Today’s Fixed Income Environment
No one saw this economic downturn coming when the market was at its peak. If someone had, they would have been shouting "The end is near! Time to sell!" and we would have laughed at them. But now they would be laughing at us and shouting "I told you so". Since nobody is out there laughing at us, I assume that even the smartest investment minds still have lessons to learn. For me, one of the lessons I have learned in the last couple years is the importance of the fixed income allocation in a portfolio.
These days I am immersed in studying fixed income investments and it is fascinating. I thought I was entering the investment arena of little old ladies and the ultra conservative. I was wrong.
Some fixed income investments are conservative. But the fixed income environment is anything but boring. Other fixed income investments could be considered riskier than many stock investments.
Take this bond play for example. These are actual investments I made within my own portfolio. For the purpose of discussion I have omitted trading expenses.
In early February the credit markets were still quite tight which had adversely affected the prices of existing corporate bonds (ie, the secondary corporate bond market). This lack of credit also negatively influenced the credit ratings of several corporations which had traditionally been considered good credit risks. The auto industry was particularly hit hard by the economy and I started looking at auto industry bonds which investors were selling at a significant discount below the face value. Two, in particular, caught my eye.
Ford had issued a 20 year debenture in early June 1990 with a 9.5% coupon. In regular English, that means that investors had loaned Ford money to be repaid in a lump sum in 20 years. The loan was backed only by the good faith and credit of Ford, and in consideration of the loan Ford would give investors $95 a year in interest per bond (usually, bonds are issued with a $1000 value and pay interest in two equal installments a year). As I looked closer at this issue it was being sold for $409 per bond, a significant discount. For the $409, someone who purchased this bond would get 3 payments of $47.50 (half of $95) and the repayment of $1000 when the bond matures in June 2010… if Ford did not declare bankruptcy in the interim and continued to pay its obligations on time. Best case scenario, an investment of $409 returns $1142.50 in 18 months. The return is 87.4% per year but it comes with a significant risk. Worst case scenario, the investment is worthless before any interest is received.
General Motors bonds were also trading at a significant discount. Specifically, in January 2001 GM had issued a 10 year senior unsecured note at 7.2%. This bond pays back the $1000 face value in January 2011 and pays $36 in interest every six months until then. Since GM was in even worse financial condition than Ford, investors who owned this bond were selling them for $193.75. This time the best case return is 124.5% per year but the probability of bankruptcy was considered greater.
On February 11, 2009 I purchased 3 of the Ford bonds for $1287.17 ($409 x 3 = $1227 + $60.17 in accrued interest) and 6 of the GM bonds for $1200.90 ($193.75 x 6 = $1162.50 + $38.40 in accrued interest).
At the time, I did not think the government would any of the auto makers fail. I figured the federal government would develop a bailout program for the auto industry just as they were doing for banks. Today, I don't think that is going to happen. It looks very likely that GM will go bankrupt before the end of this month (because they would have to pay over $1 billion in bond interest on June 1st if they don't). If GM does declare bankruptcy the value of GM bonds may not be determinable for a long time. Ultimately, they may be worth significantly less than I paid for them and may even end up worthless.
All I need is for one of the two companies to survive long enough to pay the maturity value of the bond. Since GM is a likely bankruptcy candidate, let's assume Ford makes it at least a few more years. My total investment in both companies is $2,488.07. The 3 Ford bonds have the potential to return $3427.50 which works out to 23.7% per year despite a GM bankruptcy. Not quite the return I was looking for, but nothing to scoff at either. By the way, if for some reason Ford goes bankrupt but GM survives, the return would be even better.
If I want to get out of the bonds early I could always sell them. The current market prices (as of market close 5-21-09) reflect the financial stability, or lack thereof, of each company. The Ford bonds are currently worth $840 each, but the GM bonds are currently only worth $58.75 each.
There was a time that Ford and GM bonds would be considered a good investment for a retiree. Not today. At these amounts these bonds do not even represent a significant portion of my overall portfolio. But I have always found that I learn the most by practicing and I found this play intriguing. Time will tell if I had to pay for my education or if I got paid to learn.
The preceding is an accounting of the author's experience. Actual results may vary. Please consult your tax advisor or attorney regarding your situation before investing.