The key lies in the operating environment

We know that a bond is a lending instrument. It involves putting up a sum of money upfront as an initial capital or outlay to a company or organization. To compensate for the loss of use of the money, we are rewarded through a series of coupons throughout the loan tenor and then a full return of capital at the end of the loan period.

Of course, people have become more creative and many variations of it have been dished out to attract investors.  There are discounted bonds, zero-coupon bonds, convertible bonds and perpetual bonds just to name a few. Then, there are also many kinds of investing instruments that attempt to work along the same principle, such as gold trading, land-banking, tree-planting and even REITs. We know from news that from time to time, defaults on these types of instrument did happen. But then, why are people so attracted to these instruments? The answer lies in the fact that the interest rate has been too low for too long.  In fact, I cannot remember a time since when I started to pay for my HDB flat in the late 90s after the Asian financial crisis to the time when I completed paying for it in 2005, that I ever paid more than 2.6% interest. Even if there was, the period had been too short and the increase was too insignificant for me to remember. Obviously, the interest rates for the ordinary account (OA) also remains fairly unchanged at 2.5%. When the Global Financial Crisis hit us in 2008/2009, the already low-interest rate depressed even further. Some countries even entered a negative interest rate regime. Simply put, depositors have to pay the bank to safe-keep the money instead of the bank paying interest to depositors.

 

So, what is the effect on us? Over the period of seventeen years or so, since the beginning of the new millennium to this very day, we have been enjoying a state of extremely low interest rates. It has become a new normal especially for those people who have not seen local banks paying 5% and 8% for fixed deposits (FD) like those in the late 90s and early 80s respectively. Even to this day, it does not pay to put money in the bank just for a paltry interest of less than 1%. Needless to say, a lot of those monies that otherwise would have been put into banks had already found their way into riskier assets like properties, equities, bonds and many non-regulated investments.           

Coming back to the subject on bonds and its similar instruments, in a situation that the environment does not change at all, the price of these instruments would have been fairly flat. But the ever-decreasing interest rate had caused hunger for yield to become insatiable. Many high yield instruments, like REITs,  were exactly designed to work in such environment, and that was why the price of REITs was seen to be climbing for quite a number of years and even jumped further when the FED embarked on the $80b monthly bond purchase in 2012. Those who had bought early might have eaten the low-lying fruits, but those people who joined late in the party had to pay a much higher price for the REITs. This means that it will take a longer time for the late entries to recover their capital due to the loss of capital when the interest rate rises. So, depending on the time when we buy, a high yield investment can be a tricky situation after all.

 

Actually, I believe in the minds of investors of high yield instruments, they are not looking into capital gains. They are in fact looking for high interest rate instruments to park their money instead of putting it in the bank earning a paltry interest. If the bank deposits interest is high enough, a lot of these monies would have found their way back into bank deposits. Unfortunately, many of us have been conditioned that along with high gains come with high risks. So a medium percentage that investors were prepared to accept was 5%, and this seemed to have been a magic number for quite a number of years. Any investment that gives a return of 5% or above would attract a huge herd of investors tipping it to become oversubscribed during IPOs. REITs that generally pay more than 5% were bided up and perpetual bonds that pay 5% were oversubscribed. Unfortunately, just like in soccer, we cannot depend on one leg to strike at goals. We need both legs. And both legs must be equally efficient. In the same way, to be adequately compensated as investors, we need both capital appreciation as well as dividends. Many late entrances into high yield instruments believing that these instruments are no-brainers would have been grossly disappointed. Perhaps, they believe that by parking into high yield instruments, they could shorten the payback and get back their capital quickly. Unfortunately, all it takes is a default to crash the whole game plan causing the transaction price to fall drastically. Indeed many high yield corporate bonds, like offshore marine and shipping, were caught in this perfect storm when their business turned for the worse. Even if there was no default, the prices of these assets have come down drastically because they have been bided up too high when the interest rate was falling. At the end of the day, we still need a margin of safety to put us in a safe position.      

Brennen has been investing in the stock market for 27 years. He trains occasionally and is a managing partner for BP Wealth Learning Centre. He is also the author of the book – “Building Wealth Together Through Stocks” which is available in both soft and hardcopy. Analyses of some individual stocks can be found in bpwlc.usefedora.com. Registration is free.