How To Find And Select Undervalued Fixed-Income Securities

Aug. 06, 2018 10:40 AM ETAxos Financial, Inc. (AX)C, KEY, PBB, PYS, PSEC, RRD, BOKF77 Comments

Summary

This is an educational article regarding the process of finding and selecting under-priced fixed-income securities that trade on the stock exchange.
It argues for using relative valuation when making a buy recommendation on a particular fixed-income security.
BofI Holding's 6.25% Subordinated Notes maturing on 2/28/2026 are used as a case study in using relative valuation to find a very undervalued fixed-income security.

Overview

In the world of fixed-income investing, there is no objective value, only relative value. There is no interest rate (yield) that one can say is right for a particular security. For example, preferred stocks currently sell at yields that aren't much different from yields that existed when the 10-Year Treasury yield was half of what it is now. So are preferred stocks overpriced now or were they underpriced when the 10-Year Treasury had a significantly lower yield?

My major gripe regarding some Seeking Alpha authors who promote fixed-income ideas (preferred stocks or bonds) is that they use an objective valuation approach rather than a relative valuation approach in their security selection process. They provide information about the company that issued the fixed-income security that they are promoting, and about the details of the fixed-income security that they write about (yield, price, call date), and expect that is enough to make an investment decision. However, no evidence is provided that their recommended security is a relatively better value than other similar securities issued by other similar companies. Sometimes I find the recommendations to be relatively overpriced and inferior.

Tips For Finding and Selecting Undervalued Fixed-Income Securities

1) One of the lessons I have learned from my 20 years of trading fixed-income securities is that the best values are in unrated fixed-income securities. You can generally get preferred stock and baby bond safety ratings from Moody's and S&P from QuantumOnline.com, but when checking safety ratings at QuantumOnline, you will discover that a large number of fixed-income securities are not rated. This only means that the company has decided not to pay the rating agencies to rate their fixed-income securities. But many unrated securities are extremely safe. Despite this fact, many mutual funds and other institutional investors have instructions not to buy unrated securities. Therefore, unrated securities are often underpriced due to lack of buying from "big money" and the fact that they are avoided by those who do not want to take the time (or have the knowledge) to examine the safety of the company themselves. In my opinion, it is well worth taking the time to look into unrated securities as you will greatly outperform the benchmarks by finding the unrated gems. Learning the basics of reading a balance sheet will go a long way in becoming a successful fixed-income investor.

2) For companies that are rated smaller companies tend to receive lower ratings simply because they are small despite the fact that they may have better balance sheets and better business prospects than more highly rated companies. So bargains tend to exist more in the fixed-income securities issued by smaller companies.

3) For "stock exchange traded" bonds, there may be bonds issued by the same company that trade on the "bond exchange". This gives you a chance to see if there is a relative mispricing between the company's exchange traded bonds and the company's bond exchange traded bonds. A couple of examples of this are comparing the "stock exchange traded" PSEC 2024 bonds (PBB) with the many PSEC bonds that trade on the "bond exchange". Right now PBB looks like a good relative value. An extreme mispricing can be found when comparing the R.R. Donnelley (RRD) trust security (PYS) which contains the same R.R. Donnelley bonds that trade on the "bond exchange" - the 6.625% bonds maturing 2029. PYS is extremely underpriced relative to the identical "bond exchange" traded bond. Bonds traded on the stock exchange are often better values than those traded on the bond exchange, and they are also often more liquid and easier to trade.

4) This article mainly focuses on bonds. For more information on evaluating preferred stocks to find mispriced bargains, see some of my recent Seeking Alpha articles here, here, and here where relative valuation is used to document the mispriced preferred stock bargains. Additionally, one important thing you can do in evaluating preferred stocks is to look at the yield on the bonds that have been issued by the same company to help get an idea of safety of the company and the relative valuation of the preferred stock versus the bond.

Relative Valuation Case Study Using a BofI Holding's Bond

BofI (NASDAQ:BOFI) is a branchless bank. Its sales force works on commission so there are little in the way of fixed costs, and its employee costs are under total control and in relation to the growth in assets and loans. If the economy and loan growth slow, the commissions paid out by the bank will also drop. So it has immediate cost savings when business slows to offset slower revenue growth. Banks with branches, however, still must staff their branches and will have the same fixed overhead to deal with even though revenues are declining. Here is a table of important metrics sourced from Interactive Brokers that demonstrates the benefits of this model. The banks chosen for this chart have similar balance sheet and other metrics, as you will see in the chart below this chart, with the exception of Citigroup (C) which has a lower PE ratio and "price to book" value ratio.

