The Power Stocks

When interest rates low, many investors will often explore alternatives to their traditional deposits. For many people, taking the extra risk will involve entering into bonds, which usually has a slightly higher risk profile than equities. But the risk can be measured in different ways and before one decides to invest in bonds as an alternative to time deposits which are safe, they must understand the ways that the risk profile of bonds is measured.

1. Collateral. Unlike common stock which has no collateral at all, bonds will have some type of physical security associated with them. That means that if the bond issuer defaults (is unable to pay the coupon/interest as an example) then the bond holders can collectively take possession of the collateral and sell it off. In some cases, the collateral can a piece of equipment that is specific to that bond issuer’s business which makes the collateral less liquid; in other cases, it may be receiveables, a building or group of buildings in a great location, both of which are easily liquidated and will leave the bond holders with little risk of loss. In other words, even with collateral, some bonds are more risky than others by virtue of the asset being pledged.

2. Underwriting. Although the “junk bond” industry remains alive and well, most bonds that low-risk investors seek as an alternative to term deposit rates will come from well capitalized, blue chip corporations. These corporations will often have the financial capacity to repay their bonds and easily pay the interest. For investors who are unsure about the companies, many of them will have been given a risk rating by firms like Standard and Poors, Moody’s and so on. In other words, unlike equities which virtually any company can issue regardless of the risk to the end investor, most high quality bonds are properly underwritten and present a lot less risk in terms of risk of complete loss (versus equities).

3. Volatility. In this regard, bonds are often just as volatile or more volatile than equities. However, when markets shift course, the impact is felt, almost literally, over night. With bonds, shifts in rates will impact the market value of the underlying asset and this is not felt all at once but over the course of time. For that reason, a 30% drop in a bond’s market value will happen over the course of the year while a similar shift in equities might happen over the course of a week. Still, to think that bonds are less volatile than equities is a false assumption that one must be extremely careful not to make.

Ultimately, bonds may provide less true risk than equities. However, at a time when the economy is expanding and companies start to report positive growth figures, there is a near-certainty that interest rates will increase. In such economic environments, it is almost certain that bonds will be more risky than equities and for those reasons, investors who are looking for alternatives to their low risk, low-paying term deposits need to understand where the true risks lie and what threats such risks pose to their portfolios.