Using Dividend Stocks To Get More Yield – My Experience

Low Returns

Due to ZIRP the interest available on deposits has dwindled to almost nothing. CD’s for 1 year are around 1% or so and for 5 years they are at 1.7%. After tax, this yield is minuscule, especially since interest is currently taxed as ordinary income at up to 35% or so depending on your state. While tax policy is in flux, it is safe to say that you won’t get much more than around 1% after tax on your money in the savings market without taking some risk.

On the other hand, dividends are rising for many corporations. If you go to any sort of stock screener and look world wide there are a large number of stocks with dividends in the 3% – 5% yield range that appear to be solid and well capitalized companies. In addition, under current tax policy, dividends are taxed more favorably than interest on CD’s or bonds.

Bond ETF vs Dividend Stocks – the Experiment

Thus as an experiment I decided to pit two tracks against each other.

1. Buy a reasonable proxy for the bond market and track interest received and changes in principal for return (Vanguard BND ETF)

2. Select a group of dividend paying stocks and see how they perform in terms of dividends received and capital appreciation (or declines)

I originally looked for a dividend ETF but I didn’t see one that I liked because I wanted companies from around the world, not just the US, and I didn’t want a lot of financial institutions. The ETF’s that I saw had expenses in the 0.2% up to 0.5% and I have a lot of free trades in my account meaning that my expenses for my own selections effectively cost 0% in terms of expenses. Finally, I thought I could do some “tax harvesting” and offset gains and losses and perhaps end up with a “net loss” position that I could deduct towards my net $3000 limit each year (whether or not the portfolio actually was running a loss, if I sold individual stocks that were at a loss I could either offset gains elsewhere or just take the losses against total income up to $3000 / year). This is why I picked individual stocks in this test rather than an ETF.

The Results After Five Months

My results were that the bond baseline (BND) returned about 1.4% annualized for the 5 month trial including dividends and changes in share price. The stock portfolio returned about 18% in the 5 month trial including dividends and changes in share prices. You can see the portfolio results in the links on the left or here.

As I started to invest in the dividend portfolio I realized that the stocks were highly volatile. Since I was investing ostensibly for yield (to receive dividends), I was inclined to ride out the volatility and try to do a “buy and hold” plan but as stocks gyrated I instituted my own rule that I would (generally) sell when a stock rose 15% or when it fell 10%. This rule would protect my portfolio from extreme gyrations. After all, if you are looking to eke out 3% – 5% / year you don’t want to take a 15% net loss to earn that or the whole exercise is counter-productive.

I started with 12 stocks in early July, 2012 and by the end of November (about 5 months later), EIGHT of those stocks had been sold due to the rules above. Thus roughly 2/3 of my portfolio turned over in 5 months, meaning that you’d have an annual churn rate of 160% if my picks were indicative of the overall market.

The dividend stocks seemed to be very sensitive to any sort of thought that the dividend rate might be cut, and were subject to large losses immediately if the dividend actually did get cut. A couple of the clunkers in my portfolio, AVP (Avon) and EXC (Exelon) both had dividend coverage problems and big dives as a result (relative to my goals, 10% is a big dive).

On the other hand, the overall rise in my portfolio was likely due mostly to a rise in world wide stock indices during the time frame of this effort, July – November 2012, which saw indices increase between 4% – 6% depending on which benchmark you use (which annualized out gives most of the return I received, above).

My Conclusions

Buying dividend stocks to get yield as an alternative to CD’s or similar instruments is not a good apples-to-apples choice. The return is so heavily skewed by equity market gains and losses that the dividend return is a small component of your total return.

This doesn’t mean that based on my experience that dividend based stocks aren’t a good idea – they are dependent on many variables including equity markets, your tax situation, the sectors you select, tax withholding for foreign companies, etc… but their volatility will make it a wild ride.

Debt Frontiers – Amazon and Australia

Amazon, the giant online retailer, recently issued debt at absurdly low rates. Per this Bloomberg article:

Amazon, which had no bonds outstanding, sold $750 million of 0.65 percent three-year notes that yield 38 basis points more than similar-maturity Treasuries, $1 billion of 1.2 percent five-year debt with a 63 basis-point spread and $1.25 billion of 2.5 percent securities maturing in 10 years that yield 93 basis points more than benchmarks

Let’s look at those yields again. Amazon is able to issue 10 year bonds with a yield of 2.5%. That is an amazingly low rate for a company that barely makes a profit, albeit one with a giant market cap.

Nowadays you don’t even have to have a REASON to issue debt. Amazon issued this debt partially to pay for their new corporate campus and partially for “general corporate activities”.

