Being a stock investor you must know about bonds. Bond is the other side of your investment coin; it helps in making your portfolio well diversified. Bond is a debt market instrument; it promises to the debt holders to repay the principal along with the interest. Generally Corporates, government or government Agency issue bonds in order to borrow money to expand their business.
Now one can ask why Corporates issue bonds? Why don’t they go to the banks? The reason is a large organization often needs far more money than the Banks can provide, so the bond is the solution to them.
Why should one invest in Bonds? The issuer of the bond pays regular interest in specified intervals at a predetermined rate and repays the full borrowed amount after a fixed tenure. So an investor with high liquidity needs and low risk taking capability can invest in Bond market.
“What are you worried about? You think they are going to pay you back?” Till the time company is well-respected high-flier, the answer to that question is always “Yes.”
So below are the Six simple ways in which one can analyze credit worthiness of particular bond and bond issuer:
- Priority of Claim–
First measure to look while analyzing a bond is to look at the Seniority of claim. Debt can be either Secured or Unsecured. Secured debt has high priority of claims over unsecured debt as it is backed by collateral while unsecured has general claim over issuers assets and cash flows. Collateral is more important for a less creditworthy company. As an analyst you should consider any high quality intangible assets, market value of fixed assets as compared to its book value and depreciation policy. In short, the Investors would require higher yield to accept a Lower Seniority claim as recovery would be least in case of lower ranked claims.
- Credit ratings–
Second measure is to look at issuers credit ratings issued by institutions like CRISIL, CARE, ICRA etc. Issuer’s credit ratings are called corporate family ratings while issue specific ratings are called corporate credit ratings. Issues rating from AAA to BBB- are considered as investment grade bond while BB+ to D is Non investment grade bond, can also be called as junk bonds. For example, a government issued bond will always be rated A+ and above ratings because government has high regular source of income like tax revenues and thus government bonds will offer a lower coupon rate than corporate bonds due to its high Credibility. As and when an investor moves to lower credibility bonds he would be compensated with higher yields for taking high credit risk. An important point to note over here is to evaluate integrity of credit rating agency i.e. whether the issuing agency is independent or not?
- Capacity –
Another important thing to look while investing in bonds of the company is to assess issuer’s ability to pay interests and principal on time. Capacity analysis can be done by three level of assessment:
- Industry Structure – It can be evaluated by Porter’s five forces: Threat to Entry, Power of Suppliers, Bargain Power of Buyers, Threat of Substitution and Rivalry among Existing Competitors. For example a government regulated industry would have high barriers to entry and few players .
- Industry Fundamentals – It includes influence of macroeconomic factor on industries growth prospects and profitability. It also focuses on Industry Cyclicality, Industry Growth Prospects and Industries Published Analysis. In short we should look at volatility of earnings, revenues and cash flows.
- Company fundamentals – We also need to see that what corporate borrowers’ Competitive position is, its Operating History, Management’s Strategy and Financial ratios like Leverage ratios – Debt /Capital and Debt/EBITDA, higher the ratio higher is the leverage and credit risk. Generally, the ratio is more volatile for firms in cyclical industries or with high operating leverage.
- Yield spread –
A Yield spread is the difference in yield between two bonds of similar maturity but different credit quality. Example if the 10-year Treasury note is trading at a yield of 6% and a 10-year corporate bond is trading at a yield of 8%, the corporate bond is said to offer a 2% spread over the Treasury. Therefore yield spread should compensate an investor for issuers default risk as compared to a risk free bond.
Also as an investor we must look at the Terms and conditions the issuers and bondholders have agreed to as a part of bond issue. Whether the issuer complies with all terms or not is to be seen. There can be two types of covenants:
- Affirmative covenants: are the ones that require borrower to take such actions like paying interest and principal on time, maintaining certain financial ratios etc.
- Negative covenants: are the ones that restrict borrower from taking certain actions like taking additional debt.
- Character of Management–
Most important thing while assessing an issuer’s credibility is to assess its management’s integrity and its commitment to pay loan. We can judge the character of management by its track record and soundness, accounting policies and strategies, fraud record i.e. legal and regulatory problems and prior treatment of bondholders.
“The first thing is character and Money cannot buy it” so to judge character of management is very crucial.
Thus Bonds are a crucial part of any investment portfolio and provide more stability when compared to investment in equity. It’s well said, “Risk comes from not knowing what you are investing in” so investors who are interested in using bonds in their portfolio should perform a thorough analysis of the above mentioned factors before making such investment.