Are Ford's Bonds Preferable To Ford's Stock?

Jun.16.14 | About: Ford Motor (F)

Summary

Ford's stock performance has been pretty flat in the last 10 years.

Many people buy Ford's stock because of the dividends but those investors can also benefit from Ford's bonds.

Since we are in a low-interest environment initiated by the Fed, it pays to be extra cautious when it comes to investing in bonds.

Whether to buy Ford's stock or bonds will depend on one's circumstances, timing and goal.

Ford Motor Company (NYSE:F) is one of the most popular companies in the stock market. A lot of investors have very high expectations of the company as things have been improving in North America and Europe, in addition to the strong growth figures we are seeing in Asia. In the recent years, Ford also brought back its dividends, which makes the company an even more attractive investment opportunity. Meanwhile, the company's stock performance in the last decade is far less than impressive. Exactly 10 years ago, Ford's stock price was $15.70, which indicates that the company's share price has appreciated by less than 1% annually, on average, in the last decade. If Ford's stock price has a tendency to stay flat in the long term and many investors are attracted to the company because of its dividend yield, maybe a subset of those investors would be better served by investing in Ford's bonds rather than the Ford stock.

How do bonds work?

Many times, companies need extra cash to fund their operations, future growth opportunities or other purposes as seen fit. Since the automobile industry is capital-intensive, companies like Ford need a lot of extra cash and liquidity. At times like these, companies tap the debt-markets in order to get their hands on cash at reasonable prices. Automobile companies also need funding for their credit portions (i.e., Ford Credit) in order to offer financing to car buyers and car leasers.

When investors buy bonds of a company, they become debt-holders of the company. In the event of a bankruptcy, debt-holders enjoy precedence over shareholders because a company has to honor its debt before paying anything to its shareholders. As a result of this, many people consider bonds to be somewhat more secure than stocks even though this is not always true. Bond prices are highly-dependent on interest rates and they can fluctuate as much as stock prices over time.

If one buys bonds at the issue and holds them until maturity, they will get their exact money back and collect a fixed interest rate that was pre-determined, unless of course, the company in question goes default. Those who decide to sell their bonds may receive more or less than the principle they paid, since bond prices move up and down in order to keep the yield as constant as possible. Also, bond payments occur every 6 months while most dividend-paying stocks make dividend payments every 3 months.

How do some of Ford's bonds compare with the company's stock?

As I am writing this text, Ford's dividend yield is 2.93%, and this number will play a pivotal role when comparing Ford's bonds with the company's stock. As mentioned above, Ford's share price appreciation has been almost non-existent in the last decade and the company's stock buybacks are pretty minimal in terms of size. It looks like Ford's stock is very stable and most of the returns will come from the company's dividend yield. This makes our job of comparing Ford's stock with the company's bonds easier.

There are currently two Ford companies that issue bonds, Ford Motor Company and Ford Motor Credit Company. Ford Motor Company issues bonds in order to fund its operations and growth, while Ford Motor Credit Company issues bonds to create car loans for car buyers and car leasers. Currently, both of these companies' bonds are considered "investment grade" by major credit rating agencies and they both have Baa3 ratings. Since Ford avoided bankruptcy just 5 years ago, it will take a while before the company's credit is rated AAA. This presents bond investors with an opportunity to get decent yields on the company's bonds. These days as the Fed keeps interest rates low, getting good yields on bonds is very difficult unless one takes a big risk by investing in junk bonds. Ford offers a unique opportunity for the investors, as they can get a decent yield at a relatively stable company with strong cash flow.

The CUSIP number 345370BW9 refers to Ford Motor Company's debt that was issued in 1998 and this non-recallable debt will not be maturing until 2047. The bond can be bought in increments of $1,000 and the investors are expected to invest at least $5,000. The current price is $158.40 and the current coupon is 9.98, which means that we are looking at a yield of 6.30%. This is more than twice of the company's dividend yield. When the debt was first issued in 1998, the price was 100 and the coupon was 9.98 (the coupon never changes because this is a fixed-rate debt), and it had a yield of 9.98%. Over time, as the interest rates fell, the yield fell, which increased the price. Since coupons in fixed-debt never change, the price of the debt changes in an effort to keep the yield stable. This is how bonds gain or lose value. Currently, the interest rates are very low and they are going to increase within a few years when the Fed decides to end its low-interest policy. This might hurt bond prices in the long term and investors should be aware of this.

Again, if you buy a bond at the initiation and plan on holding it until its maturity, you don't have to worry about price fluctuations. You will continue collecting coupons every 6 months and eventually your principle when the debt matures unless the company goes default, which is a low-probability event for high-quality companies with positive cash flow. If you are buying a company's bond at a premium, you might lose money at maturity when you are getting your principle back, and if you are buying a company's bond at a discount, you will gain money on top of your coupon collections. At the moment, it is very difficult to find bonds that are trading at a discount due to the low-interest environment induced by the Fed.

Typically, Ford Motor Company's bonds are non-callable and they carry higher yields than Ford Motor Credit Company. The credit company's bond is usually backed by the company's assets, such as vehicles that are either sold or leased. When debt is backed by assets, the perceived risk is reduced and this comes with a lower coupon yield. Callable bonds are a little riskier because a company might want to call its bonds back when the price falls significantly, leaving the bondholders holding the bag. Non-callable bonds give investors more control because they can hold the bonds as long as they want to or until maturity (whichever comes later).

What is the verdict then?

Before making a final verdict, it is important to introduce one more concept for those that may not necessarily know a lot about how bonds work. At initiation, a bond's unit price is always $100, and this is also the principle that investors will be getting back at maturity if they hold the stock until then. Remember that the Ford bond described above has a price of $158, which means that if you buy it today for the current price and hold until maturity, you will lose $58 per unit from principle. This is because we are currently in a low-interest environment and bond prices are artificially high. Keeping this in mind, we can calculate yield-to-maturity. This metric gives us the actual yield when we consider the fact that the buyers of these bonds will lose a good chunk of their principle investment once the debt matures. If we use the formula below, we find that Ford's debt has a yield-to-maturity rate of 2.91%.

When it comes to verdict, we can think of different scenarios. If you bought the bonds at initiation and if you are collecting your coupons of 9.8%, you are doing well, but you can still sell the bond at $158 and enjoy a huge capital appreciation along with the coupons you have already collected. If you are planning on buying right now and can't decide on whether to buy a Ford share or a Ford bond, think of how long you plan on holding your investment. If you are planning on a place to park your money for a few years and collect a good yield, the bond might be better suited for you, but if you want to take advantage of Ford's growth and have a longer-term horizon, you might be better off with Ford's stock than the company's bond because the bond is guaranteed to lose money as we approach maturity (since it will mature at $100 per unit).

When one is buying bonds of a company at large premium, they are betting that the interest rates will not increase by much anytime soon, but the Fed has already indicated that the interest rates would be rising in a few years and investors would be well-advised to evaluate their options knowing that the current interest rates do not have much room to go down, but they have a lot of room to go up.

Disclosure: The author is long F. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.