When corporations can issue debt at these sorts of low, low rates you really need to think about the rate of return that you are expecting for your portfolio. These sorts of low rates either point to a “bubble” in corporate debt (it doesn’t look like a bubble to the less sophisticated because they associate high prices for stocks or real estate with a bubble, but in terms of bonds, a low interest rate on a longer term maturity means that you essentially got a lot without paying much to investors in return) or just a long term re-setting of expectations among bond investors, a capitulation of sorts.

On the other side of the world, Australia is having a wild ride. The Australian Dollar is coveted because it is a “commodity economy” and is independent of the typical reserve currencies such as the US dollar, the Euro, and the Yen. Australia also offers higher (relatively) yields on their government debt. When I was in Australia many years ago the Australian Dollar was 60 cents on the US dollar; the Australian dollar is now stronger than the woeful US dollar (or US peso). As a result of these strengths, 63% of Australian debt is now held by foreigners (per the article). Recently some government officials are calling for a more formal registry into who is buying their bonds; the government is attempting to reduce the value of the Australian dollar because it is hurting tourism, exports and their international competitiveness and reduced interest rates significantly as a result. But all is to no avail as the value of the Australian dollar stays high, buoyed in part by the robust demand by foreigners for Australian denominated assets such as government debt.

It is a strange world where a company that doesn’t have much of an actual profit can raise debt at rates not much higher than the US government and a country like Australia has giant demand for their currency and government debt due in part to its diversification from the typical currency basket components.

Cross posted at Chicago Boyz

Market Timing on Debt

The historical “rule of thumb” is that markets are rational. This is likely true over some period of time, but not in the short run.

A recent article in the WSJ (more like a blurb, on the back page) called “The Big Number” described the current situation with junk bonds.

Yield hungry investors are making the bond market a welcoming place for even the lowest rated borrowers. The average yield paid by new triple-C rated issuers (i.e. “junk”) of corporate bonds in the third quarter hit a record low.

The current yield on new CCC bonds is 9.05%, down from 10.65% in the second quarter of last year. This is a decline of 18% in about a year, which is a giant decrease for a company considering re-financing.

In addition to being able to sell debt at the lowest rates in years, these highly leveraged firms are also able to find buyers for their debt (i.e. the market is liquid).

When the market freezes up, as it did in 2008, there are two main impacts – 1) the rates that everyone pays for financing in the short term move up sharply 2) there is little financing available for those that don’t have the strongest credit. In practical terms, #2 means that if you need money, it will cost you very dearly such as when Goldman Sachs had to borrow from Warren Buffet at a 10% preferred stock issuance.

While it is very difficult to determine the right time to buy and sell, there is no doubt that “market timing” is of incredible importance. If you have a highly leveraged company, these low rates and many yield hungry buyers willing to lend to you means that you can retire very high cost debt, load up on lower cost debt, and roll out maturities for many years, buying your company valuable time in case there is a recession or business downturn.

Today is literally the opposite point of time in terms of market timing from when Goldman Sachs was forced to pay 10% rates to Buffett; today even the lousiest company (in terms of credit ratings) can get funding cheaper than that (9.05%, per this article). This doesn’t mean that rates won’t still fall – if I could predict that I’d be on an island somewhere – but it does show the amazing difference in market conditions that just a few years made, without the economy itself changing in any substantive manner.

Who is buying all of this? Right now your bank account and CD’s effectively pay almost zero, and US government debt 10 years out is 1.6%. Thus for someone who wants income, an investment that pays 9.05% LOOKS a lot better than under 2%.

The flip side of loaning to the most highly leveraged, lowest rated companies, is risk. Risk can be business risk or their continued ability to find low rate financing (liquidity).

On a market timing basis, this is the best time for these sorts of companies.

Cross posted at Chicago Boyz

Dividend Paying Stocks and Survivorship Bias

Survivorship Bias

One of the most important concepts in all of investing is “survivorship bias”.  Per wikipedia:

In finance, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.

You should view any sort of “theory” on stock selection such as value, small-cap, growth, or dividend payers (generally part of the “value” spectrum) as a “sales pitch”.  When someone tries to sell you on something, they will use whatever data that is available to support their pitch.

The data that is generally available is in the stock market “raw” data.  You can see the price changes, the dividends, and compare these against your selected group or theory in a variety of ways.

Valuing Dividends

In general, it is more difficult to determine total stock returns (i.e. how successful your proposed theory is) when you include dividends.  It is easy to look at the “price” of a stock from 10 years ago and the price of that same stock today and said it “went up 25%” or “went down 25%”.  Or, if you owned that stock and are looking for it, that the stock doesn’t exist in the index any more (it went bankrupt, merged with someone else, or went private).  Even large and sophisticated investors sometimes forget to include dividends in their calculations.

