I love second hand clothing stores. In large part, that is how you can spot a bond person: from their love of identifying marginal relative value in obscure, non-scalable ways. The corporate bond market itself is nothing but a big swap shop (see my post “Thrift Shop” from November 15, 2013). Even so, I have a few rules that I try to live by with respect to used goods, and the main one is this: Don’t buy second hand shoes.
I bought a pair of second hand shoes once. They were Stuart Weitzman, black, with a funky composite heel. They looked amazing, they fit perfectly. They were a bargain. I wore them to work the very next day, feeling pretty proud of myself for having scored such a find. As the day wore on, I started to notice small black chunks of what I thought was dirt start to accumulate under my desk. I ignored it. I went out for lunch, and those small black chunks became large black chunks, and I realized that the funky composite heels of these shoes were flying apart at an alarming rate. I arrived at Marshall’s, two blocks away, essentially barefoot as the shoes collapsed beneath me, and was forced to purchase a cheap replacement. I now understand that there is a complexity to footwear that makes second hand shoes especially risky. That risk is un-analyzable, so second hand shoes should not be included in one’s portfolio.
I try to apply that same rule to the corporate bond market. If you keep it simple, and focus on risks you can understand and analyze, I think you can do pretty well in either the primary or the secondary market. But the market also offers plenty of opportunity to purchase what I think falls into the category of second hand shoes. My favorite current example is bank capital securities.
The market has been through several iterations of bank capital securities. As the regulatory landscape and public opinion continues to evolve, so do capital securities. Some of these securities have done extremely well – they have relatively high coupons, and generate a fairly reliable stream of income. But the devil is in understanding the details. Reading through a typical prospectus on these instruments, one finds gems such as “Interest Payments Discretionary ….the Company shall have sole and absolute discretion at all times and for any reason to cancel an interest payment ….” Or another favorite – the company can redeem the notes at par if there is any regulatory change. Also, if capital falls below a certain level – let’s say 7% — the security disappears entirely or becomes a different security, the terms of which might not even be known. What kind of bond doesn’t have to pay interest, and might or might not pay principal?
As an investor, I have owned these in the past, and I guess there are times when they make sense. But these securities are not exactly the classic pair of black pumps or mahogany penny loafers, and I don’t think they age especially well. Newly issued, there’s probably a nice window of regulatory clarity and attractive pricing that justifies their peculiarities. Right now, though, investors seem downright complacent about the risks involved in owning these securities, layering them into portfolios in an effort to boost yield.
I made the mistake last week of buying another pair of second hand shoes. They didn’t fall apart entirely, but once again chunks of material started peeling off them, and I was reminded how important it is to heed life’s hard-earned lessons. If I get tempted to dip my toe into some bank capital securities, someone please remind me of how quickly the bottom can fall out of these things, leaving you barefoot on the street at the worst possible time.
Don’t buy second-hand shoes.