In addition to the amazing returns on equity and assets that are being achieved by BofI relative to other banks, the BofI model has had amazing growth. It has grown earnings from .97/share in FY 2014 to $2.28 in FY 2018. Its model is clearly working, and a strong case could be made for the common stock, but as a bond investor, it is enough to know that the company is performing very well, with a bright future, and that the interest payments on the bonds are in no jeopardy.

The bond in question for this article is the BofI 6.25% Subordinated Notes. It trades at $25.70, matures on 2/28/2026, is callable on 3/31/2021, and carries the symbol BOFIL. Like most undiscovered bargains, it is unrated. Therefore, I have provided a chart of metrics comparing BofI to other rated bank stocks for comparison purposes. The numbers in this chart are from SEC filings and Yahoo Finance.

To make a fair comparison in terms of the safety of BofI relative to other banks, I have chosen banks with similar leverage (% Liabilities to Assets) to BofI and similar ratings relative to each other by Moody's and S&P. BOK Financial's (BOKF) bond (BOKFL) was also chosen because it is one of the few banks, like BofI, whose bond trades on the stock exchange rather than the bond exchange and it has a smaller capitalization more in line with BOFIL. Citigroup and KeyCorp (KEY) were also chosen because they have bonds of similar maturity to the BOFIL and a similar safety rating to BOKFL.

In looking at the chart, it is clear that the stock market is partial to BofI given the fact that it is trading at the highest PE ratio and at a "price to book" value well beyond the other banks. If one used the safety metric "liabilities to market capitalization", BofI would be the safest of the group because its market value is so far above its book value. In addition, the previous chart also shows that BofI is a better operator with much superior returns on equity and assets and a safer business model for handling economic downturns. Yet the "yield to maturity" is almost 50% higher than the 2 bonds with similar maturities. With regards to the smaller BOKFL, BofI matures in only 7.75 years versus 38 years for BOKFL, which provides significantly more safety for BOFIL, yet BOFIL's "yield to maturity" still significantly exceeds that of BOKFL.

BOFIL had its IPO on 3/3/2016. If you remember, fixed-income securities were crushed during early 2016 with many baby bonds dropping 20% (check symbols like PBB and JMPB which went from $25/share to below $20/share very quickly). So this was a difficult time to IPO a baby bond and the 6.25% coupon offered by BofI was almost certainly higher than it would have had to offer if it had IPO'd 6 months later. However, it seems that despite the 20% rise in many baby bonds since early 2016, BOFIL has been totally ignored. It is just off the radar screen of bond investors and I like that. As an added bonus, BOFIL goes ex-dividend on August 14th so that its stripped price is not much higher than its $25 IPO price despite the massive fixed-income rally that has occurred since 2016 and despite its blowout operating performance and earnings growth. This is the stuff of bargains.

Relative fair value for BOFIL would be at least $27.50 giving it a 4.85% yield to maturity (YTM); however, because of its call provision, $27.00 (5.15% YTM) would be a more appropriate fair value relative to comparable shorter-term bonds.

As I stated earlier, "exchange traded bonds" tend to be better values than "bond exchange" traded bonds, and this may also be benefiting BOFIL. These bonds are often called "baby bonds" due to having a $25 par value rather than $1,000. Although "baby bond" BOKFL compares unfavorably to "baby bond" BOFIL, the stock exchange traded BOKFL looks good against Citicorp's longer bond, the 4.65% of 2048, which only yields 4.55% to maturity versus 5.4% for BOKFL. So I did not choose BOKFL just to cherry pick an overpriced bond. It is actually a relatively good value compared to similarly rated bonds that trade on the bond exchange if you wish to stay with rated securities.

Summary

In this article we have discussed how relative valuation is the only thing that matters when valuing a fixed-income security. If you fail to compare a security you are considering purchasing with other similar securities that are available from other similar companies, you will significantly underperform.

Often "unrated" and/or small company fixed-income securities are the best values and can be significantly underpriced. Very smart institutional buyers comb through the often larger-cap-rated bonds leaving bargains hard to find in that arena.

Stock exchange traded bonds (baby bonds) in all sectors can potentially provide bargains relative to similar bonds traded on the bond exchange.

Lastly, using the "relative valuation" approach, the case was made that BOFIL is an overlooked bargain relative to similar bonds providing a great buying opportunity and a chance to take advantage of a significantly higher yield than are offered by similar bonds and possibly price appreciation as well.

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Summary

Overview

Tips For Finding and Selecting Undervalued Fixed-Income Securities

Relative Valuation Case Study Using a BofI Holding's Bond

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