Dividends are harder because they are payouts to shareholders and then you need to determine what happened with those dividends.  For my trust funds, for example, the dividends are received in cash.  Then we take the cash and re-invest it periodically, in our case annually.  Thus you don’t earn a “return” on that money, other than interest (which used to be significant, but now can essentially be modeled at zero since interest rates are so low) during that time.

For most models used by analysts, dividends paid are assumed to be re-invested in shares.  Thus if you receive a dividend of 2%, you essentially now own 2% more in shares, and you also earn dividends on those shares going forward, as well.  To make it a bit more complicated, there are taxes that you have to pay when you receive those dividends, so you may want to reduce the effective value of those dividends by 15% (the current taxable rate) or closer to 30% if that exclusion is taken away when the tax laws are changed in 2013.  Here is a wikipedia article that reviews the taxation of dividends for individuals.

Dividends are important.  Per the “dividends aristocrats” methodology used by the S&P 500 and found  here,

Since 1926, dividends have contributed nearly a third of total equity return while capital gains have contributed two-thirds. Sustainable dividend income and capital appreciation potential are both important in determining total return expectations.

For our own portfolios, dividends have brought in a substantial portion of total return.  The impact is largest on our biggest funds, portfolio 1 and 2, since they have more stocks and a longer time frame to accumulate dividends.

How Companies Decide on Dividend Policy

In order for a company to pay out dividends, they must be profitable.  Dividends need to be paid out of profits, or they are essentially a “return of capital” where they are giving back their investors their money received.  While this is not always technically true (you can issue debt and leverage up and then pay yourself) it is a solid rule of thumb that a company must be profitable to pay dividends.

Since a company must be profitable, many start ups are immediately disqualified as dividend-payers.  Once a company is profitable, however, many “growth” companies decide to plow profits back into the business rather than returning it to shareholders (in the form of dividends).  For example, Microsoft did not pay dividends for many years, Amazon pays no dividends (but there is an open question of how profitable their model really is, anyways, regardless of their stock price), Google pays no dividends, and Apple recently starting paying a dividend in 2012.

Thus we’ve already “narrowed” potential dividend paying companies into a smaller subset 1) those that are profitable 2) those that don’t define themselves as “growth” companies (broadly speaking).

Once companies decide that chasing growth isn’t the answer, and they then decide that they want to pay dividends (rather than buy back stock, although it isn’t always  an either / or question), they start notifying investors (and physically paying the dividend).  Investors then incorporate the dividend cash flow into their expectations, and the company is loathe to change these expectations (to reduce dividends once declared).

From the perspective of “expectations”, then, a dividend payer is viewed favorably if they pay the regular dividend they declared, along with continuing to raise their dividend regularly.  A general class of investor seeks out these sorts of stocks, and these investors are usually quite loyal (these stocks can become “widows and orphan” stocks), as defined in Investopedia:

A stock that pays high dividends and is generally considered to carry low risk.

Dividend Policy and Historically Low Borrowing Rates

Today companies can borrow debt at historically low interest rates.  For instance, ITW recently borrowed for 30 years at 4.1%, an historically low number for them and unprecedented in the 2008 stock meltdown when debt could hardly be raised by anyone at any price.  Note that this is for 30 year debt; the equivalent (risk free) yield per the US treasury is 2.8%, for a difference (risk premium) of 1.3%, which is incredibly small.

The equivalent 10 year yield for the US treasury (see table here) is about 1.7% – if you add on the 1.3% premium that ITW pays over the US treasury rate, that is a 3.0% rate.  Why is this rate important?  It is important because the 10 year debt issue would be a roughly reasonable comparison against the dividend rate that ITW is currently paying, which is about 2.6% (the 30 year duration is too far out to be a valid comparison to current dividend policy).

When you factor in the negative tax effect of ordinary income treatment, an adjusted 3.0% interest yield (10 year plus ITW’s risk premium) would receive about a 30% effective tax rate, while that 2.6% dividend payment would be at 15% (see above).  On top of that, the dividend for ITW has been growing over the last 20+ years (over 15% / year for the last 4 years), while for the debt instrument you only get your payment back (no improvement).

Thus for ITW at least, their dividend payment is higher than you can receive as an interest bearing instrument (bond or note), adjusted for taxes.  THIS IS UN-PRECEDENTED in modern times.

