This is a guest column by regular contributor Clark.
The last article on corporate bonds looked at corporate credit ratings/risk and Part IV dealt with some metrics to remember when purchasing individual bonds. In this part, we’ll look at other risks and touch upon the issue of corporate governance.
Government bonds protect an investor from credit risk, since it is relatively uncommon for countries to go bankrupt when compared to corporations. Corporations offset the additional risk borne by an investor, when holding corporate bonds, by providing better yields than government bonds. Apart from the risk of default and credit risk, there are other risks that an investor would need to be aware of.
- Liquidity Risk. In the case of individual bonds, there may not be a buyer available when needed, thereby giving grief to the bondholder. Also, the bid-ask spread may be higher than bond ETFs.
- Call Risk. Certain corporate bonds are issued as callable; these bonds give a company the right to pay off their debt (repurchase the bond) earlier than the maturity date but after a minimum time period. Companies may compensate for this right by offering a higher yield than conventional corporate bonds. Why would a company repurchase their bond? In a market where interest rates have dropped, they would call their bond and re-issue new ones at prevailing lower interest rates. It is a case of taking advantage of market fluctuations and issuing callable bonds gives them the authority to do so.
- Event Risk. As may be evident from the name, any event such as natural disaster, political instability or change in securities regulations may affect corporate bonds. If such an event triggers an adverse impact to the industrial sector of the corporation, then the ratings agencies may downgrade the company’s credit rating. It is not necessary that all companies that have issued bonds in the sector will face the brunt, since some companies may be more financially leveraged than the others. Hence, the individual liability of the business plays a big part in determining the result of the event.
- Supply Risk. If several bond issues similar to the current one are floated, then the basic supply vs. demand factor may cause a drop in prices.
Corporate Governance Ratings
No matter how good the balance sheet of a corporation, it wouldn’t take long for a poor management team to push the company to the edge of the precipice. Stories of companies going bankrupt due to management malpractices are well-known. To counter such adverse results, corporate governance ratings are published. Company board members may or may not hold these ratings in high regard but they cannot disregard the impact of poor governance ratings.
Consistent poor ratings convey to investors that the management is not doing a reasonable job and the board does not want to take action to change the status quo. Prolonged failure to deal with such situations may affect the quality of directors on board, since the good ones may leave if they find too many from the “we don’t care” camp and cannot enforce the right measures. Also, in their own self-interest, they will not want to be associated with such companies since it would reflect poorly on their personal credentials and future prospects.
Although the issue of corporate governance is important, there seems to be an apparent lack of validity to the ratings issued by the different services as discussed by this study. If you are interested in knowing more about these ratings, check out these Risk Metrics, Standard & Poor’s and Corporate Library pages for more and better details.
As seen from this three-part series on corporate bonds, there are several factors to be considered before buying an individual bond issue. The presence of credit rating agencies eases the selection process by narrowing the list of companies. Yet, there are other risk factors that need to be considered before becoming an individual bond investor. For investors who lack the time, interest or skill to research bonds, it would be wise to buy a bond fund or bond ETF. They could even go for a higher-yield security, where a few defaults will not entail significant principal loss because of the diversification.
About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.