6 lessons for private investors from Andrey Movchan. Lesson Two: Bonds

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Snob continues a series of publications on errors, “pitfalls” and abuses that await a private investor in financial markets, prepared by Movchan’s Group investment management group of companies under the guidance of investor and financier Andrei Movchan. The first lesson was devoted to the commissions of banks and brokers working with your money. Today we will talk about bonds

Bonds are a conservative investment tool. Usually. Brokers, private bankers and managers love to break this rule, because they risk other people’s money, and sometimes they don’t have much knowledge, and they’re available from popular, formal and outdated books. In order not to be surprised, like many clients who come to us, seeing in their bond portfolio created by a reputable private bank, minus 25 percent, the following rules should be kept in mind:

  1. Maturity: the longer it is, the higher the volatility of the bond. The higher the volatility, the stronger the value of your portfolio may fall if the market conditions change. And vice versa: the shorter the maturity, the more stable the paper behaves. We, being conservative investors who want to sleep soundly at night, prefer today, during the period of growth of rates in the market, bonds with a maturity of not more than two or three years. Largely due to the short duration, we have only had one negative year in our flagship investment strategy for 15 years – the notorious 2008th. And even then, against the background of the universal world crisis and the markets flying into the abyss, our minus was only 5.5 percent. For the same reason, our favorite fund ARGO, which invests exclusively in short bonds,
  2. Bonds may default. And, even worse, they can give the market the impression that they will default. And naturally, the longer the duration, the higher the risk of default. We bought a two-year bond of a good issuer – and, most likely, everything will be fine. We bought a ten, and no one knows how it will end. At the same time, three years after the purchase, some Moody’s (international rating agency) will lower the paper rating by one, the market will require more profitability from it, the yield will increase by a percentage, and eventually the market value of your bond will fall by 7 percent. Yes, and Moody’s do not even need. Inflation will grow, rates will grow – here you will see an increase in profitability and, as a result, a decrease in the market value of the bond. Of course, you can keep the paper to maturity. But then (a) you have illiquid assets in your hands, you yourself decided so;
  3. Bonds are highly susceptible to macroeconomic changes in the issuer’s country. Accordingly, where macro changes happen more often, bonds are more volatile. Whether Argentina, Turkey, or Russia — macro problems always start and form like a snowball flying from a mountain. Against the background of macro problems all bonds will fall, both bad and good. And as a rule, only professional investors are able to track signs of impending bad weather. For an ordinary investor, the situation becomes apparent when it is already being trumpeted in all newspapers, and the bad news has long been in price.
  4. When problems arise in the market and bonds decrease in price, it seems that it’s time to buy them. Try it – for a layperson it will not be so easy. In practice, for you the selling price falls much more than the purchase price. The spread sometimes goes up to 10 percent from the usual 0.5–1 percent. And if you want to buy, the price that the bank or broker will offer you will not impress you. But for professional participants, the same funds, in such a situation it will be much easier to buy paper with a discount. Because they are large, experienced, are in a privileged position with bond brokers and can directly put bids to the market at the price that interests them. This is one of the reasons why investing in bonds through funds is often more profitable than directly.
  5. Bonds, even short ones, sometimes actually go into default. This is especially “love” to make paper from the bottom of the rating scale. Therefore, if you buy papers with a CCC rating, you should not be surprised that they may not return your money and that the index of securities with a CCC rating is extremely volatile. There are defaults in the B-group, and even in the A-group. The way out is to monitor the issuers on a daily basis and very carefully, and this takes time and skills. Very often, we see how the idea of ​​“good paper is sold to customers, but it has dropped dramatically in price, take it”. Questionable suggestion: why would good paper fall in price?
  6. Another idea that is often sold is “formally risky paper (debt / ebitda = 10), but everything will be fine, they have a cool business.” Ten times will be – and you earn at 5 percent per annum more than in reliable paper. And the eleventh time will not be, and you get a minus 65 percent. As a result – minus 30 percent. Do you need it?
  7. Bank subordinated bonds and CoCo bonds (Contingent Convertible Bonds) provide increased returns. But you should not be seduced, unless you are a real cowboy. In the event of a financial problem with a bank, the owners of subordinated bonds receive payments almost as a last resort. For example, if a bank goes bankrupt, funds are paid first to depositors, then to holders of ordinary bonds, and only then does it reach the subord. It turns out that investors have practically no chances for their redemption. And the frivolous abbreviation CoCo hides the definition of “convertible in a special case”. If the reserve capital of the issuing bank falls below a certain level, CoCo bonds are converted into shares.
  8. Zones of risk are not where things are bad. Zones of risk – this is where everything is good, but it can become bad at any moment. Agrokor bonds, ruble bonds at the beginning of 2018, and Rusal bonds perfectly showed what a risk zone is. Beware of risk areas.

And also beware of unqualified or unscrupulous consultants who form bond portfolios for you. As a rule, mistakes in portfolio formation are caused by the strong desire of the consultant to attract a new client or to please the old with a high yield of the proposed bond or bond portfolio. And often this happens to the detriment of other important factors. 

Here are the problems that we most often come across when analyzing client portfolios:

  1. Incorrectly selected duration. Often, the consultant does not specify when the client may need the invested amount. And it does not explain that if the duration of the bond or portfolio is greater than the investment horizon, or the purchase is higher than the nominal value, then the sale may have a lower return on investment than the yield to maturity that was used for purchasing. Even a loss is possible if the bond will be traded below the purchase price.
  2. Incorrect currency of the bond. The consultant does not specify in what currency the client prefers to hold his funds and in what currency he plans to spend coupon income, and buys bonds to the client in a wrong currency, for example, in dollars instead of euros. And the client, without knowing it, bears currency risk and additional costs of conversion.
  3. Purchase of subordinated debt and banking CoCo to a client who does not understand or is not informed about the specific risks of these instruments, or the risk profile of this client does not imply the purchase of a minor debt.
  4. Inappropriate or illiterate use of the “shoulder”. Consultants often, to increase profitability, buy bonds from clients with leverage, incorrectly estimating the probability of a margin call or not focusing the client on the procedure for its execution. As a result, there are situations like at the end of 2014, when a collapse in the bond market caused an avalanche of margin calls. And those customers who could not make money on their accounts on time were forcibly closed and suffered significant losses, which they obviously did not expect when these bonds were sold to them.

If you trust someone to choose bonds – make sure that this person or company has sufficient expertise, and not just the desire to earn on you. If you choose a bond yourself – make sure that the issuer wants and is able to extinguish it. One last thing: diversify anyway. We in our fund, for example, do not invest more than 5 percent of a portfolio in one bond, more than 10 percent – in one country, more than 10 percent – in one industry. As a result, we have about 30 bonds in our portfolio and we feel quite comfortable. But it is us, conservative investors.