Sweet bonds can leave a sour taste

Summary: Bond products come in different shapes and sizes, and not all are created equal. There's a big difference between government and corporate bonds, and there's junk bonds

Key take-out: Retail investors should be aware of all the risks around bond products offering high returns. Some look sweet on the outside, but can leave a nasty taste if the company behind them can't meet its debt obligations.

The sweet life is something we all aspire to – and it's well within reach of active retirees according to the bonds advertisements we see from time-to-time.

You might be familiar with the ads used to sell the virtues of corporate bonds. If not, let me paint the picture for you.

The ads typically feature a few relatively young, active retirees engaged in an enjoyable social or sporting activity, laughing with friends, having the time of their lives. They're free of any concern – not a money-care in the world.

The ads are typically aimed at high net-worth individuals or those with sizeable self-managed super funds. The subtext is they're not worried about the volatility of their share portfolio because they have invested in ‘low risk' corporate bonds. The reality, of course, is somewhat different.

The problem with all bonds

Investing in bonds, corporate or government, has its challenges. We've discussed these in Minimising credit risk in bond portfolios and How to build a risk-free bonds ladder. Two considerable challenges yet to be reviewed are information flow and liquidity.

The easiest and most accessible option for investing in corporate bonds is through the ASX. Buying and selling bonds listed on the ASX is much the same as buying and selling shares.

The market has reasonable depth, and therefore, liquidity. Unless you are looking to transact in very large amounts, buying or selling is as easy as making a phone call or placing an order online.

As for information flow, issuers of listed bonds must meet the same continuous disclosure requirements as those companies with listed shares.

There are relatively few bonds listed on the ASX. All bonds issued by the Australian Government are listed, but no state government bonds are listed, and there are only a handful of corporate bonds and hybrid securities.

The capital value of the listed corporate bonds and hybrid securities is less than $50 billion. This year the size of the market has been declining as redemptions have exceeded new issues.

A rundown on investment grade bonds

Many, many more bonds are traded in the wholesale over-the-counter (OTC) market. In this investment grade market, the capital value of the available corporate bonds exceeds that of those listed on the ASX by almost a factor of ten. And the opportunity for diversification is considerably greater, with bonds being issued not only by Australian banks and companies, but by banks and companies from all around the world.

Like the name implies, the investment grade market is only for issuers that carry investment grade credit ratings. As such, default risk is very low, and so too are the coupons paid on the bonds. Right now, available yields range from less than 2 per cent to just under 5 per cent per annum.

This is a market for institutional and sophisticated investors. At a minimum, trading must be in parcels of $500,000 at a time, and liquidity and information flow are constraining factors to some degree.

OTC trading means that if you want to buy bonds, you need to find a seller or a broker with some inventory. Conversely, if you want to sell bonds, you need to find a buyer or a broker that wants to expand their inventory. Price discovery can be a problem, along with trying to lock down the desired volume.

Information flow is also problematic, with there being minimal reporting requirements. However, this is mitigated to the extent the issuers are typically very large entities for which information can often be readily found. But investors, by and large, need to take on the responsibility of monitoring their own exposures.

The junk bond market

There is also another wholesale OTC market where liquidity and information are much more problematic. This is the high yield – or junk bond – market. It's a small but very opaque market.

This is a market for specialist fixed income brokers, and for better or worse, their clients. Bond issuers in this market are typically smaller Australian companies and financiers that don't have a credit rating and don't necessarily have their shares listed on the ASX.

The attraction of this market for investors is the high yields on offer. Yields will typically exceed 7 per cent per annum and go as high as 10 per cent, and maybe even more. The yields are this high because the issuers are high risk.

And for these bond issues there will often be little or no liquidity to facilitate secondary market trading. Typically, the only broker that will deal in the bonds will be the broker that bought the issue to the market in the first place.         

Information flow may also be very limited, inhibiting an investor's ability to monitor their exposures. If the issuer is a relatively small private company, information may be limited to whatever the company has undertaken to periodically make available to investors.

It should come as no surprise this is exactly the sort of investment opportunity that is being marketed to the kinds of retirees we see in all the ads – relatively young, active, and still well able to enjoy life's social and sporting spoils.

When things go south

To illustrate the risks involved in investing in unrated and unlisted junk bonds, the plight of investors holding the bonds issued by Mackay Sugar Limited stands out as an example.

Back in early 2013, Mackay Sugar sold $50 million of five-year bonds, paying a coupon of 7.25 per cent per annum. Bond holders are unsecured and rank behind company bankers who hold fixed and floating charges over everything.

The intervening years have not been kind to Mackay Sugar. The company has reported mounting losses for the past three years.

Mackay Sugar's bonds are due to be redeemed next April, and the company is now frantically trying to sell assets so its obligation to redeem the bonds can be met and default avoided.

Investors are not optimistic about the company's prospects. Its bonds are now marked on the sponsoring broker's rate sheet at little more than 50 cents in the dollar.

Still, this could be a great opportunity for any investor with a high-risk tolerance. If the bonds are redeemed when due, an investor buying the bonds now would enjoy a yield to maturity of more than 230 per cent.

That's assuming the sponsoring broker actually has any bonds to sell.