Portfilio allocation to Bonds

[Snoopy]

the premise (1 in 30) is fully dubious in my opinion, I really dont see CEN falling over in half a decade. Almost no chance at all certainly not 1 in 30. This strikes me as intuitive rather than mathematical.

It would be fascinating to know how Graeme Wheeler and the boffins at RBNZ equate a BBB rating with a one in thirty chance that "an investor will not receive repayment on a five-year investment on time and in full." The claim is that 1/30 is from 'historical data' (so not intuitive as you suggest Peat), but what data? Was it gathered in NZ only or is the data global? What industries made up the data?

I think there is a difference between Contact 'falling over' and the bond 'falling over'. In the worst case, a capital injection from shareholders would stop Contact 'falling over'. But probably dividends would be suspended at the same time, and interest on the bonds might be a 'delayed payment' or maybe the interest would not be paid at all? In those circumstances existing bonds might become close to unsalable, unless the bondholder was willing to take a huge haircut.

The problem with this 'probability of failure within five years' is that not all five year periods are equal. At the moment it does seem implausible. But I put it to you that if you think this, you are are probably being influenced by the bombardment of information on present day circumstances. Go back less than two years and Contact has its cash resources drained with a 50c special dividend. What if Tiwai point had announced its closure shortly after that? It didn't happen of course, but that is not the same as saying it could not have happened. Right now a 1 in 30 probability of failure looks ridiculous. But back then if my 'alternative fact' scenario had played out, the chance of failure could have been 1 in 10. Contact's relatively high debt load even today (high for companies in general, not high for power companies in particular) is deemed prudent because they have great security of cashflow. If the cashflow becomes less secure then there would rightly be more attention paid to overall debt levels.

And if you spend a good number of lines discounting the bond why is the equity investment not also risk adjusted

Snoopy it seems your analysis discounts the bond for an arbitrary risk factor but the equity return should even more heavily discounted because the bond and its interest will be paid as a priority over the share being worth anything or the dividend being dropped.

I agree the equity (Contact shares) are likely to be more volatile than the 'Contact Bonds'. I did not discount that return because half of the volatility is negative (the share price might go down) and half is positive (the share price might go up). It is only negative volatility that is of concern for shareholders. Positive volatility is what we all seek and why we are in the game. 'Discounting' a share value and/or dividend because you might get 'positive volatility' makes no sense at all. "Positive Volatility' is an investment objective, not a risk factor.

The big problem with bonds right now is that potential rising interest rates are a real threat to bond values and share values, but in a broad market sense probably more of a threat to bond values. Thus I see bonds right now as higher risk and lower return than shares, even though I acknowledge that shares are also high risk. Traditionally , when all those asset allocation text books were written, bonds and shares were more often than not 'out of sync'. I don't think this is so today, which is why I don't think the traditional textbook advice of the conservative investor weighting their portfolio towards bonds works in today's market.

SNOOPY

[peat]

The claim is that 1/30 is from 'historical data' (so not intuitive as you suggest Peat), but what data? Was it gathered in NZ only or is the data global? What industries made up the data? SNOOPY

Good questions but I wasnt actually saying that the statistic was intuitive, I was saying that my view is intuitive. Sorry for that lack of clarity.

"Almost no chance at all certainly not 1 in 30. This strikes me as intuitive rather than mathematical."

Thus I see bonds right now as higher risk and lower return than shares, even though I acknowledge that shares are also high risk. Traditionally , when all those asset allocation text books were written, bonds and shares were more often than not 'out of sync'. I don't think this is so today, which is why I don't think the traditional textbook advice of the conservative investor weighting their portfolio towards bonds works in today's market.SNOOPY

Its worked pretty well I would've thought , capital gains, no failures (that I can think of) .