A corporate bond is a bond issued by a corporation to investors in order to raise money for activities of operating, expanding or conducting business. The bond will mature (maturity) at some specific date in the future (term) and pays a coupon (interest) on the principal amount over that time. A bond is sold initially at par and its value will move up or down in response to various criteria and events.
Debt investing and equity investing have very different styles both in the method and criteria that an investor will approach a company with. As an equity investor you may be interested in the long-term capital appreciation, earnings growth, dividends or future takeover prospects of a company and this determines how you analyze your prospective investment. As a debt investor your sole objective and focus is on receiving income and ensuring the security of the capital you’ve invested.
Investors new to debt should remember that debt isn’t sexy; it has a function.
Investors always hear about individuals who made millions speculating on stocks but will rarely, if ever, hear of an investor who struck it big by focusing on investing solely in debt.
Investing in debt (specifically non-investment grade) is a niche segment of the market that rarely receives much attention from the media. It takes a bit of time, research and patience if you’re used to analyzing equities but the same basic principles apply for any value investor: a strong balance sheet, strong cashflow and understanding the business are all essential.
There are various structures of debt such as convertible debentures, warrants and structured products but for this post we’ll concentrate on the most basic form: bonds.
I’ll start with risk because this is a segment of investing that I believe is the most important for any investor (equity or debt) to recognize and understand. There are five main risks a debt investor must be conscious of before they consider purchasing a bond:
- Company Risk
- Credit Risk
- Interest Rate Risk
- Term Risk
- Liquidity Risk
Company risk is what I spoke about before with reference to a company’s balance sheet and cashflow. A debt investor needs to put on a different hat than an equity investor because of the inherently different risks each investor takes with their investments. A debt investor focuses in on companies with solid tangible assets because it provides a better protective foundation for the repayment of the debt’s principal in the event a company experiences difficulties or were to go bankrupt. When it comes to company risk the more asset coverage the better; if a company can’t pay you a debt investor will want tangible assets sold in order to receive their money before common shareholders. A company’s cashflow is another equally important item to examine because this is where you determine the company’s ability to pay the interest payments due on its debt. The more free cashflow that the company has improves their ability to service the current portion of all outstanding debt owed to investors.
Credit risk refers to the credit rating a company receives from rating agencies such as Standard & Poor's (S&P), Moody’s and the Dominion Bond Rating Service (DBRS). These rating agencies examine and assess the risk to investors of holding a bond issued by a corporation. The ratings they assign, essentially risk assessments, determine the credit strength of companies and assess their risk for defaulting on their debt obligations. Default can mean either a company is unable to pay interest on their debt or a potential delay in payment of interest on debt. Each rating agency has different ratings and processes for assessment, but they each assess the balance sheet strength, cashflows and business risks that would impair the company’s ability to service and repay debt. Companies with lower credit risk (higher credit rating) often enjoy a competitive advantage over their peers because higher rated companies can sell their bonds at a premium to lesser rated bonds. These companies can issue debt at lower interest rates than their competition and this can significantly lower their cost of capital. If company ABC [Rating: AAA] wanted to issue bonds at 5.00% their competitor XYZ [Rating: AA] would have to pay a higher yield to attract the equivalent investment because of the perceived lesser quality of their debt. Instead of issuing bonds at 5.00% XYZ might need to offer investors a yield of 5.50%. When you issue millions (or billions) worth of bonds the difference in interest payments can be substantial between companies with different credit ratings. Paying a lower interest rate reduces ABC’s cost of capital and leaves more money in the pockets of these companies for other business activities.
Interest rate risk is an important consideration for investors of debt because of the impact interest rates have on the yields and price of the debt held. If you purchased a government bond a year ago for $100 with a coupon of 4.00% ($4.00 interest per year) and interest rates were to rise to 6.00% the market may price your older bond at market value for an equivalent coupon of 6.00%. This would lower your bond value from $100 dramatically to represent the current coupons of new bonds coming onto the market. Likewise if interest rates were to drop to 2.00% the price of your older bond might increase in value to reflect the premium higher yielding bonds would have. Mild movements in interest rates will often have a minimal effect on the price of bonds whereas abrupt swings in interest rates, market sentiment or investor fears, as we’ve observed in markets recently, can change the valuations of bonds dramatically over a short period of time.
Term risk refers to the length of issuance for a bond and when a bond will mature. At some point in the future a company is responsible for calling bonds at their maturity date and returning the principal amount back to an investor at the bonds’ par value. When considering term risk an investor needs to examine the duration or time the bond is exposed to. Generally speaking the longer the term of a bond the greater the sensitivity that bond will have to the movement in interest rates, changes in the credit quality of a company or company risks associated with the business cycle of a specific company, sector or economy.
