Buying Bonds But Actually They’re Stocks
So I have previously discussed buying stocks that pay dividends as the key to becoming cancel-proof. The idea is that these stocks provide a passive income and don’t require me to be a retail investor to get ahead (although I retain that option if the selling price is right). Some might have read my current content and thus concluded that — passive income being the goal — a bond is superior to a stock that doesn’t pay dividends, and they might have a good point. Let’s take a quick look at what bonds are for those unfamiliar.
Bonks versus Stonks
A bond differs from stock because it’s a form of debt, whereas a stock is a form of ownership. When you buy a bond, you are instead buying a debt relationship to the company or entity that sells the bonds, wherein the seller of the bond is basically taking a loan on which buyer profits through the interest payments. While a bond is a source of passive income, it (like most debts) has an end. This is called reaching maturity. Basically, the amount paid per year (this is called the coupon rate) is what becomes the income source for the buyer until maturity.
When the bond reaches maturity, the principal is paid back to the buyer. This usually means a nominal profit is earned (the principal plus the interest), and assuming that the coupon rate was better than the rate of inflation, a real profit will have also been earned. Even with minor inflation, this means that a single bond represents a diminishing income source over time. In order to grow wealth systematically like a holding a stock, which never expires, this usually means one would have to roll their bond profits into the purchase of other bonds, for a compound interest effect.
Because bonds are debts, bondholders have first claim to a share of the earnings of a company, which is an advantage they have over stockholders. If the company fails, this means bondholders are more likely to recover their investment. (Although, if you’re value investing, you won’t be buying stock in such companies). Like dividends are for stocks, the coupon rate of the bond is important, and higher means more profit. Having said that, I would want to buy bonds in companies that are low-risk, not just paying high yields. If I find such a company, would I not then just buy its stock? Well, it depends on the price of each at the time you look and their earning potential, and that is your job to determine when you buy securities.
Bonds by Proxy
For those who want part of their portfolio in bonds without actually having to do anything beside research for stocks, there is a way you can cheat. Some companies are specifically in the business of buying bonds and issuing other forms of debt. Owning shares of these companies effectively allows one to have bonds in their portfolio without having to do the extra digging for each bond. A shining example of such a company is PennantPark Floating Rate Capital Ltd (PFLT) and, to a lesser extent, its sister company, PennantPark Investment Corporation (PNNT).
Both of these companies offer various types of loans to middle-market companies, through a variety of agreements. They profit off of the interest paid, which is basically returned to the stockholders by way of the dividend. When they want to expand their capital, they tend to do this by creating and selling more shares, so while the revenues might grow, the stakes of the owners is diluted, and their dividend remains fairly constant (much like the coupon on a bond) and seldom increases.
Advantages of Such Stocks
While the dividend may remain stable, instead of rising, owning these shares and holding them is like owning bonds that never hit maturity. The company does the job of finding more bonds for you, and you just collect your (monthly) dividend income with relative ease. It’s not altogether certain that the dividends will never increase either. We currently have historically low interest rates. If they start to rise again, then ownership in these companies means that they will update their portfolios with loans that pay higher interest and thus more potential for dividend increases for the owners. Thus, these kinds of stocks still have some room to guard against inflation, perhaps better than a lone bond.
It should be worth noting that the dividend is never guaranteed for any company. While they have made it through the current recession, PNNT did have to reduce its dividend (and reduced it even before), whereas PFLT did not. Both companies are closely related, draw on a pool of talented investors, and follow a strict philosophy of value investment, much like I do. What then, did PFLT do better?
The diagram above, from PennantPark’s investor presentation last December, shows how differently the two companies structure their portfolios. PFLT almost exclusively prefers first lien debt. “First lien” means they have priority in repayment of debt over other creditors and thus are more likely to recover their investment. As some companies had reduced earnings or went out of business in the 2020 recession, PFLT was in a much better position to come out ahead than PNNT. Is the point here to say that you should only buy PFLT and never buy PNNT? No, the point is that kicking the job of the bond homework to company doesn’t mean you still shouldn’t do your stock homework. At the right price, PNNT is still a superior investment, and it’s your job to use information like this to under what that price might be.
There are other such companies out there. By PennantPark’s own description, giving loans to middle market companies is a competitive industry, and each of the companies that has skin in the game will be a wise investment based on how they build their portfolios, their proved dividend results under hard times, and finally, the price that is offered when you buy them.
Therefore, if you believe that your portfolio will be strengthened by having a stake in bonds but aren’t sure of how to research or find them (or if you feel that it takes too much time), companies such as these provide you an alternative.