Viability of Dividends as an Alternative to Bonds

Due to this historic inversion (companies with solid credit can borrow almost at their dividend rate, adjusted for taxes), companies have new options.  They can choose to borrow money to support items that might have been paid for our of current cash flow and support a higher dividend policy.

While this post is already covering a lot of ground, at this point today high dividend stocks can be treated as a viable alternative to debt in some circumstances.  This is due to the fact that 1) bonds are yielding almost nothing to investors 2) bonds are taxed unfavorably 3) dividends generally increase over time while interest rates are flat.  A major offset is that stocks are inherently more risky than bonds, meaning that they fluctuate in value and a large price “loss” can far and away offset any favorable impact from an increase in dividends (i.e. if the stock drops 25% in value then the dividend policy is mostly irrelevant at that point).

Survivorship Bias and Dividends

When you look at stocks, dividend policy is an ATTRIBUTE.  Thus there is a history of dividend payouts, and you can see the growth in dividends over years for those stocks that are selected.  Based on this historical data, you might infer something about that stock such as

“Company X has paid out a great dividend for 20 years and has raised their dividend 5% / year thorughout that time frame, making it a good candidate for a dividend investor.”

This all sounds rational.  However, let’s think through what (likely) really happened to company X over the years.

1) company X started out as unprofitable, like virtually all companies

2) company X started to earn more money, and re-invested it back in the business as it grew

3) company X then wasn’t a growth company anymore, and started holding cash and giving it back to shareholders

4) once you start paying a dividend and having shareholders EXPECT a dividend, it helps to GROW the dividend which makes your stock more valuable (all else being equal)

5) then the stock really becomes sort of a debt-like instrument to shareholders, and they view it under the lens of a growing return of dividends on their investment

You are looking now at a company in the fifth stage of its life.  What happens next?  Does a company forever stay in the dividend phase of its life, with the dividend growing forever?

This is where the survivorship bias comes in.   Companies that  have grown dividends for many years and managed the transition from a growth company to a value company (and a successful one, on the measure of growing their dividend) now have to continue to grow and support their dividend indefinitely, while the economy goes up and down and new, more nimble competitors enter the market (or giant competitors buy into the market by snapping up other companies).  This is not necessarily an easy thing to do long term or pull off since it is not always an “equilibrium” situation.

For example let’s look at Alcoa (AA).  Alcoa was a “dividend aristocrat” for many years, using its strong position in the US and world wide aluminum industry to pay a steady and growing dividend.  When it started out it needed cash to grow and pay for expensive infrastructure, but then over the years it was able to harvest these investments and throw off cash to investors rather than continuing to make expensive investments for growth. In 2001 they paid a dividend of 15 cents a share (and had been paying a growing dividend on a per share basis since 1988 prior to that, at a minimum) and it peaked at 17 cents in 2009 (they probably held on as long as they could to the dividend after the 2007-8 crash) until they capitulated and reduced their dividend down to 3 cents / share where it is today.  Cutting their dividend corresponded with a significant fall in their share price, as well, dropping from a high of over $40 / share to about $9 / share, a drop of 75%+ in value.

Whether the drop in dividend CAUSED the drop in the stock price or whether the events that made Alcoa less competitive in the global marketplace (overall shrinking demand and tough competition from global players, especially out of China) caused the drop in cash flow which in turn led to the massive drop in dividends paid to shareholders, is tough to tell, but they both contributed to the stock downfall.

You can see the same process happening right now with Telefonica (TEF), the ADR for the Spanish telecom company, as it drops its dividend.  TEF grew its dividends from  41 cents / share in 2007 to $1.05 in 2011, the mark of a “dividend aristocrat” (it had been paying a dividend for a long time previously, this was just the recent growth in dividends per share).  By many metrics this type of behavior would reward them and put them on recommended lists for “widows and orphan” stocks as a steadily growing payer of dividends to shareholders.

Today, however, TEF is facing hard times and cut the dividend back to 35 cents  / share, a more than 2/3 reduction from the 2011 payout.  This also corresponded (but did not necessarily cause, but likely contributed to) a stock price reduction from 22 to 14, an over 40% drop.  One item that partially shields TEF from even greater hardship is the amazingly low interest rates that corporations can now use to borrow funds – per this article (aptly) titled “Telefonica Leads Corporate Bond Rush Amid Record Low Yields”

Borrowing costs are tumbling with average yields on investment-grade securities dropping to 2.58 percent, Bank of America Merrill Lynch’s EMU Corporate Index shows, compared with 4.4 percent at the start of the year.

