An Overview of Debt Asset Classes
To be sure, specialists will tell you that there are many different types of debt. To this we would add that over a forty-year career, we have seen no end of creativity in developing new types of debt instruments. Unfortunately, not all of them have ended well for investors.
Here, however, here we will consider just one form of debt: a bond. At the highest level, bonds have two distinguishing characteristics. First, unlike common stocks, bonds represent an extension of credit by a lender that a borrower (the party that issues bonds) must repay within a fixed period of time. The exception to this is a type of rarely issued bond called a perpetuity, which never repays your capital. Probably the most famous of this type of bond is known as the Consol, and was issued in the past by the government of the United Kingdom.
The other distinguishing feature of a bond is that the borrower/issuer is contractually obligated to compensate you for the use of the capital you provide. This is usually accomplished by making interest payments. An alternative is the so-called “discount” approach, in which the borrower doesn’t pay interest, but instead gives the lender a larger sum than what was borrowed when the bond comes due (i.e., when it matures).
In contrast to a bond, a company issuing common stock has no legal obligation to pay any dividends on it or to buy it back. More technically, If you purchase the bond for 100% of its face value, the rate of return (or yield) you expect receive on the bond will be equal to its "coupon rate" or the rate the issuer has contractually agreed to pay. However, if you purchased the bond for less than its face value (that is, "at a discount"), then the actual rate of interest you receive will be greater than the coupon rate. In contrast, if you pay more than face value for the bond (that is, you purchase it "at a premium"), your yield will be less than the coupon rate.
The total annual return on a bond is a function not only of its yield, but also of other factors. The first is any changes in the market value (price) of the bond between the time you purchase it and the time you sell it. For example, if, in a given year, you received a yield of five percent, but the market value of the bond declined by four percent, your total rate of return (simplified) would be only one percent.
This example makes an important point: Debt investments expose you to different types of risk.
The first type is usually called market risk. Because the future stream of cash flows you receive when you buy a nominal return bond is usually fixed (i.e., the coupon payment on most bonds doesn’t change over time), an increase in market interest rates will cause the present value of the bond to decline (that is, the amount for which you could sell the bond today will decline in value when interest rates rise). This decline in the value of your capital also reduces the total rate of return you receive on your investment.
For example, if a bond with an annual coupon of five percent experiences an eight percent loss in market value due to a rise in interest rates, your total return on it for the year (simplified) would be negative three percent (assuming you bought it for 100 percent of face value).
Two underlying factors can cause market interest rates to increase: a rise in inflation, or a rise in real interest rates. Inflation is the year-to-year change in the average price level in a country. The real rate of interest is the annual rate of return that would be required by investors to induce them to loan money in a world with no inflation. The market or nominal rate of interest is composed of the real rate plus inflation
Finally, if there is a possibility that the bond issuer will not be able to make the interest and principal payments due to the bond buyer, then the latter will require additional compensation for bearing “credit” or "default" risk, in addition to the risk of changes in inflation and the real interest rate. Changes in perceived credit risk are driven by multiple factors, including conditions in the overall economy, as well as changes in the issuer’s sector, and in the issuing organization itself (e.g., a decline in its sales).
Real Return Government Bonds
There are a number of ways an investor can limit their exposure to increases in market interest rates. First, you can invest in bonds with shorter rather than longer maturities. All else being equal, the longer the maturity of a bond, the bigger the reduction in its present value that will result from a rise in interest rates. Of course, the flip side of this statement is also true: if interest rates decline, bonds with longer maturities will experience a larger increase in value than bonds with shorter maturities.
The other way you can protect yourself from market risk is to find a way to eliminate your exposure to changes in the rate of inflation. Until recently, this was very difficult to do. However, in the recent decades, more and more governments have begun to issue what are known generically as “real return bonds” (e.g., TIPS or Series I Savings Bonds in the U.S.). In the UK, these are known as “index-linked bonds.” The unique feature of these instruments is that investors are guaranteed to receive a constant real rate of return if inflation increases. Depending on the way the bond is structured, they may even provide some protection against deflation.
