More than 80% of the Israeli public's financial assets, ranging from provident funds through manager's insurance, mutual and pension funds, to investment portfolios and direct holdings, are invested in bonds of various kinds. About half of these are corporate bonds with various ratings, most of which are linked to the Consumer Price Index (CPI).
There are an increasing number of pessimistic scenarios about the continued profitability of corporate bonds, after they were considered an excellent investment over the past two years. Nonetheless, the sector continues to generate profit, partly because of the low interest rate and the lack of alternatives, which drives "dumb money" into mutual funds.
"A comparison of corporate bond spreads against government bonds from before the crisis and now shows that they are almost the same. In contrast, the spread widened during the crisis itself," say Kali Capital Markets Ltd. investment committee advisor Giora Serchansky and analyst Einav Avisror. "This means that investors have learned little in the past two years, and the risk in corporate bonds is considered the same as the risk on the eve of the crisis, despite all the debt settlements carried out and the ones that are liable to come."
To measure the potential risk/reward in this dominant investment in so many portfolios, Serchansky and Avisror analyzed whether it is worthwhile to keep a substantial exposure to corporate bonds. They examined the absolute return - the total return an investor receives on an investment in corporate bonds against the risk of this investment - at three points in time: on the eve of the crisis in late 2008, during the crisis, and today. The analysis used a theoretical portfolio of 100 AA-rated corporate bonds in equal proportions and with medium durations.
The test found a problematic picture: whereas on the eve of the crisis, an investor in the theoretical bond portfolio enjoyed a positive (real) return, so long as fewer than 20 companies went bankrupt during the bonds' lifespan, today that figure is eight insolvent companies (two per year).
"The test underscores the substantial rise in risk in this investment. We think that, in terms of risk-reward, corporate bonds are overpriced," say Serchansky and Avisror. "By the way, during the crisis, the same model show that corporate bonds were substantially underpriced during the crisis, and an investor who bought corporate bonds at the height of the crisis needed 36 companies to go bankrupt to have a 0% real return."
The test also found that the yield to maturity of the Tel Aviv Stock Exchange (TASE) Tel Bond 40 Index (which includes 40 largest fixed-interest, CPI-linked corporate bonds) on the eve of the crisis was 4.7%, peaked at 13% during the crisis, and is now at 2-2.5% for bonds with an average maturity of 4.6 years. "Under current circumstances," say Serchansky and Avisror, "investors should ask themselves whether the risk in holding corporate debt has fallen so much that it justifies a substantially lower return compared with before the global crisis?"
Cloudy horizons
In an attempt to offer a forecast for every possible scenario in the market, Serchansky and Avisror examined the expected returns on investments in corporate bonds. Their conclusion is not very optimistic.
- Pessimistic scenario - a renewed global crisis: the Bank of Israel again cuts the interest rate to 0.5%, but companies' deteriorating conditions sends corporate bond yields soaring and capital losses of 10-20%. The probability of this scenario is a very low 4%.
- Slow growth scenario: the Bank of Israel interest rate is kept at 2.5%, and corporate bond yields are around a low 2.5% in real terms.
- Reasonable scenario, with a 70% probability: the Israeli economy achieves medium growth with stubborn inflation at the upper end of the government's inflation target. The Bank of Israel raises the interest rate by 25 basis points every 2-3 months, which will result in a corporate bonds yield of zero, in real terms.
- Optimistic scenario - resumption of rapid growth: the Israeli economy grows rapidly and inflation is high. The Bank of Israel raises the interest rate by 175 basis points in 2011, which will result in a capital loss of 2%.
Serchansky and Avisror present a negative return of 0.5% for the model's overall weighted return. "The scenario analysis indicates that investment in corporate bonds is problematic at best," they say, and offer a straightforward recommendation to investors: "Be less greedy, lower the risk, increase your cash position, and see what the market will do. In any event, lower your exposure to corporate bonds in general, and as for investors who want to stay in the bond market - don't hold long-term corporate bonds. From this perspective, it is better to hold on short and medium-term bonds, which have a much lower risk of losses."
Published by Globes [online], Israel business news - www.globes-online.com - on February 24, 2011
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