Investment grade, individual corporate bonds are often sought after over government bonds because they can offer substantially higher yields. Many investors view the credit ratings, or the business itself, as “too great to fail”.
While an investment grade credit rating or a certain business can be “too great to fail” for a several year period, over the very long term credit quality can downgrade and corporate or consumer behavior can change in ways that negatively impact an entity’s future financial viability. This means that investors should proceed with caution when purchasing long duration corporate bonds, including those of investment grade.
A primary example is Enron Corporation. Enron Corporation was a major energy company in the United States. Enron carried an investment grade credit rating from Moody’s and S&P Global as it issued 20 and 30 year bonds in the 1990s. Many viewed Enron as too great to fail through these credit ratings, its profits, and the fact that it provided an essential service.
Yet, Enron ultimately collapsed as the result of a fast-and-furious scandal at the turn of the century, filing for bankruptcy in December of 2001. Enron’s bankruptcy came as a shock to virtually all employees, equityholders, and bondholders. It was not until 2012, 11 years from the time of filing for bankruptcy, that bondholders were issued 53 cents for each dollar they had invested. Do you think that anybody in 1995 expected a BBB+ rated Enron bond to fail and only be paid out at 53 cents on the dollar 17 years later?
There have been several other large corporations that have issued debt with investment grade credit ratings only to subsequently deteriorate and default in the future: General Motors, Lehman Brothers, and Pacific Gas & Electric are notable names. This raises the valid question: When buying an investment grade corporate bond, how long is safe and how long is too risky?
The most important factor in deciding how long is safe and how long is too risky is very dependent on the individual business. This is why it is very important to know what you are trying to own. There is much more to a corporate bond than its credit rating and yield. There is an entire business that must remain financially viable behind it. Would you lend money to a distant acquaintance from high school without knowing exactly what your money is going toward, just because he says he has an 850 FICO score and is promising to pay you back double what you give him?
The underlying theme of the referenced corporations who experienced sudden and gradual defaults is that each of them are/were in highly volatile industries: The finance industry, energy industry, and automobile industry. These are sectors and businesses not cyclical in nature such as consumer staple businesses like Coca Cola or Walmart. These sectors and businesses have high overhead and regulatory requirements that can change their financial and corporate standing on a year to year basis. If you do not know the risks of a business or sector you do not know enough about that business or sector to invest in it.
With that being said: When investing in corporate bonds it can be smart to simply avoid some industries all together. If you do find an investment grade corporate bond issued by a business you are comfortable investing in, look at the maturity date and ask yourself the following questions:
- Do I think this business will still be useful by the time this bond matures?
- Do I think people will still be utilizing this business by the time this bond matures?
- Does this company appear to have good management and media that will ensure its relevance and viability throughout the holding period of this bond?
- Do I understand the risks associated with this business and its sector, and how those risks can affect me as a bond holder?
If you answer “yes” to all of these questions, then this bond may be a good fit for your portfolio. If you answer “no” to any of these questions, then the duration is too risky.
On a personal note, I would never invest in an individual corporate bond maturing in more than 10 years. A corporate bond fund is a much safer alternative. History has shown us that poor management, changing consumer behaviors, technological advancements, and a myriad of other factors can wipe out an individual business once perceived as “too big to fail” or “too great to fail”. An intermediate to long duration corporate bond fund with a 10+ year holding duration will own hundreds, if not thousands of businesses and give the investor plenty of compound interest over that period of time to generate a handsome return.
I apologize if this was not the black and white answer you may have been seeking. There is no black-and-white answer to “how long is too risky?” But with the right questions, you can separate safer opportunities from speculative bets. A disciplined approach to duration and diversification is the key to protecting both capital and returns.
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The Conservative Investor
Sources:
1. Hitt, G. & McKinnon, J. 2002. How the Treasury Department Lost a Battle Against a Dubious Security. The Wall Street Journal, Link
2. Federal Bureau of Investigation. (n.d.). Enron. Link
3. Oppel, R. & Sorkin, A.S. 2001. Enron’s Collapse: The Overview; Enron Corp Files Largest Bankruptcy Claim in U.S. The New York Times. Link
4. Sandler, L. 2012. Enron creditors get 53% payout. Business Standard. Link
Disclaimer: All content on this website reflects the personal opinions, experiences, and perspectives of the author(s). Nothing on this site should be considered financial advice or advice of any kind. Readers are encouraged to conduct their own independent research and due diligence before making any investment or financial decisions.