Market Insight

Investing 102: Credit Risk

In our previous article we considered why bonds should be held in an investment portfolio and attempted to answer the question of how many bonds should be held. If an investor is prepared to hold risk free government bonds and is prepared to hold the bonds to maturity, then it is feasible to hold just one, so long as the investment is large enough relative to the size of the investment portfolio, to maximise the diversification benefits of bonds.

Remember Markowitz’s ideal investment portfolio of just two assets: one that only pays out when the sun is shining; and another that only pays out when it rains. Thus, the investor will have a portfolio that always pays out no matter the weather.

Risk and Government Bonds

We expanded this into a portfolio of ten risk-free government bonds with maturities staggered so that just one matures over each of the next ten years. This being the concept of a bond ladder that allows an investor to have capital returned each year, without selling a bond, and if the capital is not needed it can be reinvested in a new bond at current interest rates.

This has the added advantage of not locking in low or high interest rates for a long period of time. Remember government bonds pay fixed interest rates, not floating.

However, we noted that government bonds pay very low interest rates relative to other bonds. And this means, if the bonds are being held to generate an income, the capital invested will need to be much larger than that required if higher yielding (but not risk-free) bonds are held.

This introduces the concept of credit risk – the subject of this article. Minimising credit risk so that total return from a portfolio can be maximised requires a greater number of bonds be held: possibly a lot more than ten.

Systemic and Non-systemic Risks

Again, as noted last time, credit risk sits on a risk continuum between risk-free and equity risk. Risk in this case consists of systemic risk and non-systemic risk.

Systemic risk is the risk of industry or economic collapse. Banks that are considered too big to fail are banks that could bring down the whole financial system if they did fail. This is systemic risk.

Non-systemic risk is risk that relates to individual companies – the risk that a company could fail in isolation. This is also known as idiosyncratic risk.

When dealing with credit risk and equity risk it is possible to diversify away non-systemic risk but not systemic risk. Ten well-chosen stocks can eliminate non-systemic risk in an equity portfolio.

The number of stocks can be so few because equities come with both downside and upside risk. The value of the stocks held can move up or down.

However, with bonds risk is very much to the downside.

Ignoring short term fluctuations in bond prices, the best thing that can happen is that coupons are paid on time and principal is returned at maturity. The downside risk is that the bond issuer defaults and all is lost.

The asymmetric risk profile of bonds means that many more must be held in a portfolio to diversify away non-systemic risk. And, if an investor wants to rely on statistical averages to minimise credit risk, then the more bonds held in a portfolio the better, especially if the bonds are not investment grade.

Credit Risk and Default Rates

Default statistics compiled by Global Rating Agency - S&P Global Ratings (S&P) - over the period from 1981 to 2016 show that the five year cumulative default rated for investment grade companies is 1% and for sub-investment grade companies the rate is 15%. In other words, over a five year period 15 companies in a portfolio of 100 companies can be expected to default.

If a recovery rate of 50% is assumed, and this may be a big assumption, then over a five year period a loss of 7.5% of the value of the portfolio can be expected.

This may not be a big deal if that portfolio is returning 5% per annum but how many investors will hold a portfolio of bonds issued by 100 different companies? What if you hold a portfolio of 20 bonds but 15 of those are issued by the companies that default over a five year period?

Averages can only be relied upon if you can play with large numbers.

S&P’s numbers show that more than 11% of sub-investment grade companies defaulted in just one year – 1991. Almost 10% defaulted in 2002 and again in 2009.

Among the most lowly rated companies assessed by S&P, nearly 50% defaulted in 2009!

Another way to think about this is to consider a portfolio that is returning 10% per annum. You can hold ten bonds in that portfolio and afforded to lose one in one year.

The income for the other nine will just about cover the capital lost on the one that defaults (assuming no recovery).

If the portfolio only returns 5% per annum then 20 bonds will need to be held to just about cover the capital loss arising from one default in one year. 50 bonds will be needed if the portfolio only returns 2% per annum, and 100 bonds if the return is only 1%.

If playing in large number is not an option, then holding investment grade bonds only will greatly reduce an investors’ risk. Unfortunately, outside of government bonds, most bonds sold to retail investors are not investment grade.

Philip Bayley

The author Philip Bayley is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

Investing 101: Why should I hold bonds and how many?

