Bonds are safer than stocks.
Except for when Hyflux got liquidated, in which case, both shareholders and bondholders ended up with either nothing or a pittance.
In theory, bondholders have priority over stockholders when the underlying company goes bust.
Except for the case of Credit Suisse AT1 bonds, where shareholders received something while bondholders did not.
I could go on, but you catch my drift.
Bonds are one of the many investment choices out there.
Compared to stocks, bonds hold the promise of predictable returns which are less affected by market fluctuations and economic cycles.
But like any investment vehicle, the idea can be taken too far.
A tale of three businessmen
What is the difference between stocks and bonds?
Consider three businessmen: Mr Smart, Mr Even and Mr Broke.
All three decided to issue bonds and shares to acquire a building to rent out and make money.
Under this scenario, bonds represent the debt the trio took to finance the purchase. On the other hand, shares represent an ownership of the building, shared between the businessmen and its shareholders.
While all three of them purchased a building, that’s where the similarity ends.
For starters, Mr Smart is adept at managing the building as a business, charging enough rent to cover the costs and generate a profit.
Mr Smart pays out these profits as a dividend.
In this case, bondholders get interest payments. Shareholders, on the other hand, receive a regular dividend, often at a higher rate compared to bondholders.
It’s only fair since shareholders have taken more risk here.
Good for bondholders, not for shareholders
Next, we have Mr Even.
Compared to Mr Smart, Mr Even is a mediocre businessman. He often struggles to eke out a regular profit from the building but is able to keep revenue and costs about the same level without generating any profit.
Under this scenario, bondholders still get their interest payments — that’s because these are part of the cost of running the business.
Shareholders, on the other hand, do not get anything as there are no profits to go around.
No one wins when a business goes bust
We have seen what Mr Smart and Mr Even can do.
But what about Mr Broke?
Oh dear, Mr Broke can’t get anything right!
He struggles to attract tenants to the building. Meanwhile, costs are running out of control.
Faced with mounting losses, Mr Broke takes up loans from the bank to cover the shortfall. However, it’s to no avail as the business keeps racking up red ink. He eventually capitulates, leaving the building to be seized by the banks and liquidated.
In moments like these, bondholders are ahead of shareholders when it comes to claiming whatever’s left over.
That’s the theory, at least.
In practice, when a business is run to the ground, bondholders often do not get a full refund of their capital invested. Oftentimes, they are left with a pittance simply because there is no money left to go around.
Wait, what should you buy?
Many times, we are asked whether investors should put their money in bonds or stocks.
Sometimes, the questions are more direct: for instance, are bonds going to outperform stocks over the next one to two years? Should we exit stocks and buy bonds now? Or how much bonds and stocks should be bought?
These are fair questions.
Unfortunately, they miss the point.
The real question investors should ask themselves is: what is the purpose of your investment?
Simply said, if you are going to need this money within the next five years, you’re better off sticking to bonds.
For instance, the cut-off yield for the 6-month Singapore Government Securities Treasury Bill (SGS T-Bill) on 9 November 2023 was 3.75%.
That’s a decent return for a relatively low-risk instrument.
Step outside this circle and the risk profile changes.
Pushing the boundary
The trouble starts when bond investors start treating bonds like stocks and attempt to squeeze out a higher percentage from bonds.
Often times, these actions are taken under the mistaken impression that bonds are safe to invest.
Unfortunately, it is a slippery slope.
An extra percentage or two is sometimes enough to lure bondholders into the realm where Mr Broke operates.
And that’s when the risk in investing in bonds becomes asymmetrical — yes, you get a little bit more from riskier bonds, but you also run the risk of having it blow up in your face.
A single negative event is devastating.
The joy of a few additional percentage points will quickly be eclipsed by the dread of realising that you are unlikely to make back the losses through bonds again.
That is something I don’t wish on anyone.
Get Smart: Purpose over returns
Bonds play a role in your portfolio. So do stocks.
Always remember why these different investment classes are in your portfolio in the first place.
For example, retirees enjoying their golden years may want to have the assurance of an SGS T-Bill for short-term necessities without worrying about the ups and downs of the stock market.
That’s what bonds such as the SGS T-Bill are for.
The yield may not be high but that’s not the point. The bond’s purpose — a predictable return over a fixed time period — is more important than how much higher of a yield you can get out of these bonds.
For those who are thinking five to 10 years ahead, stocks have the potential to deliver a higher return.
In the short term, stocks such as local bank DBS Group (SGX: D05) or supermarket operator Sheng Siong (SGX: OV8) may be volatile but they both offer a dividend which can grow over time.
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Disclosure: Chin Hui Leong owns DBS Group and Sheng Siong.