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Bonds are for pessimists, shares are for optimists

Bonds are for pessimists, shares are for optimists post image

When I bit into the lamb cutlet, I knew I was going to get my money back. I turned to tell my friend Clive but he was tackling some halloumi fries. He gave me a thumbs up.

We were at the launch party of Timmy Green, a soon-to-be trendy eatery near Victoria in London.

A year before I had invested in mini-bonds issued by its parent – a start-up called Daisy Green.

Daisy Green runs Australian-accented cafes and restaurants in London. Back then they made great coffee and great cakes – but little money.

The business was, however, expanding fast. If you squinted a bit you could see strong sales and profits down the line – not least if the mini-bond proceeds helped it to reach scale sooner.

I was a fan of its cafes. I was impressed by the founder. I squinted a bit, and decided to take punt.

A couple of hundred other people did, too, and Daisy Green raised £800,000.

Risky business

Longstanding readers may remember a portfolio of mini-bonds is one of my guilty secrets.1

These so-called ‘Bondi Bonds’ were at the riskier end of this already risky portfolio.

My notes remind me the bonds been assessed as having a 2.3% annual risk of default, which was higher than the other mini-bonds I’d seen rated. I suspected even their 11% yield didn’t fully reflect the risks.

But I was confident in the brand. I judged Daisy Green was going to grow, not go bust. A big reason why I dabble in unlisted bonds and shares is to practice these sorts of assessments. So in I went.

Hey, I also got a load of free coffees!

Bondi beached

Fast-forward to December 2017 and the call proved correct. Daisy Green had doubled revenues and tripled site-level profitability since launching its bonds.

It was doing so well, in fact, that it was able to refinance with a UK bank.

The company said the refinancing represented:

“a significant and early institutional backing of our business which is rare amongst our peers.”

The founders thanked the Bondi Bond holders. The money raised via the bonds – and the support and feedback investors had given the growing company – had been important.

But the upshot was that to obtain the new facility with the bank, Daisy Green had to repay its mini-bonds.

Still, investors got their money back and some high interest payments along the way. The founders were proud to have repaid early. Everyone’s happy?

Not quite.

On a personal level, I was pleased. I like being tangentially involved in start-ups. I was pleased for Daisy Green and its people.

But having taken the risk of investing in the bonds for the reward of that 11% yield over four years, my investment had now been cut down in its prime.

The early repayment was a reminder of a big difference between owning equity and debt.

Where’s my share?

If instead of bonds the company had issued shares to raise money, then the success of the business to-date would have been unambiguously good news for investors.

Equity investors who saw the potential of the brand and the operational qualities of the business would have been rewarded as the story unfolded, because all things being equal the value of their shares would have risen. (They’d have doubled, I reckon.)

But as a bondholder, good news is almost bad news. It’s not quite bad news – default is the worst outcome for a bond holder, and whatever gets you closer to there is what counts as bad news.

Nevertheless, because conventional bonds pay a fixed coupon over time and then return the money you put into them, you don’t materially benefit from an improving company.

Indeed, it can be almost the opposite – as we’ve seen a stronger company can refinance at cheaper rates, cutting existing debt holders out of the picture.

A quick note for bond nerds: I’m talking about a top-level difference between standard equities and bonds here. Yes, you can get special kinds of both with different risk/return characteristics. More pertinently, if you buy a bond when it’s trading below face value, you can get capital appreciation as well as the interest payments should it go on to be redeemed in full. If this happens because the company was poorly-rated when you bought and has now improved, then yes you’ve benefited from the change in status. However your maximum return is still capped – it’s fixed when you buy the bonds. Also, specialist investors in high-yield and distressed debt invariably spend their time looking at terrible case scenarios. To call them optimists in the context of this piece is a stretch!

Watch my back, bonds

At its best, equity investing relationship is a partnership – all shareholders, sharing in the spoils. The success of multi-billion companies that began trading as tiny acorns shows the riches that can be generated for early investors.

