Leave bond picking to the pros

Diversifying the fixed-income portion of your portfolio means going beyond Government of Canada bonds. But choosing what to buy is tricky business—arguably trickier than picking stocks.

That’s because the documents that explain the terms of the debt agreement—called covenants—are extremely complicated, and usually contain nuances and loopholes only a trained eye can spot. Misreading this fine print can be costly.

“It’s highly unlikely that someone who didn’t spend hours reading covenants would have a good understanding of a bond’s risks,” says Heather McOuatt, a portfolio manager at Franklin Bissett Investment Management in Calgary.

Analyzing covenants is especially important when looking at high-yield corporate bonds because they have a higher risk of default. But that analysis is still essential when dealing with safer investment-grade offerings, says McOuatt. “The default risk is low; but it does happen, so you want to make sure you know where you sit on the creditor ladder.”

Here are two examples of what McOuatt’s watching for when she analyzes covenants.

Example 1:

Say you buy a bond issued by Company A. Shortly after, Company A is acquired by Company B. That means the assets that backed the bond you bought are no longer owned by the company that issued it.

Does your bond have the same priority in the event Company B liquidates? “We would examine the covenant to make sure [the] successor company supports the debt obligations of the issuer,” says McOuatt.

Example 2:

Getting acquired sometimes causes a company to be downgraded by the big credit rating agencies. To account for this, some bonds have a clause that says you can sell your bond back to the issuer for $1 more than its issued face value (the coupon stays the same). Bond experts refer to this as a “$101 put.” McOuatt notes that for this to apply, the downgrade has to be from investment grade to non-investment grade.

But there may be loopholes that keep you from getting that extra insurance. For instance, the covenant may specify that certain ratings agencies must state explicitly that the downgrade resulted from the acquisition. So, if all required agencies downgrade due to the acquisition, but they don’t state this explicitly, bondholders don’t get the option to sell back to the company at $101.

Another loophole: the covenant may specify the number of rating agencies that have to downgrade. But say one agency exits the Canadian market between the time the bond is issued and the buyout. It may now be impossible to have the required number of downgrades specified in the covenant. That means the $101-put clause won’t apply.

Bottom line

Analyzing covenants is a critical part of the bond-selection process. Unless you plan to read piles of fine-print documents for each bond you’re considering, it’s a job better left to pros.