Ben Graham, the father of value investing and the creator of security analysis as we know, was a huge proponent of investing in bonds. In his seminal book, “The Intelligent Investor,” he recommends allocating anywhere from 25% to 75% of your portfolio to bonds.
Graham recommended this allocation as a way of protecting your capital, basing that decision on market conditions at any one time.
Trading corporate bonds can be a great way to increase your margin of safety and protect your capital. Unfortunately, this is an area that is not explored much and is largely ignored by the general investing public.
The reasons for not investing in bonds are? Pretty easy. It comes down to a lack of knowledge and unfamiliarity with corporate bonds and how they work.
My goal with our continuing series about bonds is to help enlighten all of us about bonds and how they could help us.
Let’s talk about corporate bonds, shall we? They are a bit scarier than treasury bonds that we discussed in the last post. Corporate bonds have a bit more moving parts and can be a bit trickier to analyze.
But that is why I am here, to try and demystify corporate bond trading for you. In today’s post, we will discuss:
- What are Corporate Bonds
- How to Analyze Bonds
- What are Bond Ratings
- Different Flavors of Bonds: Investment grade and High-Yield
- Risks of Trading Corporate Bonds
All right, let’s get to it.
What are Corporate Bonds?
According to Investopedia:
“A corporate bond is a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company’s physical assets may be used as collateral for bonds.”
Besides using issuing shares to raise money, bank loans, or lines of credit, issuing bonds is also another way for companies to raise capital for any project or initiative that they may be working towards to increase its value.
Corporate bonds backing is usually based on the company’s ability to pay back its debt. They can also use their physical assets as well, but think of the strength of its balance sheet as an indicator of the company’s ability to pay back its debt.
Interest rates for corporate bonds are generally higher than those of the treasury type, mainly because they are seen as riskier. Treasuries are backed by the US government, which to this point have not defaulted on any debt, whereas corporations have been known to default from time to time.
Corporate bonds are issued in blocks of $1000 in par value.
What does par value mean? It means that the value of each corporate bond is set as $1000 for each bond, but the prices in the bond market will fluctuate above or below the par value.
Like treasuries, corporate bonds pay a coupon payment, typically every six months. We, as investors, would receive these coupon payments until our bond matures.
Corporate bonds can come with what we refer to as call provisions that allow for early prepayment if interest rates change. We need to avoid these types of bonds like the plague; they are not great for long-term bond investing.
One advantage of trading corporate bonds over stocks is that if there were ever an issue with bankruptcy, it pays bondholders first before stockholders. Maybe this makes bonds safer than stocks, but we want to avoid this scenario if possible.
So how do we invest in bonds?
How do we Find an Investable Bond?
If we want to pick bonds like the pros, we need to find out what the pros are picking, especially as new investors to bonds it is best to go straight to the source and determine what companies to best are investing with themselves.
I would suggest we start by taking a look at some of the funds of the best bond fund managers out there; this is what I have done both for my stock portfolio, as well as my bond portfolio. Why not use their experience, wisdom, and knowledge of picking the best bonds for their funds to our advantage?
So, where do we find this information?
Probably the best website to use to help us find out what corporate bonds the best managers/funds are trading would be Morningstar.com. Morningstar is a freemium site that allows you to create an account for free, and you can use it to screen for different funds, or in our case bond funds.
Let’s take a look at an example, so we get an idea of what I am talking about for your knowledge.
Once logged into Morningstar, we would look for a particular bond fund by screening for funds that are four to five star rated for corporate bonds and then go from there. In this case, we are going to look for the bond fund Delaware Extended Duration Bond A (DEEAX).
Once we type in the above ticker, we are going to come to a screen that will list multiple links across the page; we want the link for a portfolio.
Now, once we click on that link, it will bring us to a page that will contain a plethora of information. We are looking for a breakdown of the portfolio as we are searching for individual corporate bonds to invest our money.
Towards the bottom of the page, there will be a breakdown of the largest holdings for this particular fund. Once there, you can see what corporate bonds this fund is holding.
In this particular fund, we can see that they are investing in Verizon (VZ), CVS, Anheuser-Busch, United Technologies, and so on.
The above list gives you a fantastic starting point to start to develop a portfolio made up of these particular companies.
Now that we have this info, what do we do? Do we trade these corporate bonds and go along on our merry way? Uh no!
We need to do some additional research to investigate these companies to determine if their particular bonds are investment-worthy.
Good news, now that we have a company that we want to investigate, we can go about researching that particular company just like we would if we were buying the equity, versus the bond.
We would use many of the same techniques:
- Understanding what it is the company does.
- Looking at the quarterly and yearly data, looking for many of the same ideas, such as revenue growth, free cash flow, ROE, and ROIC, among just a few.
- Looking at the strength of the balance sheet.