Liquidity risk is the same concern for a debt investment as any equity investment. The number shares or bonds that trade on the market in any given period of time (minutes, hours, days) dramatically affects an investors ability to buy or sell his/her investment. Debt investments such as bonds tend to be fairly illiquid because a fewer number of investments are issued by a company and they generally trade at much higher prices per investment. The smaller the issue the tighter the market and buying into or selling out of a bond before maturity might force an investor into accepting a price that is prohibitive.
Bond Information – Where to Look
When looking for information on corporate bonds there are a number of online resources I utilize. For the average investor with a small amount of capital to invest in fixed income bond funds and ETFs are the most cost effective and best diversified vehicles. Unless an investor had $50,000 - $100,000 in fixed income to allocate individual bonds would likely be too cost restrictive and offer poor diversification for the risks outlined earlier.
One of my favourite authorities on fixed income investing is James Hymas of Hymas Investment Management Incorporated in Toronto, Canada. James, a former Canadian bond fund portfolio manager, is an authority on fixed income investing including bonds and preferred shares. He operates the Malachite Aggressive Preferred Fund , is a monthly contributor to Canadian MoneySaver and his blog PrefBlog is on my daily reading list. For preferred share junkies James also provides detailed information on Canadian preferred shares through prefinfo and a paid monthly subscription newsletter titled PrefLetter. James recently began a series on bond characteristics that prospective debt investors will find informative and useful.
Canadian Fixed Income is a site I visit frequently after the markets close to identify changes in the fixed income market for Canadian bonds (government, corporate, municipals and real return)
In Your Best Interest is a site provided by Hank Cunningham of Blackmount Captial, author of In Your Best Interest, The Ultimate Guide to the Canadian Bond Market.
Bill Gross of The Pacific Investment Management Company (PIMCO) is an individual whose monthly commentary offers excellent insights into the domestic and global fixed income markets.
Paul Gardner & Paul Harris of Avenue Investment Management are two individuals I watch when on BNN as regular guests or eagerly read when any fixed income related content is published from their website or in the media.
Bond Valuations – Determining Price
Bonds will trade at three different valuations: premium, discount or par.
- Premium refers to a price above the par value (price at maturity) and the interest rate is lower than the coupon of the bond at par.E.g.: Company ABC Corporate 2015 6.50 trading at $105 (6.20% yield).
- Discount refers to a price below the par value (price at maturity) and the interest rate is higher than the coupon of the bond at par.E.g.: Company XYZ Corporate 2015 6.50 trading at $95 (6.84% yield).
- Par indicates the bond is trading at its issue and maturity price with the exact yield on the bond as the initial coupon.
Depending on the credit quality of the company’s bond you are assessing the bond will often be classified as either an investment grade bond (BBB or greater) or junk bond (BB or lower).
When determining price I’ve found that an investor doesn’t need to get fancy and develop some elaborate formulation to determine value. As a buyer or seller of a bond you need to acknowledge and accept the decision of whether the bid (offer to buy) or ask (offer to sell) is suitable for your current position; Do you want to buy or sell at the price being offered?
There are times when miss-pricings occur, just as with equities, and higher credit quality bonds sell at a discount to lower credit quality bonds for any number of external issues (poor earnings, industry concerns, investor fear, etc). As a debt investor you must be prepared to ask yourself an important question when considering an investment in a corporate bond: Am I being adequately compensated for risk versus government bonds, equities and cash?
With all bonds a sales commission is built into the spread by your broker between the price you pay to buy a bond and the price you get when you sell the same bond. The size of the spread depends on how large a purchase you make (typically the minimum is a $5,000 value) and each broker will have different premiums for different bonds. Retail investors should shop around to see what pricing differences there are between competing brokerages since a premium of 1-2% may make a substantial difference in the price you pay to buy or sell a bond. Brokers don’t publicly share this information easily so being informed and searching out resources is very important.
Bond Quality - What to Look for
Bond quality is really important. Investors interested in fixed income or debt investing should always remember that your number one priority is ensuring the safety, stability and security of your capital. Every investment has risk, but the majority of risk taking should be left to equity investing in a diversified portfolio. Many investors will never want to venture outside investment grade debt (BBB or higher) and will only find themselves holding bonds which are considered junk after the debt has had its credit rating downgraded. The problem with junk debt is that there is little or no liquidity because few investors want to take on the risk of default or of a missed payment. Junk debt will often leave you holding until either one of two things happens: the debt you own matures or the debt is defaulted on. Individual investors should take the time to research the credit rating of the companies and bonds they plan on investing their money into in order to better understand the different risks that can affect the bonds’ price over the length of time it is held. Don’t blindly trust the credit ratings either: analyze the company risk, cashflow and balance sheet in order to make an informed decision yourself in accordance with credit rating information.
