It is natural for non-professional investors to at times fall victim to some misconceptions and forego opportunities or find false opportunities. For those looking to pre-empt this I think it is worth reading on.

1. Bonds trading above par are a poor investment choice

For many, buying a bond at 105 and awaiting maturity to receive 100 does not come naturally. However, one has to consider that the return includes the coupons and the capital gains. Assuming a hold-to-maturity investment, the capital gains would be -5 but this could easily be offset by coupons. A simple exercise shows that for a 10% coupon bond with 1 year maturity the total return would be 5 or 4.8%. In normal market conditions, a comparable bond trading at par will have a coupon of about 4.8%.

To take a real life example, 4% Metro AG 2024 trades at 121, yielding around 1.5%, in line with the newly issued Metro bond (1.5% Metro 2025) which trades around par.

2. Stocks paying low/no dividend are bad investments

Some companies are loss making and hence they pay no or low dividends. Alternatively, even though a company is profitable it can choose to reinvest rather than distribute its income. This is not necessarily a reason for shrugging them off. Sometimes the reason for such practices is that the company is investing in expanding its capacity, enhancing its products or increasing its competitiveness. In such cases the investors could find relief in the fact that profitability could grow going forward and so will the company’s capacity of paying dividends.

Thus, what matters more is understanding why that stock isn’t earning a dividend and, if the reason is high investments, judging whether these will act as tailwinds or headwinds. It is no coincidence that dividends are more predictable for sectors such as utilities or for blue chips companies. Such companies are more often than not mature companies for which capital spending has peaked.

3. Buy a stock ahead of the dividend payment

There is another reason why focusing on dividends could be poor judgement. Once a dividend is paid, or more accurately on the ex-dividend date, the value of that stock on the market will drop by an equal amount. This happens because cash leaves the company and hence, its assets decrease commensurately; meanwhile the debt remains unchanged resulting in a decline in the value of the equity (which is the residual value after liabilities are deducted from assets).

4. Government bonds are low volatility/risk investments

I do not have to resort to Greece’s example to prove this point. Whatever the country under consideration, bond yields (which move inversely to bond prices) depend on the economic conditions and on monetary policy expectations (changes in Central Bank rates or its possible intervention in the market). Hence, the government yields tend to drop (prices increase) when the economy slows down and increase (prices decrease) as the economy picks up and the changes can be sizable.

Taking a recent example, the 2.25% US Government Treasury 2024 started the year at 100, reached as high as 105 in end-January and in early March sunk to 100. The volatility is explained by ebbs and flows in market worries around Federal Reserve’s monetary policy.

5. The longer the maturity, the higher the yield should be

Time to make use of what Greece has taught us. At the moment the shorter term Greek bonds yield much more than the longer term ones. The 2 year note has a yield of 20%, while the 10 year one has a less striking yield of 11%. This is because, in the short term the country has a rather limited room for manoeuvre, which implies higher risks for investors. In the longer term there is however hope that the country’s challenges will be resolved, resulting that long term bonds carry a lower return.

Although such divergences are rather exceptional, it is not uncommon in the high yield space to find flat yield curves (i.e. longer bonds yielding more or less the same as the shorter ones). This is particularly the case for more vulnerable sectors, such as retail, mining or energy.

Another factor that could decrease the time premium for bonds with longer maturity is speculations for some kind of corporate action (call or tender). Such expectations usually depend on the debt maturity profile of the issuer and/or the coupon of those respective bonds. For instance a company which has several debt maturities in 2025 and has an outstanding bond which yields 6% but has a coupon of 9% might have a great incentive to call/repurchase that note. Bottom line, a conclusion must be reached on a case by case basis.

6. Revenues beat, profit beat…all seems good

Well, as the old saying goes, ‘’cash is king’’ and this is why it is important to understand that cash and profit are not synonyms. A company can be profitable and yet be cash strapped or vice versa. This is because profit is calculated as revenues less expenses and not as cash collected less payments. Simply put, revenues are booked when a good is delivered even though payment could sometimes be due in 90 days. Meanwhile, the cost of those goods is accounted for when they are sold and not when they are purchased or paid by the merchant. Hence, assuming that the merchant has to pay those materials in 30 days and that his customers pay him in 90 days, he can easily go bankrupt even though on paper he is profitable.

Thus understanding a company’s cash generation capacity is important for investors. Equity holders will not benefit from dividends and bondholders could be at risk of recovering their investment if increasing cash is problematic for the issuer.

Have a ncie day!