- Inspecting the debt, both long-term and short-term, to make sure the company is not just taking on debt to pay dividends or to buy back shares, but to grow the company or their income-producing assets.
Once we are satisfied that we understand the company and feel like the company is a strong, viable company, and the likelihood of the default of its debt is remote. Then we can look to other factors to consider when buying a corporate bond.
Another issue to consider would be making sure you are diversifying your corporate bonds across many different sectors. A mistake some beginning investors make when starting to invest in trading all tech stocks, financial, or retail, for example.
The same rule applies when buying a corporate bond; it is very important to diversify when investing with bonds too. Too much concentration in one sector could lead to more risk and potential for harm to your portfolio.
It is best to spread your risk with corporate bonds among the many different sectors, trying to allocate no more than 15% across each sector.
There are many different sectors to consider the most common being:
Bond Ratings: What Are They and Can They Help?
Bond ratings are considered the most important measure of the strength of a bond. There are three major bond rating agencies, Moody’s, Standard and Poor’s, and Fitch.
These companies have tremendous sway in the bond market and can make or break a bond issuing.
Each company has a slightly different twist on their ratings, which rate the credit quality of each company and it’s bond issues.
Many different factors go into the ratings of a bond:
- Economic sensitivity – How sensitive is a company to the strength or weakness in the economy. Think about Walmart during the last recession and how they survived versus someone like Macy’s who has struggled mightily since.
- Interest coverage ratios – These ratios are critical to judging the company’s ability to cover their interest payments on bonds given the various economic situations that might exist. These ratios can indicate how risky a bond might be if their revenues decline or cash flow dries up.
- Seniority – Bonds that are paid before others if the company runs out of cash, does the company pay us first, or are their other issues that preceded us? The seniority of our position can indicate the strength of our bond.
- Recoverability – If the unimaginable happens and our company, government, goes into default. Are there enough liquid assets to cover our bond. Think about a tech company like Apple because their debt is so small compared to its equity that, in the case of default, they would have enough equity to cover its debt.
Let’s take a look at a chart to give us an idea of the different bond ratings that exist.
The best get the AAA ratings, and the worst get the C ratings. Bonds with higher ratings typically pay lower yields, whereas lower ratings pay higher yields. The difference in yields is one of the risks that we need to balance when investing in bonds.
These ratings can have a huge impact on bonds and the yields and prices they offer. Higher rated bonds may offer a higher price on their face value and pay a lower yield than a bond that is not investment-grade. Remember that price and yield are inversely related in the bond market; as price goes up, yield goes down and vice versa.
Ratings have come under a great amount of scrutiny over the last dozen years or so because of the nature of how they work and the company’s that rate them. Remember the movie “The Big Short”? There is a scene in the movie where there is a discussion about the validity of some ratings that were given to a suspect company.
It has since been revealed that companies can pay rating agencies for higher-ratings; this has been under review and will hopefully become more regulated to help eliminate unnecessary fraud in the system.
You can search for the company’s ratings on each rating agency’s website. You much have an account with them, which is free. I took the liberty of looking up the rating for Verizon (VZ) on Moody’s to give you an idea of what it would look like on their website.
As you can see from the info above, Verizon has a Baa rating from Moody’s, which is an investment grade but on the border, which would bear watching in the case of investment. The rating can be a great way to test the strength of a company you are thinking of investing in their stock as well. The strength of their bond offerings can indicate a strength in their overall credit rating, which is a great thing.
Different Flavors of Corporate Bonds: Investment Grade versus High-Yield
The debate between investors about which is better, investment-grade versus high-yield, will rage on. Let’s take a look at these ratings and how the bonds function so we have a better understanding of the potential risks and rewards.
Let’s discuss high-yield bonds for a moment.
High-yield, formerly known as junk bonds, can offer investors many potential benefits, balanced by specific risks, mainly a higher risk of default.
Because of their lower ratings, the company’s bonds may have shakier credit ratings or be suffering from a downturn in their business. They may also be a newer company with a shorter track record, thus less credit rating ability.
Some benefits they offer:
- Diversification – high-yield bonds typically have a very low correlation to investment-grade bonds, which means that adding high-yield bonds can add more diversification to a broad bond portfolio. Diversification doesn’t protect you from loss, but it can help decrease overall risk and improve the steadiness of the returns.
- Increase current income – to encourage investment; high-yield bonds offer a higher yield than investment-grade bonds. The higher-yields can help increase the overall yield of our bond portfolio.
- Capital appreciation – An upturn in the company’s fortunes can greatly increase the price of a high-yield bond. This capital return can greatly enhance our portfolio in the long-term. Of course, the inverse is true as well. If a downturn in the financial health of the company occurs, this could drive down the price as well.
