Don't Buy a Bond Until You Read This

Marilyn Cohen, Forbes Magazine, 07.07.97

EVALUATING STOCKS means reading financial statements. Assessing a bond requires that, plus close scrutiny of the offering's prospectus. It's there that you will find the covenants, the details that can mean mischief or good news for bondholders.

The fine print in a bond prospectus isn't fun reading, but it's worth doing if you want to avoid getting all or some of your money back at par;particularly painful when you have paid a premium to buy the bond. Other surprises that can wreak havoc on an unsuspecting bondholder: asset sales, poison puts, reimbursement plans.

If you don't much care for this kind of reading, make your broker do it. This is what he should find out for you:

Under what circumstances can my bond be called?

Some are pretty exotic. During the 1980s, for example, the California Veterans Administration issued mortgage bonds to help veterans purchase homes. The VA agreed to provide mortgages at lower-than-market interest rates, but a little-noticed provision in the covenant allowed the agency to call the bonds at par. When they did, investors who had paid premiums to buy $400 million worth of the bonds ended up losing 10% to 15% of their principal.

Are both principal and interest rated?

Recently, a colleague was being pressed by a salesperson to buy a newly issued collateralized bond obligation for his mutual fund clients. Only when the manager read the prospectus did he discover that only the principal was rated. Big difference.

Does the bond have a poison put provision?

A 10% junk yield became investment grade almost overnight.;

This is a way to protect bondholders if the company that issued their bonds is taken over. With a poison put, bondholders can sell their bonds back to the company at a predetermined price, often just above par. Bond- holders don't have to sell if they like the new ownership, but if they don't, the door is open.

When Sears bought Orchard Supply, a leveraged outdoor do-it-yourself company, the acquired company's 9.375% bonds due Feb. 15, 2002 were yielding 10% to the worst possible call date of Feb. 15, 1998. Happily for bondholders, a 10% junk yield became investment grade almost overnight. But suppose Orchard had taken over Sears. In that case, Sears' bonds might have become junk. Nice trade.

What happens in a spinoff?

What's in store, for example, for owners of RJR bonds if the parent spins off Nabisco and leaves the bonds with the cigarette company? The prospectus' fine print says there can be no spinoff of RJR's controlling interest in Nabisco unless the tobacco company maintains an investment-grade rating. As long as the tobacco business is held hostage to plaintiffs' lawyers and the smoking police, investment-grade ratings are not likely. Thus the spinoff couldn't take place unless the cigarette company made a spinoff worthwhile to the bondholders.

Am I protected from an "act of God"?

On Mar. 19 a fire in a storage warehouse owned by Iron Mountain Inc. destroyed documents stored there by the company's corporate clients. Equity investors dumped the stock on the news;it sold down 3 points;but bond prices stayed steady. Those who had read the fine print knew Iron Mountain has a sophisticated disaster-and-recovery program plus generous insurance coverage. Also, its standard customer contract limits its liability to a low predetermined amount.

For some investors, a called bond is good news. Investors in General Motors Acceptance Corp.'s tax-deferred zero coupon bonds would dance a jig if their bonds were called. That's because the call is at par value, some 67% more than the bonds are currently worth in the market.

A bond portfolio should be the anchor for the rest of your investments. This means principal and income you can bank on. But there are traps for the unwary in the bond market.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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