Beware This New Hidden Risk in Your Portfolio: Goldman Sachs Group, Inc. (GS)

On its face, bond investing is simple. You lend money to a company for a certain period of time, accepting a certain interest rate for your trouble. When the bond matures, the company pays you back.

What makes bond investing a lot more complicated is what happens when things go wrong. Ideally, what you want as an investor is maximum protection from adverse consequences. But with bond yields having come down so far and with so much investor demand for corporate bonds, especially in the high-yield sector, some of the protections that bond investors have come to rely on are starting to disappear.

Goldman Sachs Group Inc (NYSE:GS)

The ins and outs of bond protection
Bond investors make much different demands on companies than stock investors do. When you own a stock, you have a clear understanding that the amount of power you have over the company is extremely limited. You’re last in line to receive anything from the company in the event of a liquidation, and more often than not, adverse events like bankruptcy will entirely wipe shareholders out. Although shareholders may have the right to vote on certain major events, such as a proposed acquisition, they have little ability to drive ordinary corporate policy.

By contrast, bonds usually come with covenants that give bondholders rights to take action if the company doesn’t meet certain conditions. Here’s a short list of common provisions that you’ll find among bond covenants:

  • Change of control. In order to protect bondholders from a leveraged buyout or other acquisitions that involve a massive increase in the amount of debt outstanding, some bonds have covenants requiring accelerated repayment in the event of a merger or acquisition or that simply forbid such transactions entirely. This has been an issue with Dell Inc. (NASDAQ:DELL)‘s bonds recently, as they apparently don’t include change-of-control covenants and thus plunged on fears that a massive increase in debt from the proposed leveraged buyout would reduce their quality substantially.
  • What constitutes default. Clearly, not paying interest or principal when due is a default event. But any number of other provisions can qualify as default events, ranging from certain levels of debt-to-equity ratios or interest coverage to a bond-rating downgrade or other adverse impact on credit quality. In turn, once a default condition exists, it can give bondholders remedies that they don’t otherwise have.

With bond indentures and other materials extending for hundreds of pages in some cases, it’s complicated to understand all the protections a bond can offer. But knowing that they’re there can give you assurances about how they’ll perform if something goes wrong.

Deteriorating quality
Unfortunately, more companies are starting to negotiate weaker covenants and other unfavorable attributes that aren’t as generous to bondholders. For instance, Moody’s said earlier this week that bond quality in January hit an all-time low. The report noted that many new bonds, including issues from Netflix, Inc. (NASDAQ:NFLX) and aircraft manufacturer Lear Corporation (NYSE:LEA) , lack covenants governing certain restricted payments and incurring additional debt. Overall, more than half of bonds issued in January got a rating of Ba, which tend to have weaker covenants, compared to just over a quarter on average over the past two years.

Moreover, so-called payment-in-kind bonds are starting to get more popular as well. Last year, for instance, a unit of Goldman Sachs Group, Inc. (NYSE:GS) arranged to have bonds issued to finance its buyout of TransUnion that had a payment-in-kind toggle option. These securities don’t pay cash interest, instead issuing additional bonds. Obviously, these bonds have less-demanding cash-flow requirements for issuers, but they leave bondholders with increasing exposure to an issuer even if its credit condition erodes.

Be careful out there
When you’re desperate for income, you may be willing to accept conditions you wouldn’t ordinarily take. But with the risks already involved in lower-quality bonds, accepting weak covenants or payment in kind can leave you unprotected when things go wrong. By fully understanding what’s involved, you can better assess whether the higher income is worth the risk you take.

The article Beware This New Hidden Risk in Your Portfolio originally appeared on Fool.com and is written by Dan Caplinger.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Goldman Sachs and Netflix. The Motley Fool owns shares of Netflix.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

blog comments powered by Disqus
Insider Monkey Headlines
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months Click to see monthly returns in table format!

Lists

50 Crazy Facts About Japan You Won’t Believe

Top 10 Least Expensive Hybrid Cars to Save the Planet With

The 10 Biggest ‘Gate’ Controversies in History

The 10 States with the Highest Nursing Shortages Leaving Their Hospitals Depleted

The 10 Best Value Investment Blogs that Every Investor Must Read

The 6 Cheapest Boarding Schools in Europe 2015

The 5 Most Expensive Cars To Insure in the World

The 10 Most Common Genetically Modified Foods

10 Self-Made Billionaires Who Came From Nothing

The 10 Most Expensive Cities to Live in North America

The 13 Most Expensive Headphones in the World to Represent

The Top 20 Wealthiest Soccer Teams in 2014

4 BuzzWorthy Cannabis Stocks And Some Smoking Derivative Plays

The 10 Healthiest Fast Food Chains in America to Dine At

The 5 Most Expensive Cat Food Brands You Can Spoil Your Kitty With

The 6 Best eCommerce Platforms for Small Businesses

The 10 Worst Mistakes an Entrepreneur Can Make

The 5 Most OP Characters in League of Legends to Carry Games and Crush Foes With

The 5 Best Foods to Eat Before Running that Will Help You Pound the Pavement

10 Glaring Plot Holes in The Walking Dead that a Zombie-Filled Bus Could Drive Through

The 5 Biggest Celebrity Stoners Who Love Their Reefer

The 10 Most Overrated Movies Of All Time by Out-of-Touch Critics

Top 6 Least Expensive Cruise Destinations For 2015 that Will Take You to Paradise

10 States with Lowest Substance Abuse Rates in America

The 14 Most Watched TV Finales Ever

The 10 Best Selling Role Playing Games of All Time for PC

10 Most Influential Papers In Economics

Top 8 Biggest Charities in the US

10 Worst Celebrity Career Moves Ever

Top 10 Best Paid Tennis Stars in the World

10 Cities with High Demand for Nurses

6 of the Worst Greeting Card Messages Ever Crafted

How to Make Money in ArcheAge and Build Your Empire

10 Foods To Eat To Lower Cholesterol Levels

The 10 Most Hated Television Characters of All Time

The 30 Worst Halloween Costume Ideas Ever Brought to Horrible Life

10 Vocational Skills in Demand Today with Jobs Waiting to be Filled

10 Best Places to Visit in Central and South America

The 10 Greatest Empires in History Which Nearly Conquered the World

The 6 Cheapest Boarding Schools In America 2015

5 Clear Reasons LoL is Better than DotA, Continues to Rule MOBAs

The Only 9 Teams with a Chance to Win the Super Bowl

The 15 Most Common Phobias in America that Induce Fits of Panic

Top 6 Least Expensive Tourist Destinations in 2014

Jim Goetz, Peter Fenton, Jim Breyer: Top 6 Venture Investors for 2014

Top 15 Billionaires in 2014

5 Pitfalls To Avoid When Buying a Franchise

Top 20 Medical Schools in the US – 2014 Rankings

4 Business Strategies that Turned Jamie Oliver into the World’s Richest Chef

6 Qualities That Make You A Good Team Player

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 47.6% in its first year! Wondering How?

Download a complete edition of our newsletter for free!