At this type of rate TEF is roughly able to borrow funds at approximately the same rate as they paid out to shareholders in their last dividend payment in 2011 (35 cents was about 2.84% of the stock price at the time).  Adjusted for the tax deductibility of interest rates to the corporation (dividends are not deductible), the company is able to borrow for LESS than it takes to pay out their dividend, meaning that in some sense on the margin they can borrow money from the bond market and pay it back to the stock market to prop up their dividends.  This isn’t saying that the company is actually doing this, but on the margin for their dividend payout ratio and their most recent debt issuance this could be considered the financial impact overall.

Conclusion

Like most items about stocks, the conclusions are hazy and subject to interpretation.  In general, whether a company pays a growing and steady dividend is more an attribute of its (accidental) place in  its life cycle and overall competition and profitability than a strategy that investors should lock into looking for yield as an alternative to low debt rates.  However, once a company is identified as a growing dividend payer, it becomes loathe to change that strategy because their shareholders view growing dividends as a source of worth for the stock and once the dividend policy capitulates (usually with a strong drop, not a little haircut) the stock is punished (although it potentially could be punished for other reasons, as well).

Buying a stock is a forward looking act and not a backward looking act.   A history of dividend paying growth is one of many signals to look at, although a powerful one because once a company is locked into the “dividend growth” crowd, leaving that crowd will likely take a significant part of the stock price with them (i.e. lead to a big drop in the stock price).

Take the “dividend aristocrats” with a grain of salt.

Cross posted at Chicago Boyz

The Role of Bonds in a Portfolio and Foreign Bonds

A while back I was talking with a friend of mine in the money management industry. I asked him if any of his high net worth clients bought non-US bonds in their accounts (the securities are held in the name of the client, but the advisor helps with selections) and he said one of them picked up a big position in Australian bonds. How did he do? I asked. The answer:

His bond positions increased significantly in value

Why is this? And what was the client trying to accomplish?

The client was likely looking for an increase in the value of the Australian currency against the US dollar, and buying bonds as a proxy for this bet. Bonds have the advantage of paying off interest as well as providing diversification from the US dollar, but in the case of this Australian debt, the percentage of the return that came from the increase of the Australian dollar vs. the US dollar provided most of the gain. The Australian dollar was as low as 63 cents per USD in late 2008 / early 2009 and is now at over $1.03 per USD as of mid 2012. That is a 95% gain! Any interest income or changes in creditworthiness (short of seismic market events like the Greek default) don’t move the return like this.

His client wasn’t the only one. At about that same time I talked to another professional who also said that the commodity producing countries were going to have stronger currencies relative to the US dollar, and was making his equity picks accordingly. If you bought an Australian ADR on an Australian exchange in 2008/9, in US dollar terms it would also be up an additional 95% (give or take some) in US currency when compared on a similar apples to apples basis, before taking into account the performance of the underlying stocks. Google Finance offers a simple graphing tool to see the performance of various currencies against one another over multiple time periods – the US dollar vs. Australian dollar is here.

Let’s look at BHP (Broken Hill Proprietary), the massive mining conglomerate out of Australia. On the ASX (Australian stock exchange) you can see that the price was about $25 in late 2008-9 when the Australian currency was at its nadir and the price today on the ASX is around $32, a gain of about 28%. However, the price of BHP as an ADR listed on the US stock exchange (which is exactly the same instrument, denominated in US dollars) was drastically different – it went from around $35 to $65, a gain of 86%. The difference in the change of the currency contributed to over 2/3 of the total gain during this period.

A different example is Bankocolumbia. Here is a graph of the Columbian Peso (COP) vs. the USD per Google Finance for the year to date through mid 2012. The Columbian peso is up almost 10% vs. the US dollar during this time. The ADR for Bancolombia S.A. (CIB) is up about 9% during the year (listed in the US on the NYSE). Bankocolumbia listed on the Columbian exchange (and obviously denominated in Columbian dollars) can be found on Reuters (Google apparently doesn’t include the Columbian exchange in its price history) and the price has been roughly flat during the year to date ended June 2012 at a price of around 27,000 CP.

Based on these examples if you know 1) the performance of the stock on its “home” exchange 2) the performance of the currency vs. the US dollar 3) the performance of its ADR on a US exchange, you can see the portion of the return that is “currency based” and the portion of the return that is “stock based”.

While sophisticated investors have known about the impact of currency changes on portfolios for decades, given the relatively rapid (in years, not decades) shifts in relative currencies that is occurring today, it is important that smaller investors start to understand the impact of these currency changes on their investments.