For example, in the United States, Treasury Inflation Protected Securities (TIPS) guarantee that the principal value of the bond (which is adjusted with inflation) will not fall below its face value, even if a prolonged period of deflation suggests that this is what should be done to maintain its real return. As a result, the real return on these government bonds would actually rise during a prolonged deflation, though by less than the rise in the real return on nominal government bonds.
To put it slightly differently, real return bonds protect both principal and interest against inflation, and (depending on their structure) sometimes principal against deflation. By comparison, nominal return bonds (that is, any bond that isn’t a real return bond) protect neither principal nor interest payments against inflation, but protect both of them against deflation
On the other hand, real return bonds still leave an investor exposed to changes in the real rate of interest. For example, during periods when the economy is growing quickly, demand for capital and real rates of interest can rise, causing the capital value of real return bonds to fall. The opposite can happen during recessions. Still, because they eliminate some, but not all of the risk associated with a change in nominal interest rates (which can be caused by changes in expected inflation and/or real rates), real return bonds should be less volatile (that is, have lower standard deviations) than nominal bonds of comparable maturity.
Nominal Return Government Bonds
Nominal return government bonds do not adjust their interest or principal payments when the rate of inflation (or deflation) changes. Like real return bonds, nominal return government bonds in theory are free of credit risk.
A reading of history will tell you that this is a bit of an overstatement, as it implies that a government’s economic ability and political willingness to make payments on its debt will never change for the worse. As a veteran of the Latin American debt crisis back in the 1980s, I can assure you this isn’t always true! That said, there is a general belief that major developed countries’ national governments (but perhaps not lesser political jurisdictions within them) will never default on their debt.
Nominal return government bonds are particularly attractive during deflationary periods, as the fall in the general price level increases the real value of both the interest and principal payments received by bondholders. In contrast, during inflationary periods the real value of bond interest (assuming fixed payments) and principal declines, and bondholders sometimes earn negative real returns (particularly if they hold long maturity instruments).
Nominal Return Investment Grade Credit Bonds
In addition to market risk, investors in bonds issued by non-governmental organizations (e.g., private sector companies) also take on credit risk (that is, the risk that the issuer of the bond will default, and you will lose some or all of your capital).
To help investors judge this risk, many bonds are rated by a credit rating agency. Typically, bonds receiving the top four ratings (e.g., AAA, AA, A, and BBB from Standard and Poors) are considered “investment grade”, while those with lower ratings are politely called “high yield”, and less politely called “junk bonds.”
Broadly speaking, there are two types of investment grade bonds. The first are issued by corporations, but are not secured by any collateral (technically, these are known as “debentures”). The second are bonds secured by some type of assets, the most common of which are mortgage bonds (though there are many other types of “asset-backed bonds” secured against things like credit card receivables or automobile loans).
As is the case with nominal government bonds, nominal investment grade bonds are particularly attractive during periods of deflation, and unattractive during periods of inflation. In both cases, the yield will be higher on an investment grade bond than on a nominal government bond of equal maturity because of the extra return for bearing the former’s credit risk.
However, nominal return investment grade bonds do not meet our criteria for being a broad asset class, as their correlation of returns with nominal return government bonds is too high. Rather than a distinct asset class, it is more accurate to regard them as a tilt one can take within an asset class in search of higher returns from taking on credit, in addition to inflation and real interest rate risk.