As a bond owner though, there’s almost an adversarial dimension. At best you get what you expected when you bought the bonds. Things can only get worse from there.

On the flip-side, bonds have other attractions.

The most important is, again, that you do know when you buy a bond what return you should make, provided it doesn’t default and it’s held until it’s redeemed.

Equity investors might hope for this and that return, but there’s no guarantee with share prices. Even the dividend can be cut or scrapped.

Another important draw for bondholders is they stand ahead of shareholders in the queue for any cash that comes out of the company – interest payments are made before dividends – and for whatever is going when a company is wound up. Shareholders rarely see any leftovers.2

These important properties of bonds again concern downside protection, though, whereas you own equities for the uncapped upside.

Bonds are for pessimists, and shares are for optimists.

Of course, in investing it’s best to have both optimism and pessimism reflected in your portfolio.

Fair dinkum

We never know what life or the markets will do. We therefore look ahead to all weathers.

The point of bonds in an equity-focused portfolio is to dampen volatility and to shore up returns when things get rough.

Similarly, even the most safety-first, bond-heavy portfolio will improve its expected return with 10-20% in equities. That’s the benefit of diversification.

Also note that while most Monevator readers invest via funds, not in individual bonds and shares – and rightly so – the same principles hold true.

You might object and say you’re not naturally very optimistic but you hold shares because the data says they’ve beaten the other main asset classes over long periods. I agree. But understand there is no guarantee they will do so in the future, especially over just a decade or two. That shares will even go up over time and deliver a positive return is not a given.

In contrast with bonds the expected return can be calculated. It might be a low return and you might not like the look of it, but that’s a different matter!

Shares are an optimistic investment, and bonds the pessimistic backstop.

  1. See that post for my flimsy rationale as to why. Unlike my co-blogger I’m an active investor in individual shares, which is something I think most people shouldn’t do. Putting money into mini-bonds is something I think even I shouldn’t really do! []
  2. Note for pedants: Yes, I am grossly simplifying what happens when a company is wound up here, the capital structure and so on. That’s for another day! []

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{ 31 comments… add one }
  • 1 Simon January 24, 2018, 8:19 pm

    I am a very great admirer of your work but, if I may be frank, while you are open about the risks of mini-bonds, I suspect indulging in that segment is a guilty secret best kept to oneself …. I have a picture of the more avaricious section of our fellow citizens stuffing their portfolios with these and then ending up eating cardboard in retirement. Too rich for my blood.

  • 2 The Investor January 24, 2018, 11:40 pm

    @Simon — Cheers for the feedback and I do take your point, but to be frank this blog almost ground to a halt in 2017 due to my concerns about what I was writing for what audience, what comments I’d get, divergences from the passive mantra, and feeling I had to write 2,000+ words to preempt potential objections from a handful of deep enthusiasts (if not pedants 😉 ) where once I would have written 600 to 800 words. (It stopped being fun, in other words). I never even finished some stuff like the Lifetime ISA article for that reason.

    So one resolution in 2018 is just to try to start writing what I feel like again (with warnings where appropriate and so forth). 🙂

  • 3 Accidental FIRE January 25, 2018, 1:14 am

    Great post. Bonds have always been a key part of my portfolio, although I’d like to get more of them into my tax-free vehicles. But I didn’t set it up that way years ago when I was a much less savvy investor.

  • 4 hosimpson January 25, 2018, 8:42 am

    Wasn’t it Swensen who said that he though there were better ways of taking equity risk than by investing in corporate bonds? And yet everybody has some – either directly or through things like LifeStrategy funds.
    Well done to you for taking a punt, if you have time and ability to understand the investment that’s the way to go. Even private equity is generally a mix of equity and debt. Had you been able to keep your investment for 4 years, do you think it would have adequately compensated you for the risk as well as the effort you spent on the due diligence (in whatever form) before taking it on?
    I think what I’m saying is that unless you are familiar with the company and have reasons to believe in its future other than the numbers on the paper in front of you, it takes large stakes to justify the time costs, and large stakes in startup investing are hardly advisable. Having said that, I’m thinking of dipping my toe (just one) in the Discovery Yachts’ crowdfunding for (probably) similar reasons you invested in Daisy Green – I like the brand, believe the industry has good prospects for the medium term at least, reasonable track record, AND in my case these guys are offering equity.

