Is the Party Over for Corporate Bonds?

Look at the chart below. It shows soaring investment in a particular group of assets in Tel Aviv. Now ask yourself: would you buy that asset? Does the steep climb frighten you?

If you're typical of the great anonymous "public", you'd say, I'm not scared. I want in.

The chart shows, as it says, the index of corporate bonds listed on the Tel Aviv Stock Exchange. These are bonds issued by Israeli companies, not by the treasury. And that spike on the graph is one of the biggest stories in the Tel Aviv arena. After years of being a downtrodden, neglected sector compared with shares and government bonds, corporate bonds were noticed.

Actually, the ones who discovered the corporate bonds were mutual fund managers. Using advertisements that targeted the public and also investment advisers at the banks, the mutual fund managers explained that these bonds conferred the potential of handsome capital gains at low risk. They also showed decent historic yields achieved by mutual funds that specialized in corporate debt.

Their investment in advertising totaled an estimated NIS 3 million in just January-February alone, and the mutual fund managers managed to transform corporate bonds into the latest fashion. Fashion? Yes, explicitly so. here's a quote from an advertising executive who specializes in financial issues, one Rami Yehudiha: "Consumers hear 'corporate bonds', the advisers sell corporate bonds. Now is the time to sell them. They're the latest fashion."

Corporate bonds can be an interesting avenue of investment. But there is risk that the companies issuing the bonds will go broke, and not return the money, which is why these bonds offer higher returns than government bonds do. The government is a better risk than a given company, simply.

Also, when a mutual fund builds a thoroughly diversified portfolio with dozens of corporate bonds, it reduces the risk: one company defaulting won't ruin its clients.

History also supports the case for corporate bonds. Unlike the U.S., over here hardly any of the companies that issued debt on the stock exchange went belly-up, not even during the slump of the mid-1990s, not during the financial troubles in 2002.

But there are no free lunches, and there are risks, even if they don't leap to the eye.

1. Why, actually, have so few issuing companies gone bankrupt in Israel? Because until recently, most of the companies borrowed from the banks, not from investors, and the bank has zero interest in declaring its client to be bankrupt. Banks prefer to reschedule repayment, to do anything they can to revive the customer's fortunes.

Yet when a company with debt traded on the market fails to fully meet all payments exactly ion time, it is immediately declared to be in default, and trading in the paper is halted. From that moment, a lengthy legal process begins, at the end of which investors will see only some of their money, if any. Usually bondholders from the general public are the last in the line of creditors, far in the rear behind workers, income tax, National Insurance Institute, and the banks.

2. Debt increases a company's risks. When a company issues shares, the public becomes the owners' partner. It doesn't owe them any money. But when a company issues bonds, it needs to return the money, and that debt is sitting there on its back, making it a riskier prospect.

3. Bankruptcies cluster. Would you be prepared to extend a huge loan to a builder you'd never met? No? Yet you're probably much more sanguine about lending to dozens, maybe hundreds of companies. That is exactly what you're doing when you invest in a mutual fund that targets corporate bonds.

Diversification is always a good thing. But it doesn't always work. Bankruptcies come in waves. Crisis in the local real estate sector? Expect builders to default. Another change in the law governing company cars? Leasing companies may start to stagger. Global economic slowdown? Rising interest rates? The entire sector of corporate bonds becomes more dangerous in a cluster.

4. You could lose money even if nobody goes bankrupt. Because corporate bonds are traded, their price can rise and it can fall. You can lose a lot of money even if none of the companies in the portfolio collapses. Unlike shares, a bond can only rise so far in price. It can't go beyond the price of comparable risk-free government bonds. All that has to happen is for investors to feel that bonds rose a bit too far, and their price will sink.

5. Don't expect a repeat of the remarkable increase. Bodies like mutual funds and provident funds did beautifully by identifying the potential of corporate bonds before anybody else. But now the secret's out.