Nominal Return Bank Loans
In recent years, a new type of indexed debt investment product has appeared, based on so-called "leveraged loans." Historically, this term referred to bank loans that were made to sub-investment grade (i.e., BB or lower rated) companies to finance leveraged buyouts — that is, the purchase of assets financed with substantial amounts of debt. Today, these products are based on a wider range of bank loans, but still usually share three characteristics: (1) They bear floating rather than fixed interest rates (thus reducing investors' exposure to capital loss caused by changes in inflation rates); (2) In the issuer's capital structure, they are usually senior to all other types of debt, and thus have a higher likelihood of having some or all of their principal repaid in the case of bankruptcy; and (3), These loans' credit risk is often further reduced by a security interest in some or all of the issuer's assets.
Sounds great, right? Unfortunately, in financial markets you rarely get something for nothing, and if you do the deal usually doesn't last for very long. In this case, while leveraged loans' floating interest rate indeed protects investors from inflation risk, the rising cost of servicing its loans, particularly in a highly leveraged capital structure, should also lead to a rising risk of issuer financial distress (e.g., restructuring or bankruptcy).
Nominal Return High Yield and Emerging Markets Credit Bonds
High yield bonds are issued by domestic companies whose creditworthiness has been judged to be below "investment grade" by one or more of the major bond rating agencies (e.g., Standard and Poor's, Moody's, or Fitch). High Yield bonds carry ratings of BB or lower.
Emerging market bonds are issued by companies and governments located in what are generally viewed to be less developed or "emerging market" countries. These bonds are often, but not always denominated in U.S. dollars, Euro, Yen or Pounds rather than the local currency of the issuing country. Because relatively few emerging market bonds carry investment grade ratings, we are including them in this section.
Both high yield and emerging markets bonds have higher credit risk than investment grade bonds. When economic or political conditions deteriorate, yields on these bonds tend to increase much more, and more rapidly, than yields on investment grade bonds of comparable maturity. In this regard, high yield and emerging markets bonds behavior is similar to equities.
It is also important to note that, as is true of nominal return investment grade credit bonds and leveraged loans, the correlation of returns on high yield and emerging markets bonds with other broad asset classes is too high for us to treat them as a separate asset class in our portfolio allocation models.
Foreign Currency Government Bonds
Bonds issued by developed country governments and denominated in a foreign currency are a distinct asset class that can provide some very attractive benefits to a portfolio. The key difference between this asset class and domestic government bonds is the inclusion of currency risk.
In calculating the total return received on a foreign currency bond, it is not just the interest payments received and change in the market price of the bond which matter, but also changes in the exchange rate between the investor’s home currency and the currency in which the bond is denominated. The good news is that by holding a portfolio of foreign bonds that are denominated in a range of currencies (not including the home currency), bond funds can, to some extent, reduce this currency risk. Time also helps reduce currency risk, as over long periods exchange rate gains and losses tend to net themselves out, leaving similar real returns across countries
The correlation between returns on domestic equities and foreign currency bonds tends to be lowest during periods of equity market distress (due to the flight to quality phenomenon). This is exactly the opposite of what happens to the correlation between domestic and foreign equities during periods of distress. In other words, foreign currency bonds tend to provide diversification benefits when they are most needed, while foreign equities tend to do the opposite.
Foreign currency bonds also provide a natural inflation hedge, because an increase in domestic inflation relative to the rest of the world will result in a depreciation of one's home currency and an appreciation in the value of foreign currency denominated assets. That said, other asset classes also provide a similar benefit, including real return bonds, and, to a lesser extent, commodities and property.
Some Final Caveats
As we have noted in our writing over the past 20 years, the application of capitalization index weighting to debt investing is fraught with risk (e.g., see the December 2004 edition of The Index Investor). To cite a simple example, cap weighting would give the greatest weight to the issuer that has issued the most debt — even if doing so put that issuer at the greatest risk of default. Over time, different products have been introduced to address this problem, which is one that index investors must always keep in mind.
Another point to keep in mind is the introduction of index products based on senior bank loans. These usually have floating rates (which limits value loss form rising inflation, but also limits price gains when market rates fall) and, in the case of default, have seniority in access to collateral. As such, they potentially represent another attractive investment option within the domestic nominal return credit asset class.
