© 2000 John Petroff
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© 2000 John Petroff |
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As seen in the previous chapter, the calculation of a bond value is usually extremely straightforward because bonds are debt instruments with most benefits clearly defined in the form of repayment of principal and periodic coupon payment of interest (if the bond is not a zero coupon bond). This is specified in the indenture, or title of bond ownership. But bonds are far from being all the same. Issuers of bonds may compete for investors' money by offering higher coupon rates, opportunities for capital gains, shorter maturity or possible redemption, various forms of protection or additional benefits which are further explored in Chapter 12 Section D from the point of view of the borrowing company. Here, our interest is in the strategies of bondholders and the type of analysis each strategy requires.
Among the different types of benefits
one may find
- 1 a right of conversion into a specified number of shares of
common stock
- 2 an attached warrant which is an option to buy common stock
a stated exercise price
- 3 a right to put (i.e. a right to sell the bond back to the
corporation)
- 4 a call provision (i.e. a right of the corporation to buy back
the bond prior to maturity, usually with a premium)
The protection consists primarily
in the appointment of a trustee to oversee compliance with corporate
obligations (or take over the supervision of the board of directors
in case of default). Some bonds also contain a pledge of some
specific asset as a mortgage. Less common protection consists
in limitations on distribution of dividends, limitations on floating
new bond issues or sale of assets.
Each of these additional elements of benefit or protection must be analyzed and evaluated separately. It is not uncommon for a corporation to have several bonds with different maturity, seniority, conversion rights, protection and value. Because of the great variety of instruments present in the market, there are different approaches to investing in bonds and consequently in analyzing bonds as investment opportunities. Most investment textbooks explain the different types of bonds and the different strategies in much detail, and are recommended. Let's briefly review here some of the strategies and the type of analytical work associated with each.
One can distinguish three types
of bond investment strategies:
- buy and hold to maturity,
- active trading,
- speculative investment and finding mispriced securities.
See review questions Q-4D.1 through Q-4D.4.
1)- Buy and hold
A large proportion of corporate bonds are held in pension funds, mutual funds, banks and trusts because of the safety that periodic payments offer to all investors who need fixed periodic income. These bonds are usually held to maturity and most of them must meet a threshold of safety generally regarded as a rating of "investment grade" security by the major rating agencies, Moody's and Standard & Poor, discussed in Section A1 of the previous chapter. What these agencies do to assign such a rating to bonds is outlined below.
Notwithstanding the fixed nature of the obligations, bond prices experience significant price swings over their life. Price variations can be attributed primarily to changes in market interest rates. Changing rates affect all long term issues, and corporate bonds in particular. The phenomenon of changing prices due to changing rates was referred to as interest rate risk (see Chapter 2 Section G). Traders can earn profits if they are capable of predicting correctly when rates will move up or down. Here, the work performed by an analyst deals with the various elements which affect interest rates (listed in Chapter 2 Section D-2 and illustrated in Chapter 15 Section 15D-6). One recalls them to be inflation rate, compensation for non-use of money or investment demand, liquidity preference, monetary policy and length of contract. In this analysis, little attention is given to internal conditions within the issuing firm or the clauses of the indenture (except for the length of contract and coupon size).
All bonds are affected by interest rate changes, but not to the same extent. Bonds with longer maturity and smaller coupons will change more than others (as stated in Chapter 2 Section G). This implies that a holder of a long-term-and-small-coupon bond portfolio will see its return vary constantly as interest rates change, and new bonds with most up-to-date market features replace maturing bonds. There is, however, one technique that allows to lock in a target yield over a planned holding period. This technique is called immunization of interest rate risk. It consists in selecting bonds so that portfolio duration is equal to the planned holding period, and in rebalancing the portfolio to maintain that equality. Duration of a bond portfolio is the average of durations of the bonds in the portfolio, and duration of a given bond is the weighted average of number of years to collect all cash flows from the bond (i.e. coupon and principal), with the weights being the present value of each cash flow in proportion to bond price. The formula for duration is
D = Sum( t . wt)
Duration is shorter than maturity for all bonds except those that do not pay interest. The formula appears intimidating, but is easy to handle in any spreadsheet. The difficulty is in neither theory nor calculation. The problem is that immunization requires portfolio rebalancing that imposes hard work and added costs. Moreover, perfect immunization is very hard to achieve. Traditionally, immunization also assumes a flat rate structure which is contrary to empirical evidence most of the time. However, finance textbooks now offer new formats of immunization that deal with changing rate structures and additional returns. The strategy still requires careful selection of bonds and monitoring of anticipated interest rate changes (a work load that is well beyond an ordinary buy and hold approach). The task of an analyst is first to forecast interest rates accurately (which is outlined in Chapter 15 Section C-6), then determine a bond profile that will immunize the portfolio, and finally find in the market issues that match the profile.
See review questions Q-4D1.1 through Q-4D1.10.
See research assignments R-4.7 and R-4.8.
