Time Part 2

Investing in fixed income securities

The arrow of time makes our existence meaningful. Tomorrow becomes today, and today becomes yesterday. All actions and inactions define our timeline. The same is true for investing. The position we do not take is at least as crucial as the one we take.

Moreover, time impacts various financial instruments differently. Equity is implicitly dependent on time, while instruments like bonds and options are explicitly dependent.

As a side note, I write mainly for the LEAPS strategy, which is executed with long calls. So, I treat time, i.e., option time decay, as a risk management fee to get protection against path dependency. In that case, time works against me. I already covered velocity, time, and distance in the context of LEAPS calls.

Today, it’s time to write about bonds. Unlike long options, time is our friend when we invest in fixed-income securities. The issuer's probability of default is a function of time. If all variables are equal (balance sheet, debt amortization schedule, liquidity), bonds with shorter life spans have lower chances of failure compared to long-term bonds. The closer the maturity is, the lower the odds we picked the wrong issue.

The fixed-income universe is diverse and complex. Most market participants ignore it because they focus on the path with the least resistance, which is equity investing. Investing in stocks has the lowest entry barrier, considering the required knowledge, experience, and capital to play the game.

I am not saying investing in stocks is easy. It is not. My point is that neglecting a whole asset class is like a plumber who likes to work only with an adjustable spanner. All financial assets represent our toolbox. To gain Alpha, we must know what we have at our disposal. This means applying any tools according to the task—of course, only if we thoroughly know how to do so.

Can I generate Alpha with fixed-income tools?

The short answer is yes. It sounds counterintuitive because bonds are considered an income generator, nothing more. This is partially true for investment-grade government bonds. Let’s dig deeper.

My discussion covers corporate and government bonds with 12-36 months to maturity, higher coupon rates, and issuer’s credit rating between A- and B- (S&P scale). At first glance, buying bonds below investment grade sounds too risky. That's true, but only to a certain degree.

The relationship between issuer credit risk and bond coupon rate is not linear. The curve describing the dependency between risk and coupon is convex. This means the risk growth rate is slower than the coupon growth rate in the first ¾ of the curve. Then, after an inflection point, both equalize, and the relationships become almost proportional.

Simply put, a bond with an 8.5% coupon is not inherently riskier than a bond with a 5.5% coupon. Of course, both issuers are not identical, so their risk profiles may differ. The point is that both issues (and bond issuers' risk profiles) are more similar than different. Hence, by investing in a 7.5% bond, we get better compensation for the risk taken.

Conversely, a 15.7% coupon bond is much riskier than an 8.5% coupon bond. Hence, risk-reward sharply decreases. To simplify, bonds with grades triple B to B offer the best balance between income and risk. Higher-grade bonds do not provide attractive income for the risk, yet lower-grade bonds bring too much uncertainty despite their luring coupons.  

Fixed-income securities offer inverse asymmetry. We can gain from coupon payments and optional capital profit, while we can lose 100% of the principal in the worst-case scenario, i.e., issuer default. In equity investing, asymmetry favors us, translating into substantial risk rewards and reasonable odds of winning. This means we can create a concentrated portfolio with 5-10 large positions.

With bonds, we must take a different approach. A fixed-income portfolio resembles an insurance company book. Insurance companies underwrite options. The insurer is an option seller, which means she or he has a small predefined upside and a massive yet predefined downside. On the other hand, the odds of winning and losing are easier to estimate compared to equity positions.

How low are the odds of a total loss of principal?

I will share a simple heuristic borrowed from an insurance business. The probability of losing equals the differential between the bond’s coupon and free-risk return interest. If, for example, the security offers a 10.0% coupon and US10Y is 5.0%, the odds of losing the principal are 5.0%, or from 20 individual bond issuers, one will fail.

This is an oversimplification that illustrates how to estimate the risk of losing the principal roughly. It is not a precise measurement of probability and its distribution. Unlike life insurance, tables with mortality rates for fixed-income securities do not exist.

Knowing probability means we are aware of the frequency of occurrence. However, what we do not know is the distribution. So, we may experience a cluster of losses for a short period of time. So, entirely relying on the above rule could be dangerous. Treat it as a directional guide.

What is essential in investing in fixed-income securities is to focus on the chances of NOT losing—in other words, the probability of the issuer weathering a liquidity crisis. That being said, our job as bond investors is not to seek big winners but to find the best bankruptcy avoiders.

To recap, we must stay in the middle of the credit ratings chart, where the balance between income and risk is in investors’ favor—that is, between triple B and B.

Inverse asymmetry combined with a low probability of losing the principal means shifting our approach from diversified concentration to concentrated diversification. In our book, we must diversify debt issuers and maturity periods. Thus, we distribute the credit risk among issuers and spread their risk over time. Of course, the number may rise to 40 or 50 individual positions for large portfolios.

If selected properly, bonds can bring Alpha with predefined risk. To achieve that, we must buy securities that trade below par. I am not talking about Venezuela or Lebanon gov bonds. They fall in the distressed debt category, which is not the subject of today's discussion. I mean bonds sold at a 5-20% discount from their face value.

Let’s give an example. Assume we have a bond with a 9% coupon rate that trades at $90 (a 10% discount from the bond’s par value of $100). The bond matures after 12 months, and the payments come annually. This means we will receive the interest and principal on the maturity date. How much can we potentially earn?

First, let’s measure the yield. At the $90 price, the bond yield is 10%. The next step is to estimate the capital gain. When the bond matures, we will receive the principal back. This means we gain $10 or 11.1% based on the price we paid. For 12 months, we realized 21.1% (10% yield plus 11.1% capital gains) with mitigated risk based on a low probability of being wrong. The chances of losing the principal are single digits, based on 3.83% US10Y and a 9.0% bond coupon—definitely not a bad investment.

This simplified example illustrates how we can achieve reasonable returns under well-defined risk in terms of probabilities and consequences. However, in reality, investing in bonds is not that simple. Risk management is a priority (as usual) to avoid permanent capital losses. When discussing fixed-income securities, our task is to spread the risk between multiple debt issuers over time.

Final thoughts

Today’s piece is a primer on bonds. Its idea is to turn readers’ attention to another neglected and underestimated tool at our disposal.

Fixed-income instruments require a solid understanding of the role of time. If I rank equity, bonds, and options based on complexity, bonds hold the middle ground, while options are the most difficult, and stocks are on the other side of the scale. Options and bonds, as you already know, are explicitly dependent on time. Stock is implicitly dependent.

Explicit dependence is a massive advantage if used properly. We like the forgot the impact of time on markets and life. Nevertheless, time never forgets for us. By using fixed-income securities, we turn time into our ally.