For readers interested I wrote a Description of Credit Ratings in PDF for you to download. for comparison between Moody's, S&P and DBRS.
For an investor who doesn’t have enough capital to create a diversified fixed income portfolio of 7-10 corporate bonds (at $5,000 each) there are a number of products (ETFs) that invest in corporate bonds to consider:
- iShares Corporate Bond: LQD
(27% Banks, 10% Financial Services, 10% Pharma/Biotech, 6% Healthcare, 6% Telecom)
- iShares Real Return Bond: (XRB)
(86% Federal, 13% Provincial)
- iShares Canadian Corporate Bond: (XCB)
(54% Financials, 12% Energy, 12% Infrastructure)
James Hymas, mentioned earlier, was kind enough to offer some useful insights for readers who are interested in becoming fixed income investors.
He highlighted two common mistakes made by retail bond investors:
- Having fixed income portfolios that are of too high quality
- Having fixed income portfolio that are too short term
Too high in quality refers to a tendency of Canadian investors to invest in Government of Canada bonds (Canadas) or Provincial bonds (Province) exclusively. These bonds are large and highly liquid where investors will pay a premium (lower yield) for the ability to trade large volumes without moving the market by affecting the price dramatically with one trade. He believes that, “ most retail investors do not require this level of liquidity” and that there is a, “premium paid for the ability of banks and insurers to hold assets with little or no capital charge.”
Capital charges refer to the calculation of risk-weighted assets that are important for regulatory ratios such as Tier 1 Capital Ratio and Total Capital Ratio. These capital charges are supposed to give a rough measure of default probability although it's important for an investor to realize that they only provided a rough measure of default probability since default probability is a form of forecasting.
James wanted to emphasize that "high quality is often an expensive substitute for diversification." If an investor only has enough capital for a small amount of issues (2-5 different bonds) quality is appropriate, but without enough capital for adequate diversification an ETF is usually the better option than directly holding only a few bonds. For smaller portfolios James would recommend an investor consider a bond fund or ETF in preference to Government of Canada bonds.
With respect to a portfolio that is too short-term James stated that many investors would not go beyond a five-year term. The reluctance to invest in a longer term bond reduces, “the price risk and inflation risk” for an investor, “but it also reduces the yield and increased reinvestment risk.” His suggestion is that the average duration of the portfolio, the average term, should, “reflect – at least to some degree – the time at which you anticipate spending the money.” The one advantage of a shorter term bond is that an investor will have something to sell if necessary.
To increase the security of income for a longer period, we need to extend term, which increases term risk and inflation risk. To increase security of capital, we need to decrease term, which will reduce inflation risk and term risk, but increase reinvestment risk.
A longer term for a bond can maintain an investor’s income through a period of low interest rates, but will additionally inflate your money away during a period of high inflation.
In summary James offered five key concepts a fixed income investor should pay attention to:
- Adequately diversify your portfolio with an ETF as a viable alternative to a small collection of only high quality bonds
- Focus on maintaining good overall quality; portfolio average of an "A" credit rating
- Maintain a high quality reserve that can be sold quickly to either raise cash or adjust your portfolio for duration
- Remember that dealers (brokers) are not obliged to bid anything at all for bonds you might later wish to sell
- Pay attention to liabilities when investing assets. Ask yourself how much money will be coming out of your portfolio over the next ten years?
Ten years is a prudent allocation to bonds with a conservative allocation of 20 years' worth for withdrawals.
Simplicity really works in this situation and building a fixed income portfolio should always reflect your needs as an investor as with any equity portfolio. The mechanics of investing in bonds and equities are different, but fundamentals still reign. Risk should always be a focus of any investor and understanding what you invest in is one of the best methods of mitigating risk. Mistakes will happen, companies will surprise with negative news and no investment is every 100% risk-free. My belief remains that, "the best investment decisions are made when an individual considers their risk tolerance and are adequately informed."
ETFs and cheap bond funds are excellent opportunities for investors to invest in fixed income, gain diversification and take the time they need to study the more sophisticated elements of individual bond purchases and ownership.
My thanks goes out to Scott (Scomac) and James Hymas for taking the time to provide their valuable insights and experiences related to corporate bonds and fixed income investing. I will also thank a number of my dedicated readers who persistently insisted both publicly and privately that they wanted me to undertake the writing of this post. Questions and comments are welcomed as I hope to follow up with further articles in response to the needs of readers.
Disclosure: I do not own any individual bonds, but hold a portfolio of fixed income investments comprised of CorTS’, US/European preferred shares, TD Canadian Bond Index Fund (TDB909), CEF.A and cash (high interest savings account).