  • 5 Neverland January 25, 2018, 9:19 am

    I’ve never understood why anyone would invest in mini-bonds when you get do VCTs or EIS and get tax advantages plus some equity upside

    Just seems like one of those trendy fads like bitcoin and crowd-funding

  • 6 oldie January 25, 2018, 10:22 am

    In my umble opinion it is the discussion of investment and savings opportunities and peoples experiences that makes this site useful to me. I certainly do not agree with many of the views discussed, but I’m sure my views would not be common with all.

    The comments are as valuable as the initiating discussion that sets them off.

    I have some retail bonds which i will hold to maturity, that have outshone cash, which i keep in my non equity portion of my “edge fund”.

  • 7 The Investor January 25, 2018, 10:26 am

    Yes, Swensen states something along those lines in “Unconventional Success”. My rule of thumb is that if corporate bonds are going to do well, then equities will probably do better, though nothing holds true over all periods.

    Very occasionally corporate bonds may seem to be distressed enough to be a superior investment on a risk/reward basis, but I believe it’s hard to disentangle hindsight bias from evaluating such prior periods.

    For example see this ‘hot take’ by me on corporate bonds from the depths of the crisis in early 2009…

    http://monevator.com/what-are-the-benefits-of-corporate-bonds/

    …and consider what happened over the next few years with both bonds and equity markets, but also what *might* have happened.

    On top of that, individual bonds are more complicated than just buying a basket — arguably harder to analyze than individual equities, particularly when it comes to risk/reward.

    As I and others have stated, while mini-bonds are technically corporate bonds, they are not corporate bonds as our textbooks know them! Mini-bonds should be considered a whole other asset class really, or at the least high-yield and very sub-investment grade bonds (but with further complications such as institutional money isn’t looking at them).

    As I said in my previous ‘guilty secret’ post I don’t think it’s quite as simple as “they are definitely worse”… though I think all told they are, and I could easily knock out an article damning them. But I suspect there were some quirks in the pros/cons mix due to their novelty, which I have modestly tried to take advantage of in my mini-bond portfolio.

    However I wouldn’t recommend them to the average reader. It’s moot for now, anyway, as their nascent issuance seemed to get killed off a couple of years ago by Government schemes to get banks lending again. I haven’t bought for a couple of years, anyway.

  • 8 UK Value Investor January 25, 2018, 10:50 am

    “So one resolution in 2018 is just to try to start writing what I feel like again”

    Amen to that. Life’s to short to spend it doing a bunch of stuff you don’t want to do, especially when you don’t have to do it.

  • 9 Matt January 25, 2018, 12:22 pm

    Great article! Mini bonds are a bit rich for my tastes, but I enjoyed learning from your experiences!

    As to writing about what you like – I think that probably works better tbh – it means more variety for us!

  • 10 The Rhino January 25, 2018, 1:35 pm

    On the MV writing front I’m hoping 2018 will be the year I can get my hands on a copy of TA’s book. I assume it will have a glowing TI foreword?

    Hopefully he can then resume business on the blog?

    Not much from GB and the analyst of late – are they still on board?

  • 11 Scott January 25, 2018, 4:18 pm

    Carry on writing what you feel like; I’m confident the vast majority of readers would prefer this. Keep in mind, the number of naysayers is far, far, smaller than their sonority would suggest.

  • 12 Simon January 25, 2018, 4:29 pm

    @ The Investor Your point is well taken; certainly you must write on what interests you/as the Muse takes you “Sing, goddess, of the wrath of Achilles” etc., (Odd that the greatest tale ever composed was IMHO the very first one).

  • 13 ermine January 25, 2018, 5:57 pm

    > So one resolution in 2018 is just to try to start writing what I feel like again

    Bravo and I look forward to the results.