- Equity-like returns – There is a very strong correlation between high-yield bonds and the stock market. The correlation can lead to similar returns over a credit cycle. However, returns on high-yield bonds tend to be less volatile than stocks because the income portion of the return is higher, providing great stability. The combination of enhanced yield and potential for capital appreciation means that high-yield bonds can offer stock-like returns over the long-term. However, the returns are less than equities and do come with a higher risk than investment-grade bonds.
Let’s take a look at this chart from PIMCO.com, one of the leading bond fund providers in the world.
As you can see from the chart above, the potential for returns is enticing, especially for a bond portfolio. However, we must balance this potential against the risks of default and loss of capital.
What are the risks involved with high-yield bonds?
Here is a list of some of the risks involved:
- Default risk – missing interest payments are greater for high-yield bonds versus investment-grade bonds.
- Downgrade risk – If the company’s financials deteriorate, there is a risk that its high-yield bond might be downgraded, which would include a decline in the bond’s price.
- Interest rate risk – When interest rates rise, bond prices fall and vice-versa. If interest rates fall, bond prices rise.
- Liquidity risk – This risk illustrates the possibility of difficulty in selling a bond quickly and at an optimal price. The lack of liquidity is reflected in the bid-ask spread, as the spread increases the ability to sell the bond quickly lessens.
The above is just a shortlist of the risks involved in investing in high-yield bonds.
For reference, according to Moody’s, the trailing twelve months have seen a rate of default of 3.4% of high-yield bonds, this among the B-rate bonds. As one would expect, this rate spikes during downturns in the economy, such as the Great Recession and the .Com bubble meltdown.
Compare this to the default rate of AAA-rated or AA-rated bonds over the last 30 years of 0.0% and 0.2%, respectively.
How do we buy Corporate Bonds?
Now that we have done our research, we are finally ready to purchase our first corporate bond.
Not so fast! There are a few more steps to work through before we can pull the trigger.
Trading or buying corporate bonds exists at two different levels.
- Primary market
- Secondary market or OTC
Let’s discuss primary markets first.
The primary market represents new bond issues. Think of these as IPOs for new corporate bonds. When a company decides to sell bonds to raise the capital, it negotiates with investment bankers and large institutions to place their bonds in the markets, just like an IPO.
The pricing of these bonds is pretty straightforward and easy to understand. When the bond is purchased, everyone pays the same price, which is known as the offering price.
The bad news about this market is that it is a closed-loop for the small investor. We need special relationships to have access to the ability to buy any of these new bonds. Typically as a small investor, these primary market bonds are out of bounds.
The secondary market is the place that most buying and selling of bonds occurs after an initial offering or IPO. Small investors like us can buy in this market but we need to be cautious.
The secondary market occurs completely over-the-counter. Most trades are in a closed system and must be conducted through a broker.
The trick with the secondary market is pricing of bonds can be tricky, in the ability to track and understand.
When buying in the secondary market, we must make sure that we are paying a “good” price. We need to aware of the “mark up” or “spread” that brokers will charge to sell us that bond.
The spread is the difference between what a broker paid for that bond, versus what he wants to sell it to us for. Consider it a commission. Unlike stocks, the spread is built into the price you would pay for that corporate bond, which makes it difficult to determine what the spread or markup or how much profit the broker is making.
FINRA, a non-governmental regulatory agency, now offers the ability to track recent bond transactions through it’s TRACE system, which gives us some insight into spreads on recent bonds.
Before you buy a bond from a broker, use this system to look at recent quotes on bonds you are interested in. TRACE can give you an approximation of the spread your broker is charging.
Make sure you do some research on your broker before you pull the trigger, recently there have been some scandals concerning bond salesman. There has been a greater degree of transparency in the bond market as a result of these scandals, but it still pays to do your due diligence before buying.
Trading corporate bonds can be a great investment, but the corporate bond market requires a large amount of due diligence and effort.
As we have discussed corporate bonds, we have discovered that there can be a great many benefits to using these vehicles to help grow our money.
There can also be some risks involved investing with corporate bonds, among them default risk.
Corporate bonds can be a great investment with safety not offered in the stock market. The returns can be lower when compared to the stock market, but the trade-off is the lower risk of loss of capital.
Depending on your risk profile and where you are in your investing journey, corporate bonds can be a great addition to your portfolio. And if your risk appetite is greater, there are options to achieve equity-like returns with high-yield bonds, but you must be aware of the risks of investing in these bonds.
Also, keep in mind that playing in this market requires larger amounts of capital to play. Each bond requires at least $1000 to buy any one bond, with many requiring much more, say $5000 to $10,000 to invest in their bonds. Unless you have that amount of capital available to invest in corporate bonds, you might be better served to consider bond funds as an opportunity.
As always thank you for taking the time to read this post, I hope you find it helpful and answers a few questions for you. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time.