The most important part of the view is what you DON’T see on your (relatively worthless) brokerage statement – the “absolute” return of your dollar denominated assets relative to what they would be if they were denominated in other currencies. By this (theoretical) example, if you held assets in US dollars, and you could have had those same assets held in Japanese Yen over the same period, you lost 35% of your value over the last 5 years due to the decline of the US dollar vs. the Japanese yen. Until a turnaround in 2012, the US dollar had been declining against virtually every other major currency in the world, and reducing returns in the US in absolute terms, as a result, whether we noted it or not in our statements.

Thus the conclusion (this is obvious, sorry) is that the relative return of stock instruments is substantially impacted by currency returns, and thus if you are selecting an ADR of a foreign country you are betting on 1) the future price of the stock vs. today’s price 2) an increase or decrease in that country’s currency vs. the US dollar, with increases in that country’s currency vs. the dollar “boosting” your return here in that stock in the US. This can be seen clearly by the three components listed above. Since stock investors are (generally) trying to earn a long term return above inflation and inclined to take some risks, these risks are reasonable given the “mission” of stock investing and thus is in line with investor motives (depending on their risk profile).

For instance, why are people discussing the relative merit of a split of stocks vs. bonds vs. cash? When I sign into my brokerage online what jumps up instantly is a split of my instruments and a split of what is stock vs. bonds. This is due to the fact that there is a basic premise that “stocks are risky money” and “bonds are safe money”, thus investors should split their dollars between these two pools of money in order to provide for upside risk (stocks) and avoid downside risks (bonds).

A recent New York Times article titled “The Search for Calm In Bond Markets” discusses this impact among other issues in the article.

A 2011 study by the Vanguard group showed that currency fluctuations, not market moves, account for a vast majority of the overall volatility in foreign bonds.

Thus what are you trying to accomplish with bonds in the first place? Is it preservation of capital and “keeping up” with inflation, which is the implied theme in most investing literature? If this is the case, then investing in foreign bonds generally violates this “purpose” of investing in debt.

However, another “implied” conceit underlying the typical bond / stock discussion is that depreciation or decline in the value of the “base” currency (the US dollar, for this discussion) doesn’t really matter, when in fact it matters greatly, especially over time. The net value lost to US citizens caused by the US government’s zero interest rate policy (ZIRP) which contributes to the currency’s decline, along with other elements, is very significant and over 30% depending on how you measure us against other economies and currencies.

To jump around a bit more, CIB (the Columbian bank) is now issuing debt for Western (US investors), denominated in US dollars! While debt doesn’t always directly impact a stock price, moves in a currency now could significantly impact the company depending on whether or not that debt is hedged against the dollar (and if it is hedged, the cost of those hedges must be considered in addition to the interest rate on the debt from the perspective of a stock holder, since it isn’t free). Recently I wrote about the vast riskiness of these plays, given that currencies can move significantly and the issuer must be prepared for these moves. CIB issued $1 Billion in bonds denominated in US dollars with a 10 year maturity payable annually at an interest rate of about 6%. Western investors who are hungry for yield apparently snapped up the bonds, and this went virtually unnoticed in the popular press. Given the (stale) perception of Columbia as a drug haven tied to virtual civil war, it is pretty amazing that they are now able to borrow $1 Billion US dollars at 6% over a period of 10 years and it isn’t news anymore. I hope whomever bought those bonds understands the risks, and the fact that 1) this is Columbia, not a state down the street 2) the bonds are denominated in US dollars and CIB needs to be prepared for swings in relative values of currencies, which have moved over 25% on a given year 3) 6% is a rate that would have been unheard of even 5 years ago.

If I was advising someone getting into the finance industry today I’d say that bonds is where the action is, not stocks. Bonds range from some of the most risky instruments on the low or high end and encompass all sorts of risks and opportunities. To someone just looking at bonds as a safe asset class, you are missing the mark.

Dollar Denominated Debt

Debt is traditionally thought of as a conservative financial instrument. You buy a bond, it pays you interest (tax exempt or taxable), and then you receive your principal back when the bond matures. The interest you receive depends on the duration (time until you get your money back), riskiness of the borrower (traditionally the US government has been the safest lender with the lowest rates, but it may not be that way forever), and the overall level of interest rates in the economy (either the prime rate or LIBOR).

There are many, many variations on bonds, however, and this view of debt is out-dated. Convertible bonds allow the debt to be converted into shares’ of the company’s stock at certain price points, which allows the company to offer a lower interest rate on debt (because of this “upside”). Distressed debt is often bought by hedge funds and others as a way to take over companies in distress because post-reorganization the equity holders are generally wiped out and the debt-holders receive the new company’s shares.

