18 January 2015

The New New Bond Market

Forget everything you know about fixed income investments.  The days of corporate bonds, treasuries, and real estate income properties are over.  In are crowdfunded startups, movie projects, and student loans.   The new class of exotic asset backed securities promises investment choice, high yields, and upside.  But are the risk and fees worth the return?

I remember in 1997 when the “Bowie Bonds” turned heads.  For the first time, one could invest in the individual portfolio value of the rock icon’s song library.  Since then, alternative bonds have come in large baskets of regulated instruments such as mortgage backed securities and REITs.  But a loosening of regulations coupled with an increase in investor demand has brought excitement back into fixed rate securities.  The website SoFI gives access to a yield-producing basket of student loans from your alma mater.  Upstart can help you provide loans to individual people or career paths.   I got an email last week from a Hollywood producer who was looking to fund her next movie with a guaranteed 20% return.   There is something for everyone.  

Despite the implied steady returns, I wonder if they are sufficient enough to cover the risk.  Even back then, the unproven Bowie Bonds only offered a 1.5% premium above the 10 year treasury rates.  I don’t know if a 5% interest rate for Harvard loans are worth it (certainly a personal decision), but people should be cognizant of the risk associated with them.  Remember the AAA mortgage bonds?  Even the top credit agencies in the US failed to understand these novel complex securities.  It is tempting to chase yield in the current near zero interest rate environment, but the returns should be commensurate for the incremental risk taken.   

Fees associated with these securities also come into play.  Taking a page out of the hedge fund playbook, many charge both a management fee to participate and a “carry” percentage of the profits.  For the asset managers, it is a good way to shift capital risk to investors while taking fee income and participating in the upside.  Some will promise a “preferred return” which is far from guaranteed (despite a stated interest rate) and the ones that don’t charge a start fee (such as the crowdfunding sites) will take a larger percentage of the profits.   While I can understand this hefty cost in an equity-type scenario when the upside is tremendous if the next Facebook hits, it’s hard to justify them in a fixed interest rate arrangement.  A 2% charge on an 8% net return is a 20% fee.  Large fees don't always mean good performance;  remember the popularity of actively traded mutual funds that charged big loads despite most of them doing worst than their benchmarks.

Simply put, equity risk should not be taken for fixed income investments.  While I like the flexibility and ease in which to get into some of these new investments, it is imperative to assess the quality, diversification attributes, and fees associated with them.  There are many creative instruments out there with a limited track record and opaque risk disclosures.  While we'll never know whether the Bowie bonds were a financial success (Prudential bought them for the in-house portfolio), the choice is ultimately yours.  Do  you want to merely listen to “Ziggy Stardust” or invest alongside it?

2 comments:

  1. I tend to lean towards stocks, but I would like to understand the bond market better. 20% return on a Hollywood movie? How can you guarantee that?

    ReplyDelete
  2. This comment has been removed by a blog administrator.

    ReplyDelete