Buying and selling bonds

Back in February 2001, Deutsche Bank was very bearish on a major US telecommunications

company. In a credit review, the bank’s analyst said that "per concerns/trends

summarized above, [the company] will be downgraded,"adding that "we

seek a cap at the current level. Risk appetite reduced."

Three months later, Deutsche Bank was very bullish on a major US telecommunications

company. It was lead manager on a record-breaking $12 billion bond deal, talking

up the credit in markets around the world. If you were to ask Deutsche Bank

whether risk appetite for this credit was a good idea, they would respond with

a resounding yes.

You can see this punchline coming a mile off. That’s right, we’re talking about

the same company here: WorldCom. If you were cynical, you might even say that

Deutsche Bank had a double interest in selling WorldCom’s nuclear-waste bonds

to as many investors as possible: not only did its fees go up as the deal got

bigger, but its own loans to the company, which matured long before the bonds

did, would be easily refinanced with the fresh billions pouring in from unsuspecting

investors.

And it’s not just Deutsche Bank, either: JP Morgan, Citigroup and Bank of America

are all in substantially the same boat, according to a New York Times article

today. So, should you ever trust them again when they try to sell you bonds

from major borrowers like WorldCom or Argentina? Unfortunately, you have very

little choice. Since the repeal of the Glass-Steagall Act, all the major bond

underwriters (the investment banks, as were) are also major lenders (the commercial

banks, as were). Citibank merged with Salomon Brothers, Chase bought JP Morgan,

Deutsche Bank bought Bankers Trust.

Chances are, then, that if you’re buying a bond from a broker-dealer, that

institution probably also has a lending relationship with the issuer. In fact,

the securities houses are very proud of this fact: they call it "one-stop

shopping" or the suchlike, and quite openly buy bond mandates with large

loans. In the case of WorldCom, an $800 million loan commitment from Citigroup

directly resulted in a lead-manager position on the bond issue and a $20 million

fee. Quid pro quo.

Meanwhile, Citigroup will have been regaling WorldCom with its prowess at "distribution".

Since they bought Smith Barney, they will have said, they have access to an

enormous number of stockbrokers who could deliver the retail investors

that WorldCom desperately needed in order to diversify its investor base.

Once more in English? Basically, we’ve got millions of suckers who’ll put their

money wherever we tell them to. These aren’t sophisticated institutional investors

who do their own credit analysis before buying a bond, they’re little guys with

savings accounts who trust their broker to ensure that their fixed-income investments

are relatively safe. (If they wanted risk, they’d be buying stocks.) Meanwhile,

as the new guys are coming in, the bank itself is getting out.

With regard to emerging-market sovereign debt in particular, I’ve made

the case (PDF file) that retail investors (that’s you and me) should simply

not be allowed to buy individual bond issues: if they want exposure to the asset

class, they should buy mutual or index funds instead. I’m hesitant to extend

that case to domestic bond issues like that of WorldCom, but most of the arguments

apply.

In any case, this should be a lesson to any individual investors out there:

yes, you should always have a certain amount of your portfolio in fixed income.

But picking bonds is not like picking stocks: you’re extremely unlikely to outperform

the pros, even if you get lucky. And, as we’ve learned again today, you’d be

foolish to trust your broker. So buy funds instead.

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7 Responses to Buying and selling bonds

  1. itay livni says:

    well I certainly like anyone who bashes the big houses. However your advice is terribly wrong. Bond Mutual funds are probably the worst type of fund a retail consumer can buy ( i dont care what kind of returns you had the last 2 years) because bond funds have to be fully invested. Therefore they have to chase after lower and lower yields. Secondly you say that the retail investor should not buy individual bonds, well as you know stock holders are subordinate to bond holders when things go wrong. Finally as in both the case of bond and stock retail investing there is nothing better than buying an ETF or HLDR product instead of overpriced mutual funds. And if you think you knw something buy your individual securities.

  2. Felix says:

    You have some good points, Itay, but basically I disagree.

    On the fact that mututal funds have to be fully invested, this is true, but if you don’t like the yields they’re offering, then you can simply sell all or part of your holdings. If yields have been going down, then you’ll make a tidy profit. I would never presume to dictate what proportion of your holdings you should have in fixed income. I’m merely saying that once you’ve decided what that number is, you’re better off in funds than in individual bonds.

    Naturally, the decision as to total exposure to fixed income has to be made in light of the fact that bonds are senior to stocks. But it makes no difference at all whether you hold the bonds outright or via a fund: it’s still no reason to buy individual bonds.

    I do agree with you on exchange-traded funds, though: they are a better bet than mutual funds most of the time.

    As for your final comment, I might conceivably agree if you’re talking about buying bonds at a large discount or with a very high coupon — where you’re taking equity-level risk for equity-level returns. In general, though, bond investors simply want to be safe. And putting all your eggs in one or two baskets isn’t safe.

  3. simian says:

    As for not allowing retail investors to take positions in individual issues: the trend, quite rightly, is in the opposite direction. Alternative investments of various sorts have become increasingly available to retail investors. Implicit in a belief that this is a good thing is the principle of caveat emptor: the buyer has nobody to harm but himself (we are not talking about selling firearms here), and is free to make poor decisions if he so decides. It goes without saying that most equity investors are also too ill-informed to be proper fiduciaries, and yet no-one would think to limit their access to the equity markets.

    A final observation is that it takes no more than a few hours’ study of the markets – the minimum amount of time one should commit prior to making decisions on such matters – to figure out that there exist conflicts of interest in the securities industry. All of the Spitzerific righteous outrage over investment banking relationships is a bit bizarre given that we all knew it was happening all along.

  4. Felix says:

    On your second point, you’re right, simian, and I’ve as much myself. But on your first, I still think there’s a world of difference between stocks and bonds. One of them is a gamble where you can make a lot of money; the other is meant to be a safe haven where you can’t make a lot of money but at least you’re not going to lose everything.

  5. Gherimiah says:

    Felix,

    As you know, there is no natural law that says fixed income investments are inherently safer than equity. Perhaps we should exchange todays “High Yield Fixed Income Assets” description for the more pedestrian term, “Junk Bonds”.

    But more to the point I take exception to your advice regarding eggs…

    Behold, the fool saith ‘Put not all thine eggs in the one basket’ – which is but a manner of saying, ‘Scatter your money and your attention;’ but the wise man saith, ‘Put all your eggs in the one basket and – watch that basket.’” – Mark Twain

    Gherm

  6. Felix says:

    Gherm, I’m sorry, but you’re simply wrong on this one. On any measure of risk and return, fixed income investments are inherently safer than equity. I’d be astonished if you could show me any data to the contrary.

    As for the eggs, what benefits it a man to buy a single bond and watch it? Is he meant to sell it if it drops in price? Seems like a lot more work for marginal benefit. Better to buy a basket of bonds — a fund — and have less work and less risk.

  7. david says:

    At Google Answers, there’s a good discussion of finding out information and stats on bond trading:

    Worth a look!

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