A risk with debt and all financial instruments is an implied currency risk. In the US we don’t directly “see” the impact of the falling dollar in our day to day activities, but it is immediately evident if you leave the country and go somewhere with a strong currency, as I found out when I traveled to Norway and spent $20 USD to buy a drink and lunch for 2 in a decent cafe was over $100. More subtle signs of the dollar’s decline are the hordes of foreign tourists from countries that have a trade surplus with the US buying everything in sight – Dan and I saw an entire upscale mall full of them in San Francisco.

Along with changes in currencies, there is a general hunger for “yield” meaning income that can be earned with relatively low risk (or at least according to models and rating agencies), meaning that borrowers are rushing to market to take advantage by issuing debt at historically long term rates. Countries that may have had difficulty borrowing in the past or paid high rates like Mexico are now able to issue at interest rate levels that are very low by historical standards – Mexico is now able to borrow with a 10 year maturity at 5.85% (in local currency). These types of rates are at historical lows.

In addition to governments (with decent credit ratings) going out to market for more debt, companies are also issuing debt to take advantage of these historically low rates. Even if the companies have no immediate use for the cash, they are taking advantage of the rates to build funding if the economy turns, for acquisitions, or even to buy back stock and take advantage of leverage to increase EPS. Per this article in the WSJ:

Their timing could hardly be better. Average corporate bond yields finished Monday at 3.28%, just 0.01 percentage point from the all-time low going back to 1973, according to the Barclays U.S. investment-grade index. Industrial bond yields are even lower, at 3.07%.

For private companies in foreign countries, often local banks provided financing. In the US corporations traditionally don’t rely on banks to the same degree and issue bonds to the general public (many of which are bought by pension funds and insurance companies, as well). As banks pull back around the world, foreign companies are now trying to take advantage of 1) historically low interest rates 2) hunger for yield by tapping into this demand for debt by buyers.

Many of the buyers in countries are now issuing “dollar denominated” bonds. Dollar denominated debt means that they agree to pay at the rate of the US dollar against their local currency, regardless of what happens to the local currency. This insulates the buyer (probably a foreigners from the US) from currency fluctuations in countries like India, Mexico and Chile – but on the other hand it makes the entire transaction much riskier from the seller’s perspective (assuming they don’t hedge this risk). There aren’t just US dollar denominated bonds – there are Euro denominated bonds, Yen denominated bonds, and likely more Chinese currency denominated bonds in the future.

The interesting part for me is the long term “evolution” of debt from a relatively straight-forward low risk instrument (except for default risk, which supposedly could be “rated”) to a very complex instruments with myriad risks. One OBVIOUS risk on these dollar denominated bonds is – what happens when the country’s currency falls vs. the US dollar and these bonds have to be paid back in US dollars? What do you think happens?

According to this article “Weak Rupee Hits India Bondholders“:

The Indian rupee’s sharp depreciation has added to the woes of Indian companies scrambling to repay foreign currency bonds – and it is increasing the likelihood that foreign investors will be hurt… in 2005-2007… the rupee was strengthening, trading at a record of around 40 rupees to a dollar. The bonds were sold only to foreign investors, and companies used the money to fund their growth plans… Indian companies have to repay nearly $3.4 billion in foreign-currency bonds before the end of 2012.

But now, many of these bonds are coming due when the rupee has lost nearly 40% from its high and is trading around all-time low levels.

The article goes on to mention several companies who are having trouble making payments and asking for reprieves from lenders, which typically involves extending terms and / or changing the interest rates. And since these were sold to foreigners, good luck trying to take action within the Indian legal system unlike the US where debt can lead to an implied stake in the post-bankruptcy entity (this wasn’t mentioned in the article and I am not an expert on this so it is only my opinion).

I don’t know how any investor looking for yield and wanting to avoid currency risk just assumed that these risks didn’t exist because they were being borne by the issuer and not them when they received their payment in US dollars. Now these chickens are coming home to roost, and it is pretty obvious in retrospect that these issues were very risky on the currency side and were much closer to a high risk investment than a vanilla boring interest bearing security. The hunger for yield and the fact that these were issued in US dollars made them appear to be much less risky than they apparently turned out to be.

Cross posted at Trust Funds for Kids and LITGM

NYT Article on Emerging Market Bond Mutual Funds

Recently I wrote about ETF’s for international bond funds that are denominated in local (non US Dollar) currencies.  The NYT in their Sunday edition had a mutual fund report (they still segregate mutual funds from ETF’s, even though they are generally substitutes for one another) that discussed a similar tactic called “Emerging-Market Bonds Quench a Yield Thirst“.  This article is focused on emerging markets (like Brazil and China and the Asian countries) rather than the developed markets that those ETF’s target.

