Bankrupt Bond Companies
Seniors like bonds due to the fact they’ll presumably offer a gradual financial gain, diversify a stock portfolio, and are backed by the insurer’s monetary strength; however things don’t necessarily go as planned. Firms often have money issues and must file for bankruptcy.
Investors holding bonds in bankrupt firms will, at a minimum have the comfort of knowing that, as unsecured creditors, they’re second in line for payment. Secured creditors, those with claims backed by collateral, like plant & equipment or other assets, are paid 1st. Stockholders come last and that is only if there’s any cash left once the creditors are paid.
There are 2 general kinds of bankruptcy: Chapter seven and Chapter eleven. With Chapter seven, a corporation is liquidated and bondholders ought to file a claim to receive some of the value of their bonds. In Chapter eleven proceedings, however, the method is totally different.
Chapter eleven permits the corporation to reorganize. Its bonds may still trade, however, holders won’t receive principal and interest payments. As a result, a default may occur, and also the price of the bonds may decline considerably. Or the court could approve an exchange of the recent bonds for brand new ones, that may have a lower price.
How are you able to ascertain if a corporation that you just lent cash to, by buying a bond, has filed for bankruptcy? TV reports, newspapers, and money magazines usually offer an account of firms that recently declared bankruptcy. The company also will send you info on the reorganization plan and request you vote thereon. And if a establishment holds the bond for you, it ought to forward everything from corporation to you. The key here is to be checking up on your bonds on an everyday basis.
7 different types of risks with bonds :
Inflation. High inflation=bonds worth less.
Interest rates High current rates=bonds worth less
Default. Company defaults = bonds worth 0.
Downgrades. Company downgrade = price falls.
Liquidity. Low market volume = harder to sell.
Reinvestment. Called bonds = lower interest rate.
Rip-Off. Heading into the secondary market alone.
When I look out in both the Treasury and Government Agency markets I do not see prices quoted at par ‘100’, but upwards of 130-140. When you calculate the yield to maturity on many of these bonds you will discover that they are either 0 or negative. Unbelievable!
We are lending the government money for free. The shoe drops however, when (not if…but when) rates rise. Remember interest rates of 0 can only go up! Prices, then, are going to fall through the floor. So, unless you are prepared to hold these bonds till full maturity, at tiny rates of return, this may not be the place to park your money.
Do you ever question the safety of Municipal Bonds? If not, you Must. States & Municipalities across the county are NOT making end meets. And, to make matters worse, the Federal Reserve won’t give them a printing press like the one they have in Washington. So, those poor souls have to make due the old fashioned way. Cut expenses or keep spending until they go bankrupt. Today, many states have a $1 trillion (or more) funding gap on their state pension plans and other worker obligations.
INVESTMENT GRADE CORPORATES
Investment grade bonds carry a rating of BBB up to AAA. Their default rate has historically been less than 1%. For that reason they can generally borrow money by issuing bonds and pay a reasonable rate (coupon).
In this low interest rate environment, bond prices can only go lower as interest rates rise. Aside credit quality, one of the other biggest factors affecting why bonds rise or fall, is their maturity.
For example, an investment grade bond maturing in 2022 will be less affected by rising interest rates than would be for a bond maturing in 2030. Let’s face it, if current interest rates rose to 4% and, you were sitting on a bond with a coupon of 4%…for ten more years, why would anyone buy your bond? They would only if rates were falling, not rising. Therefore to make the sale, you really have to drop your price to make it worth their while.
Another factor here with Corporates is, once again, heavy supply. Because the banks are afraid to lend, more and more companies are being forced into the bond market to raise their needed capital. More supply will mean higher coupon rates to entice investors. Bonds with lower yields are going to get crushed. Tread very carefully.
Junk bonds are rated BB down to D. A rating of BB is considered speculative and a D rating is for a company already in default. The default rate is much higher for junk bonds than all other classes of bonds…generally as high as 15%.
The only way these companies can float a bond issue is by offering very high rates of return (coupons). That means that they borrow money at 8-10%, or perhaps even higher. That puts a great strain on the firm’s financials…which are already considered weak to begin with (ergo, their junk bond status).
A rise in interest rates just worsens the financial burden for these companies. Then you also have the risk of a ratings downgrade. Frequently that’s enough to put them in default. One default is often enough to put your portfolio in arrears. If you had 10 bonds at $10000 each, and your yield was 12%, and one defaulted, you basically break even for the year. Two defaults will put you under water.
When buying funds, most investors look at past returns. There’s a reason the main disclaimer for mutual funds is, “past performance is no guarantee of future results.” An average of 90% of mutual funds underperform their benchmark.
Bond funds have a lot of money they need to invest, which means they need to go further out on the maturity spectrum in order to buy yield. When I look inside these funds I generally find a hodge-podge of bonds ranging in maturity from one year to twenty years. Once again…if rates rise, these things drop like a stone. Unless you’re prepared to really examine the fund’s portfolio, tread cautiously.