    On an electroncs page many years ago I read a sage Dutchman observe

    fools are much more fool than I am clever,

    I read your wisdom in 2009 and applied it, along with a fair helping of luck, to the extent I got eight years of my life back, without that I would still be working for The Man for the next three years. The luck wouldn’t have done me any good without the wisdom. You qualify the caveats well enough and don’t dangle chimeras in front of people. It was obvious to me from the article that mini-bonds don’t fit my risk profile or investing tastes, but it’s a sad state of affairs when people only want to read what works for them, or that passive investing is the one and only true way even if it is. A curious and inquiring mind is the greatest asset to being informed. Bring those articles on!

  • 14 Jonathan January 25, 2018, 6:21 pm

    “The point of bonds in an equity-focused portfolio is to dampen volatility and to shore up returns when things get rough.”

    Why do I care about volatility, as long as the long-return is good?
    My future-pension-fund holdings are long-term. Why would I pay the cost of volatility dampening by buying bonds, when I’m not going to access these funds for two decades?

    In other words — one understands that bonds dampen volatility, but why worry about volatility for funds which are long-term?

  • 15 Scott January 25, 2018, 6:49 pm

    @Jonathan – if you have a long investing timeframe ahead of you then, go for it. However, at any given moment, there will be people in retirement living off their portfolio, people approaching retirement, etc. The right mix for your personal risk profile is unlikely to be right for everyone.

  • 16 ermine January 25, 2018, 6:56 pm

    > but why worry about volatility for funds which are long-term?

    Because unless you have cojones of carbon-steel, volatility is the sort of thing that makes you sell in bear markets. And only people who have seen that suckout and not sold earn the hallmark of quality on their nuts. All others are potential lambs to the slaughter. Invest over your risk tolerance, and you get flattened in bear markets. How do you find your risk tolerance? You find it written on the floor at the bottom of bear markets 😉

  • 17 David January 25, 2018, 7:13 pm

    Enjoyed the article – I find the offbeat subjects and the more personal writing the most interesting.

  • 18 Hospitaller January 25, 2018, 7:27 pm

    @Jonathan

    For pensions funds, and with a very long time to drawdown, you may be okay with 100% equities provided (a large proviso) you have the courage not to sell when a bear market comes (nominally down 20%, possibly next time down 40%). (Non pension funds are of course a different form of sport – since emergency needs happen at any time, there it is sensible to always keep a substantial cash or bond portfolio so that you are not forced to sell equities in the down times). As a personal matter, and this is true even within the pension portfolio, I aim to actively profit from bad times in equities and so always have a 10% additional reserve in bonds (ie beyond emergency funds) so that I can go in when I want to.

  • 19 Mr Optimistic January 25, 2018, 8:35 pm

    Nice article. Investment return isn’t everything: this was definitely a case of putting your Money where your mouth is.

  • 20 Oliver H January 25, 2018, 9:54 pm

    I think I might have seen an advert for those and didn’t take up the offer.. ah well.

    I did my first micro investment.. although instead of money I’m supposed to get a bottle of cask strength whisky in a few years. Hopefully I’ll at least get a nice dram out of it

  • 21 zxspectrum48k January 25, 2018, 10:24 pm

    @Jonathan. Your missing the fact that diversification both reduces volatilty but also can improve returns. The path dependency of asset returns can be utilized to the investor’s advantage.

    Take UK gilts and the FTSE ASX as an example. The annualized total return of a typical gilt index over the last decade is 6.1% with a volatility of 6.9%, while the total return of the ASX (dividends reinvested) is 6.3% with a volatility of 14.7%. The return correlation between the two total return indices over that period is -29%.

    Now take a 50:50 ASX:Gilt portfolio, and rebalance quarterly. The portfolio volatility is just 7.1%, a huge reduction vs. a 100% ASX. Even better, the total return of that portfolio is 6.6%, better than either asset class. Lower vol, higher returns, job done.

