As part of our recent discussion of the Goldman Sachs affair, it seemed that people were willing to take positions on what could be considered "bad bonds." The question arises: Why would investors buy such garbage? The answer is "price." Or as one Wall Street veteran explained it, "there are no bad bonds, there are just bad prices."
Caroline Baum, in a commentary in Bloomberg, said investors "buy crap all the time. They purchase distressed debt, defaulted loans and foreclosed properties. They buy them at a discounted price that compensates them for the risk. They stand to lose little and win big."
Price becomes the means by which participants in the economy make decisions on the merits of a purchase or sale. Baum describes price as the mechanism through which "consumers convey what goods and services they want to buy."
If you want to play it safe, you can purchase Treasury bonds backed by the full faith and credit of the United States. (Admittedly, that has lost a bit of its luster, but the U.S. is still seen as a safe haven in times of distress.)
Attempting to achieve rates above Treasury bonds -- known as a "spread" -- requires you to take on additional risk. Investors require a higher yield with the increased risk in order to compensate them for the chance they are taking.
High yield (junk) bonds pay a higher rate of interest because they are backed by questionable companies or countries (think Greece). Mutual funds are a good way to invest in these bonds, if desired, because they own dozens, if not hundreds, of these debt instruments. This diversification means that the failure of any one bond has less of an impact on your overall investment.
Of course, it gets more complicated. For one thing, the rating agencies were not always adept at appropriately grading certain bonds as to their level of risk. A bond from Bear Stearns was rated fairly highly before the firm went under.
And as the Goldman Sachs affair made clear, many of the transactions did not involve buying individual bonds, but making bets on a pool of bonds that were not necessarily owned by the parties to the deal. These transactions were particularly hard to rate and the rating agencies sometimes failed miserably in doing so.
Whether buying bonds or betting on a pool of bonds, the concept remains the same. Given full and accurate disclosure, it is not wrong to buy or sell garbage. It is unfortunate, however, when you do so at a bad price. This means that buying a bond that defaults may not have been a bad deal if the price you paid was worth the risk. Caveat emptor!
Words of Wisdom
I don't get no respect. I told my landlord I want to live in a more expensive apartment. He raised the rent.
-- Rodney Dangerfield