BP's Wakeup Call to Bond Investors
When it comes to bond investing, the diversification message is often no more than a whisper. But as BP bonds show, it should be louder and clearer.
Market Update
Investment-grade corporate bonds as measured by the Morningstar US Corporate Index have risen about 3% on the year but trail Treasuries by close to 1%. In hindsight, you would have rather been in Treasuries, but a diversified corporate bond fund or exchange-traded fund has probably still produced positive returns.
The key word is diversified. Investors have no shortage of reminders as to the importance of diversification in asset allocation and stock portfolios. The message is loud and clear. When it comes to bond investing, however, the diversification message is often no more than a whisper.
By most measures, BP bonds could have been considered a conservative investment in early 2010. All three rating agencies had the bonds rated within one or two notches of AAA. The oil companies were cash rich, the price of a barrel had stabilized, and stock prices were holding up.
The BP bond maturing in 2014 was yielding more than 3%--not earth-shaking, but certainly more attractive than money market funds or a similar-maturity Treasury note. A prudent investor--even while acknowledging the price risk, both systematic and nonsystematic--could reasonably assume that, at a minimum, principal would be returned in 2014. Certainly BP is not going away in four years, right? Finger pointing at the rating agencies is bad form in this case. A crystal ball they do not possess.
The investor deciding that single-name bond exposure offered only minimal risk, when that issuer happened to be BP, now sits with losses close to 15% and the very real possibility of losing his or her entire principal. The bond that was rated AA+ by Fitch at the beginning of the month is now BBB, and the markets are pricing BP as if it has already lost its investment-grade status.
Bonds aren't always boring, and yield is a very narrow measure of risk. You don't build an equity portfolio with one name. Don't build a bond portfolio with one name. Issuer risk is real.
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