolio.  Of course, if debentures had paid that much, investors would have sensibly stayed away, so they were instead priced at 3 or 4% above safer bonds, and thus fooled investors into thinking they were safe.