Radical Guide to Bonds: A Quick Introduction to Corporate Bonds

The registered corporate bond market is fairly easy to grasp.  Although direct retail holdings of corporate bonds neared $1 trillion in 2003, the large issuers tend to be the same.  The names are familiar. 

GE Capital, Toyota Motor Credit and Pfizer are top-shelf, AAA-rated credits.  Telecoms, national and regional banks and other financial services companies show up consistently among the A-rated credits.  That said, titanic shifts can happen to well-known companies.

Until recently, Merck had been a reliably AAA-rated credit.  The largest credit shock of 2005 came on May 5, when S&P downgraded about $290 billion of GM and Ford bonds to below-investment-grade.  That day, GM shockingly fell two notches to a double-B S&P rating.  (The last leg of the U.S. automakers’ stool, Daimler, is still in BBB territory).  

No retail or institutional investor has a sure view on any credit.  (Enron comes to mind).  While credit shifts do happen, it is important to be mindful of what counts most: a default.  For the majority of buy-and-hold retail bond investors, nothing else matters more than good payers. 

Credit risk appears to come in bunches, as in the years 2000-2002 or the years 1989-1991.  According to NYU’s Prof. Altman, in 2002 and 1990-91, the annual default rates escalated to 10+% and then retraced to 2-4%.  (See Further Reading.)  In his data, the par-weighted average default rate is 5.3% from 1971 to 2003. 

Not great statistics; maybe even a little worrisome.  That said, however, the historical credit statistics also make another point.  According to Moody’s, the better the credit rating, the less likely the bond will default.  By staying with BBB-rated or better names, you will greatly minimize your credit risk.

You will need to evaluate the credits of the bonds before you buy them.  After your evaluation, consider buying your bonds from a low-cost online bond broker.  Here are some tips on buying corporate bonds:

  • Make sure your online broker offers these two corporate new issue selling programs: the LaSalle Bank Direct Access Notes (or “DANs”) program and the Incapital InterNotes program.  Take advantage of the access to these programs.  They are probably the cheapest way to buy retail, current-yield corporate bonds out there.

Why are they so cheap?  The short answer is that the issuer is paying the broker to sell the bonds to you (aka the “selling group concession”).  You are buying the bonds at par, with no discount or premium.  In most trades, with both online and traditional brokers, you pay both the concession and ticket charge.  So in new issue programs, the issuer is picking up the charges.

These programs offer very “clean” formats.  You see the week’s coupon and you buy at par with no accrued interest owed.  These programs are designed in a best efforts format, meaning that you will get allocated if you order some bonds (in theory).  Finally, the offerings are open for a few days, sometimes for an entire whole week.

  • Buy, but do not trade, a new issue corporate bond bought through the DANs or Internotes programs.  Because a new offering is printed in these programs every week, you will see many, many new issue bonds in the market.  No single dealer has its name attached to any of these new issue bonds.  Because they are not attached to any of these new issue bonds, dealers are reluctant to provide a strong bid for them (i.e., to buy your bonds). 
  • Be careful with buried call features.  You need to ask, call or email your broker for more information on corporate bond calls.  Even after speaking with your broker, you should still read the downloadable prospectus. 

The two most popular call features are “conditional” and “make whole” calls.  The first call feature is triggered by a condition, such as the drop in receivables at Sears (explained in A Quick Introduction to Treasury Inflation-Protected Bonds (TIPs)).  The second call is where the issuer will call your bonds and pay you the NPV of the remaining coupons, making you “whole”.

These calls are everywhere in corporate bonds --- Be on the lookout!

  • Ask your broker for the TRACE price.  For corporate bonds, the trade reporting system is called TRACE.  Ask your broker what the most recent TRACE price is on a bond in which you’re interested. 

It shows that you know something about the market.  It puts your broker on notice. (Kudos to Jason Zweig of Money Magazine for suggesting this strategy in a September 2004 article). 

We will discuss trade reporting data in more detail in the guide “How To Buy and Sell Bonds Online.”  Suffice it to say that knowing the trade reporting makes you a smarter buyer.  It shows you’re watching.

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June 3, 2005 | Permalink


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