  • 22 october January 25, 2018, 10:48 pm

    Slightly off piste, but interesting to see MiFID II info. on the popular Vanguard LifeStrategy 60/40 fund showing 0.11% Transaction Costs on top of the 0.22% Ongoing Costs.

  • 23 FIREplanter January 26, 2018, 5:40 am

    Thanks for the post! Really gave me a new perspective on bonds especially on how they work on human’s pessimistic nature. Would love to hold some bonds at some stage in the future for all it’s properties and quality but not at current prices! But then again people have been complaining about prices for so long, so maybe it is not the prices that are the issue.

    To be honest, I don’t know enough about the different kinds of bonds other than long and short term to determine which are useful for me. Would love an article: 101 on Bonds.

    -FIREplanter

  • 24 AAJ January 26, 2018, 11:22 am

    I know mini bonds are high risk etc. But can someone please tell me why they are comfortable with their investments in a chemical plant in Nigeria and a cotton mill in Pakistan, but not comfortable with an investment in their local community? It feels to me that there is something fundamentally wrong with the way we invest money inthe UK when you’re far more likely to support a corrupt politician or arms dealer than you are to someone selling a bread based product on your own high street

    AAJ – clueless investor –

  • 25 The Rhino January 26, 2018, 4:38 pm

    @AAJ – I think you are confusing risk and ethics? you can be comfortable/uncomfortable with either but you don’t have to conflate the two?

  • 26 tony bage January 26, 2018, 7:28 pm

    It would be interested in finding out where we can see all the MiFID II revelations of the transaction costs quite rightly as ‘october’ mentions above.

  • 27 october January 26, 2018, 9:32 pm

    @ tony bage
    For Vanguard funds, click on ‘Transaction costs apply’ on their full list of funds and then ‘Vanguard full fund costs and charges 2018’ on their web site.
    Currently (re)reading Jack Bogle’s latest version of Little book of common sense investing where he puts so much emphasis on costs, including transaction costs. Interesting to see such a difference on headline ongoing costs and total costs including transaction costs for the popular Life Strategy funds.
    I have e-mailed ishares for transaction costs on funds such as SWDA and am still waiting for reply

  • 28 tony bage January 26, 2018, 9:52 pm

    Indeed, very interesting that vanguard are adding a THIRD more costs to that readily advertised.
    Would transaction costs also be added on a common tracker fund?

  • 29 Adrian January 26, 2018, 10:42 pm

    @zxspectrum48k
    who would want to put all their equity allocation in the FTSE ASX?

  • 30 Mathmo January 27, 2018, 11:20 am

    This is a fascinating asset class — not least for the fintech disruption (why not just invest in FundingCircle rather than individual mini-bonds?) — and also the curious features of the asset class.

    As a business owner who has a way of turning money into more money, I like debt and informally issue minibonds but have never done so outside of a small circle of investors (Apply within). I dislike the pfaff and costs of the arms-length. I think if I didn’t, then an intermediary offering — such as Funding Circle or Assetz — is the obvious way to get one of these away, although I don’t know whether lawyers and bankers have figured out a cookie-cutter prospectus which is even cheaper to get a mini-bond to the market.

    As an investor, I note that they are illiquid high-yield limited-upside investments. If I were to put them into my portfolio, where do I lump them for asset-allocation purposes? If the world is divided into volatile drivers of yield (“equities”) and inversely correlated places to keep your powder dry while the main asset class gets cheap (“bonds”) , then this asset class feels very much more at home in the former than the latter. Beware lumping the mini-bond in the bond part of your portfolio simply because it has “bond” in the name.

    As such, it represents and interesting diversification of the “equity” asset class, and so small as to be not heavily traded by well-informed investors, there is likely to be price premium to be gained. If you think you can pick-em, join-em.

  • 31 Mathmo January 27, 2018, 11:32 am

    @Simon – Gilgamesh pre-dates Homer by about the same timespan as The Bible pre-dates Monevator.

    Although I’d agree with you in both instances that the later work makes easier reading.

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