Portfilio allocation to Bonds

[Snoopy]

The thing about a good bond is that its top of the pecking order and so capital loss is almost a zero probability (well maybe not quite ) They should be better than bricks and mortar - they should be rock solid. Hence low returns are acceptable for that part of the portfolio because its actually more about capital preservation.

Peat, Contact 040 bonds are a BBB rated bond with a coupon rate of 4.63%. If I read the market price correctly you can buy them at a market coupon rate of 3.75%. IIRC a BBB rated company has a 1 in 30 chance of a severe capital stress event (going bust without a capital injection) each year. Let's say you are buying the bond in year zero for $10,000, are paying 30% tax, and want to hold for 30 years.

Your total expected income is: 30 x ( 0.0375 x 0.7 x $10,000 ) = $7,875m

After 30 years the chance your investment will still be intact is:

(29/30)^30 = 0.3617

This implies the chance of losing your investment is:

(1-0.3617) = 0.6383

Or in dollar terms your expected capital loss from business failure will be:

$10,000 x 0.6383 = $6383.00

I hope you can see that your expected after tax income barely covers your expected capital loss.

Can you see why I bought CEN shares yielding 6% gross return ahead of the bonds?

SNOOPY

[Snow Leopard]

...IIRC a BBB rated company has a 1 in 30 chance of a severe capital stress event (going bust without a capital injection) each year....

If the Bond is rated BBB then I understand that it mean than there is a 1 in 30 possibility, over the 'life' of the bond, that there will be a default on paying the interest or repaying the capital.

But as I don't do Bonds I could be wrong.

Best Wishes
Paper Tiger

[Snoopy]

If the Bond is rated BBB then I understand that it mean than there is a 1 in 30 possibility, over the 'life' of the bond, that there will be a default on paying the interest or repaying the capital.

Looking at the Reserve Bank published pdf on credit ratings above. This says:

https://www.rbnz.govt.nz/-/media/Res...8179.pdf?la=en

Approx. probability of default over 5 years (The approximate, median likelihood that an investor will not receive repayment on a five-year investment on time and in full
based upon historical default rates published by each agency.) is '1 in 30'.

So let's look at a 5 year time horizon for Contact 040 bonds.

Let's say you are buying the bond in 'year zero' for $10,000, and are paying 30% tax.

Your total expected income over five years is: 5 x ( 0.0375 x 0.7 x $10,000 ) = $1,312.50

The chance your investment will still be intact after 5 years is 29/30.

This implies the chance of losing part of your investment is 1/30:
The worst case here, should Contact Energy fail, is that you will lose all of your investment. Your 'expected' capital loss in this worst case situation is therefore:

(1/30) x $10,000 = $333.33

Some might call that pessimistic. But even if you don't lose all your investment, a partial recovery of what is left might take years. So I think 'total loss' is the real world scenario you should plan for. So I would argue the expected return over five years is:

$1,312.50 - $333.33 = $979.17

This represents an annual net rate of:

($979.17 /5) / ($10,000) = 2%

Compare that with

1/ Buying the Contact shares at a 6% gross yield ( 4.2% net) on market ( approximately true with a $5.50 share price ) and
2/ The possibility of a capital gain from the shares

then the bonds look very unattractive as an 'income generating investment' and an investment in general.

SNOOPY