Modern Portfolio Theory (MPT) emerged in the early 1950s via a seminal article published in the academic Journal of Finance and authored by Harry Markowitz. Without meaning to make light of Markowitz’ contribution (Markowitz is a Nobel laureate) MPT is just a fancy title for the old maxim that has been around since Adam was a boy: “don’t put all your eggs in one basket”.

Markowitz’ real contribution was to put some logic and process around the maxim, as it relates to investing. The simple concept is, in an ideal investment portfolio, two assets will be held: one that pays-out when the sun shines, and one that pays-out when it is raining.

Thus, the investment portfolio will always pay-out no matter the weather.

If this is applied to a portfolio of shares and risk-free government bonds, when investors are risk seeking and share prices are rising, bond prices will fall. But when investors become risk averse, share prices will fall and bond prices will rise.

Just think of only a few years ago when the world had a bi-polar fixation with the RORO trade – risk on, risk off.

Bearing in mind that Markowitz is an American economist, bonds serve another useful purpose in an investment portfolio, that otherwise only holds shares. Bonds pay regular coupons and thus generate an income.

Many shares in the US (especially in the past) do not pay dividends. Without bonds in an investment portfolio an investor would be forced to sell some shares each year just to generate an income, if an income was required.

In Australia, and elsewhere around the world, the need to hold bonds to generate an income is less of a priority. Nevertheless, combining bonds with shares serves the useful purpose of reducing the risk of an investment portfolio, while maintaining an appropriate rate of return.

This is why bonds should be held in an investment portfolio, but how many?

So far only risk-free government bonds have been considered. Risk free government bonds are bonds issued by the sovereign; in our case, the Commonwealth of Australia.

The bonds are considered to be risk free because the government cannot default on a debt obligation denominated in its own currency (this does not apply to state government bonds or any other bonds). Thus, to obtain the benefits of risk-free government bonds in an investment portfolio it is only necessary to hold one, in sufficient volume, and provided you don’t want to sell it before maturity.

But. And this is a big but, because this is where practicalities take us away from a neat theory.

Risk-free government bonds have some disadvantages not the least of which is; they don’t pay very much and this is because they are risk free. Higher returns come with greater risk – it’s always the way isn’t it?

At the present time, 10 year Commonwealth government bonds are yielding just 2.6% per annum. A three year bond yields less than 2%.

If you want to hold only risk-free assets in your self-managed superannuation fund, and you want to generate a retirement income of $100,000 a year without tying up your money for too long, you will need to have more than $5 million invested in three year government bonds.

The disadvantages of risk-free bonds are now starting to become obvious.

Another possible disadvantage is that the bonds typically pay a fixed coupon. The interest rate paid will be fixed at 5% per annum, or perhaps 10% or maybe just 2% per annum.
It will all depend on level of interest rates in markets at the time the bond is issued.

But if you are holding a 5% bond and interest rates rise to 10% you are probably not going to be happy, especially if you can’t hold the bond until maturity and have to sell the bond. The price of the bond will be something less than face value and a capital loss will be incurred.

The reverse will be true if interest rates fall to 2%.

Investors wishing to mitigate the impact of interest rate changes on their risk-free bond holdings will employ what is known as a bond ladder. The idea is that you hold more than one bond and in fact you might hold ten, with one bond maturing each year over a ten year period.

This gives you a source of capital each year, if it is needed, or alternatively the proceeds from the maturing bond can be reinvested in a new bond at current interest rates.

Now that we are up to ten bonds in an investment portfolio, we can address the possibility that you don’t have $5 million in your SMSF to generate a risk-free $100,000 per annum. Generating $100,000 per annum may still be possible but it will require investing in riskier bonds.

Riskier bonds are bonds that can default, which as said earlier, are all other bonds. Introducing the risk of default introduces credit risk to an investment portfolio and in so doing, moves us further away from Markowitz’ ideal investment portfolio.

On a risk continuum, credit risk sits between risk-free and equity risk and the more credit risk introduced into a portfolio, the more bonds that need to be held to minimise the adverse impact of an event of default.

In this context, asking how many bonds do I need to hold, is a bit like asking how long is a piece of string? How much of your capital are you prepared to loose, if a bond issuer defaults?

This will be the subject of a follow-up article, “Investing 102: Credit risk”.

Philip Bayley

The author Philip Bayley is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.


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