Monday, January 4, 2010

Bonds Now!...Part 2: Credit investors have delusional expectations

In this post, I begin my discussion of why corporate credit doesn't generally make sense to me as an investment. In this second installment, I'll look at the demand side of corporate bonds. What do the buyers seek?

Let's begin with a really simple assumption: The world is a risky place. Companies and people engage in risky activity in order to earn a living, thrill seek, whatever. Let's also assume that companies engage in risk in order to earn returns on capital, not simply because the managers seek risk for thrills. Then, it should be pretty clear that companies take risks that can turn out good (better than expected), or bad, (worse than expected.)

Bond buyers don't like variation. At all. At a fundamental level, the bond buyer seeks to know up front what the outcome of risky activity will be. They seek the maximum (assume fixed coupon bond, no conversion features, etc.) payment the company can support, accepting only downside variation. (This is the "put" feature described in my previous post.) The problem is, this is unknowable. The buyer of the bond wants to make activities that are inherently risky, variable in both positive and negative ways, into something else.

As a result of this framework, owners of bonds tend to set themselves up for diaster. Bond issuers understand this. That's why bond issuers exist! If bond buyers understood clearly the puts they were selling, they would not agree to sell them.

Wait, you say: The issuer of the bonds, if secured, give the lender a first claim on the assets of the company (just like your bank has a first claim on your house if they hold your mortgage.) I'll grant you that. I'll even grant you that the issuer has sold a call on the company's assets, contingent on disaster at the company (e.g. default on the bonds.) But guess what: Management issuing the bonds gets a call on the upside of performance because the bond coupons are fixed. And, Management either walks away, or gets a new contract to run the company when disaster strikes and the bond holders now own the company.

This is no different than the housing risk banks face today: Borrowers of money can always walk away when things go wrong. When things go right, lenders don't generally have any upside.

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