2)- Active trading
Investment grade securities are also often used by those who trade actively in bonds. One of the strategies of bond trading is called "riding the yield curve". Originally, riding the yield curve referred to the strategy of buying a long term bond and selling it after a short holding period, instead of buying a short term bond that matures quicker but earns lower yield (as one will recall from Chapter 2 Section D-4).
| Suppose an investor has $20,000 saved for sending a daughter to college in two years. That investor would normally buy a bond maturing in two years, which in the United States in January 2001 would offer 4.84% interest. But, the term structure of interest rates, or yield curve shown in Chapter 2 Section D-4, has been historically upsloping most of the time, and yields on longer maturities are higher than short maturities. Consequently, our parent of the college bound student can buy a long term bond, sell it in two years, and earn an extra quarter point with a interest rate of 5.17% on 10 year comparable bonds. |
Today, the strategy of riding the yield curve includes all forms of trading based on differences in yields associated with maturity of bonds of identical grade. A typical such strategy can capitalize on difference in appreciation (or depreciation) of bonds of different maturities caused by changes in interest rates (as spelled out in Chapter 2 Section G). Thus, if rates are predicted to rise, prices of long term bonds will go down, but prices of short term issues will not (or not as much). A trader will sell long term bonds when a rate rise is anticipated, and buy short term bonds; thus avoiding a loss on long term bonds. Then, when rates are anticipated to go back down, he/she sells short term bonds, and buys back long term bonds; thus, earning a gain from rising prices of long term bonds when the rates do go down actually. Clearly, this strategy depends entirely on the accuracy of predictions of the timing of interest rate movements. Knowing beforehand what will be in a Federal Reserve announcement, or when a surprising jump in consumer price index can be expected, is what an analyst must uncover.
See research assignment R-4.9.
Another source for price variation and bond trading strategy stems from the different impact the business cycle has on different companies. Here, traders will switch into speculative grade bonds when the economy is recovering and increases in interest rates will decrease the price of high grade bonds much more than that of low grade bonds, then, the reverse in periods of recession. (Another justification for this strategy is that the spread between high grade and low grade bonds widens in recessions, prices of speculative bonds are severely depressed and the potential for bankruptcy is heightened; consequently, one should have sold off these bonds before the recession has started). In this investment strategy, bondholders rely on rating services for the yields to expect on each grade of bonds (and consequently their potential price change). The major analytical task consists of determining correctly the timing of the business cycle which is discussed in Chapter 15 Section C-5, and which, with the help of indicators, is usually less challenging than guessing at the content of next Federal Reserve announcement. The real challenge of this strategy is to select low grade bonds that outperform high grade bonds when the economy recovers, and, especially, to have the courage to buy such risky bonds at the trough of a business cycle when prospects are still gloomy.
See review questions Q-4D2.1 through Q-4D2.4.
See research assignment R-4.10.
The last approach to bond investing strategy is to find bonds which have been rated erroneously by rating agencies. There are over 2000 companies whose bonds Moody's and Standard & Poor rate. Periodically, each of the bond ratings is reviewed and modified as needed. The modification cannot physically take place more often than once a year (or six months for some companies). In the meantime, economic conditions may very well change in such a way that most bond investors would not be aware of the likely impact on their holdings. An astute analyst that can determine how new developments will affect a given company and its bonds, will gain by trading in these bonds for which a modification in rating is unavoidable.
One group of bonds that can generate rather large price increases and thereby profits, are those bonds that are rated lowest (i.e. speculative or "junk" bonds). Many such bonds are those of corporations in "turn-around" situations; in other words, companies that are in imminent default or close to bankruptcy, but that manage to come out of this predicament. Thus, bonds that trade at a fraction of their face value, can rise in price dramatically and generate large profits, if the company recovers. Correctly predicting such turn-around situations and modifications of bond rating by rating service is naturally difficult. But that exemplifies the reward of hard work in financial analysis which is likely to be as extensive as the most thorough investigation of a company by a shareholder described in Section F of this chapter.
Few individuals engage in this last form of bond investing strategy because it demands indeed a lot of work and skill. Most rely on the major rating agencies for the commonly traded issues and on smaller and more specialized rating companies (such as Fitch Investors Service, Duff & Phelps, or McCarthy, Crisanti and Maffei, and for banks IBCA, as pointed out in Chapter 1 Section 1D-1c).
4)- Analytical approach of rating services
As an example of rating agencies' approach, the Standard &
Poor publications list the following elements as the basis for
corporate bonds ratings:
1- industry risk, or stability and growth of revenue and earnings
in the industry,
2- company position in the industry given the competitive nature
of the market and the company strategy,
3- company efficiency in using materials, labor and energy and
in generating a profit margin,
4- company management in terms of its planning ability and its
actual achievement of targets,
5- accounting methods used by the company,
6- earnings stability relative to sales that translates in stable
return on equity,
7- asset protection in the sense that they are undervalued on
the books and not too leveraged,
8- adequacy of cash flows in meeting debt obligations and projected
requirements,
9- financial flexibility relating to the use of financial leverage
and freedom to expand.
Compared to the previous analytical approach for other forms of debt (in Section 4B for instance), the elements of bond analysis shown in S&P approach are paying much greater attention to economic and industry factors. The analytical approach is not strictly numerical since the first five criteria are more qualitative and relate to outside conditions of the firm. The last four criteria are quantitative. An example of desirable values for the different ratios are shown below.
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-- Example of rating of a bond --
| In Spring 1995, no bond rating service has yet emerged in Russia, in part because corporate long term bonds are non-existent. Even for the large number of government bonds from both Russian Federation, regions and cities, no publication is recognized as useful to determine their default potential. The only rating that takes place is on banks. |
See review questions Q-4D3.1 through Q-4D3.3.
See research assignments R-4.11 and R-4.12.
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