The article approaches foreign bonds as a way to achieve a higher yield (interest income) since US interest rates are minuscule.

With the measly yields now offered on presumably safer bonds, like United States Treasuries, savers are seeking more appealing sources of income.  And in the first quarter this year, the average emerging-bond fund tracked by Morningstar returned 7 percent, versus 0.3 percent for the Barclays Capital US Aggregate Bond Index.

The article gets more sophisticated but this is a “classic” case of confusing risk and return.  The return on emerging market debt SHOULD be substantially higher than for less-risky debt, assuming that US debt is actually less risky.

The relative risk of emerging markets compared with developed markets has changed… The average debt level of emerging market countries like Brazil and China is far lower than that of developed ones like the United States and Japan… emerging economies have continued to surge even as much of the developed world keeps struggling with the aftermath of the 2008 financial crisis.

That’s true.  If you ignore the complexities of legal systems and whether or not a country like Brazil or China would default if it was in their best interests to do so, by statistics alone they are superior to the developed world.  Having a modern legal system and being tied to the West didn’t save Greek debt holders from having to take a 75% loss on principal, after all.

The article goes on to describe two key differences – bonds issued in US dollars (“dollar bonds”) and those that invest in bonds denominated in local currencies.  In the previous article on foreign ETF’s I covered Germany, Canada and Australia – those countries would not offer bonds denominated in anything but their local currencies (Euro for now, Canadian dollar, and Australian dollar) but for emerging countries often the debt is denominated in some other currency which makes it more palatable to investors, particularly non-local investors.

If you denominate an emerging market bond in US dollars, then that has the same effect as “hedging” your bond portfolio against fluctuation in the local currency against the dollar, which is a frequent practice for many mutual funds because investors wanted purely the higher yield (and theoretical increase in risk of principal loss that come with this) and didn’t want to also add in the “currency risk” of fluctuations against the US dollar.

Whether the mutual funds invest in “dollar bonds” or bonds denominated in local currency will impact the potential returns of the fund as well as the riskiness of the assets in the fund (likelihood of default).  Per the article many of the funds operate a “mix” of these strategies, which may mitigate some risk (dollar bonds may be issued by more solvent issuers and also don’t have currency risk) but likely leaves some yield “on the table” from local issuers willing to pay a higher rate in local currency as well as the potential gain or loss on fluctuations from the local currency vs. the US dollar.

In the US, corporations mostly go to the public corporate bond market for funding, whereas in emerging countries companies often go to local banks (and Europe is somewhere in the middle).  Since so many companies in the US rely on markets for debt funding, the overall market is (relatively) liquid and large in size, and as a result there are many metrics to track and there is a long history of data to review.  In developing countries, the corporate markets aren’t very deep, and those that do issue debt rather than going to banks often issue it in “dollar” bonds instead of local currencies.  Per the article:

Local-currency corporates exist in Brazil, but the market isn’t very deep… in a less mature market, he might stick with dollar issues.

Compared to the total universe of mutual funds and ETF’s, the portion that is tied to

  • emerging market debt
  • has bonds denominated in local currencies and / or “dollar” bonds
  • has a liquid enough market to make sense
Is still very low compared to the vast universe of mutual funds and ETF’s that cater to US based debt obligations.  However, this is a growing market as investors
  • Shy away from the pitifully low yields offered from US entities
  • Realize that the credit quality of the US (recently downgraded) and many states (such as Illinois, which is in dire financial straits) is not what it used to be
  • Realize that the US dollar has been in a long term decline over many decades against many major currencies and by being substantially invested in US dollar denominated assets they are in effect losing return when compared against foreign based assets (even though it doesn’t show up directly in the US dollar based financial statements)
I am still researching these areas for my personal investing and learning more about 1) the markets 2) how the mutual funds and ETF’s are structured 3) how currency risk is managed or not managed (hedged) within each of the financial instruments 4) the types of instruments that each fund is holding and the benchmark that it uses to determine success.  Specific mutual fund companies that offer these funds include JP Morgan, Barclays, Power Shares, iShares, and others.
Another item to note is whether the financial instrument is an ETF or a mutual fund.  ETF’s generally (but not always) avoid capital gains and losses being pushed to you annually and you can defer them until the instrument is bought or sold on an exchange, which is generally more tax efficient.  You can learn more about the particular instrument that you are considering buying by looking to see their pattern of historical distributions and whether or not they have paid capital gains.
Cross posted at LITGM