At T&T Capital Management, we avoided the massive losses most investors took from buying bonds at the incredibly low yields that prevailed over the last 15 years. It was really simple, the interest rate risk wasn’t worth it, regardless of the ridiculous cookie-cutter asset allocation models that most financial advisors use, which almost always must include a certain component of bonds. In 2023, you have seen us change out tune, and the simple reason why is, interest rates are a heck of a lot higher. Remember that bonds are debt, so by buying bonds, you are buying the debt of a company, country, or municipality. In the corporate world, bonds are higher in the capital structure and should just about always be repaid in full, unless there is a bankruptcy or similar restructuring event. Even in a bankruptcy, recoveries in bonds are far greater than recoveries in equities, which usually go to zero in those circumstances.
When we buy bonds there are a few things to consider. One is the credit quality. How likely are we to be repaid in full? At TTCM, we look at the credit rating but also perform our own analysis, given the relatively shoddy history of the credit rating firms, and their biases and skewed incentives. Secondly, what is the duration? When does that bond expire? A shorter-term bond entails less interest rate risk but can bring with it more reinvestment risk. Let’s say that interest rates drop by 4% and your bond that was yielding 9% matures, but when you look to reinvest the money, you can only get 4%. This is a major consideration in today’s higher rate environment because if we do get a recession where rates drop, we want to make sure that we have enough duration where we are still getting that yield. When yields drop, all things being equal, the bond prices rally, and our returns can actually be significantly greater than even the yield to maturity on an annualized basis if we decide to lock-in those profits. The third major factor is the yield-to-maturity of the bond, which includes the yield, plus any amortization from a discount or premium that the bond trades at. I thought it would be helpful to provide an example of a bond I find highly attractive to walk you through it.
So, the company is a global real estate company that is rated B2, so just below investment grade, which is B3. The company is in solid shape and is diversified across a wide variety of real estate sectors and countries. It has well-funded financial backers that have shown a willingness to inject capital when attractive opportunities come up, so to me I think it is rated too low and should be investment grade. The 2030 bonds are trading at 75.32, so a material discount to par, due to the rapid and steep rise in interest rates. When the bonds were issued a few years back, the coupon was only 4.75%. These bonds have a yield-to-maturity of 9.7%. This is a fantastic return and what I like about it is that you are getting that return over the next 7 years roughly, so the reinvestment risk is not there like it is in shorter-term bonds. Remember that if you make 10% over 7 years, you are just about doubling your money. If interest rates decline, you’d likely see the bonds rally aggressively, which could accelerate your profits, but as long as we simply hold to maturity and the company doesn’t go bankrupt, which we view as extremely unlikely, you make nearly 10% per annum over that seven-year period.
I don’t think equity markets will return 9% per annum over the next decade or even close frankly. The starting valuations are very high, which does not augur well for index returns. Of course, there are plenty of great individual opportunities like we have been discussing and this is an excellent example of a bond that provides equity-like returns, with less risk in my opinion. When we build portfolios, we certainly look to diversify so I’m not advocating being too concentrated on any one bond, but I thought this little glance into the market and our process would be beneficial for you!