Why Invest in Bonds ?
Investors can utilize Corporate Bonds as an avenue for the diversification of one’s portfolio. A diversified portfolio helps to reduce the risks caused by a concentration of similar assets. It could also be used to save for future expenses such as education or retirement. There are two main types of bonds we can invest in – government bonds and corporate bonds.
What are Corporate Bonds ?
When investors like us purchase Corporate Bonds, we are essentially lending the business our money. In return for the use of those borrowed funds, the bond issuers make periodic interest payments and return the principal amount at bond maturity.
Companies can raise capital in a number of ways; when they issue bonds, they are essentially incurring a debt, very much like going to the banks for a loan.
What are bond investment returns?
Investors earn returns in two ways:
- When they receive coupons (i.e. interest payments)
- Capital gains
If you buy a bond at a higher or lower value than its face value, your return is based on the coupon you receive, plus any capital gain or loss from holding the bond (i.e. the difference between the price you paid and the price you sold the bond.)
What are some of the Pros of Investing in Corporate Bonds ?
- Fixed coupon rate (Fixed Income) – Bonds pay a fixed interest, also known as coupon, to investors during the holding period. Investors receive coupon payments regardless of the financial performance of the company. This is unlike stocks, whereby dividends are not guaranteed and stock prices can fall below what the investors initially invested.
- Low volatility – Even in times of financial downturn, coupon payments are still likely to be constant and investors’ principal is still preserved till maturity.
- Higher Priority of Claim – Investors in bonds have higher priority to the claim on assets in the event of insolvency or bankruptcy.
- Good form of Diversification – Bonds provide yet another avenue to diversify one’s asset classes owned. Former cross-asset sell side strategist and current investment manager/researcher Dylan Grice once outlined what he called a “cockroach” portfolio that should survive any financial fallout – it consisted of an equal split between equities, bonds, cash & gold. He notes that cockroaches can even survive a nuclear blast, and questions whether we are able to build portfolios that was as robust as these critters.
How to calculate one’s Yield-to-Maturity ?
Before we teach you how to calculate yield-to-maturity, one has to understand the following terms:
Face value or par value: The underlying value of a bond. Upon maturity, bondholders are paid this face or par value of the bond.
Yield-to-maturity (YTM): Refers to the annual returns for the investor from the point of purchase to the maturity date of the bond. It assumes that all coupon payments will be reinvested at the same rate of return.
With advancements in technology, one does not need to remember or calculate the complex formulas of Bond Yield by oneself. Instead, we would like to refer you to Phillip POEM’s BOND CALCULATOR.
In most cases, a bond’s attractiveness depends on its coupon yield. The following are some basic considerations for assessing a particular bond’s yield:
The probability that the bond issuer/borrower will default
Bondholders will demand a higher yield from borrowers who appear to be less likely to make timely interest payments or return the principal on maturity. This all depends on the credit-rating and trustworthiness of the company/borrowers. Companies/ Organizations with high credit rating will issue coupons at lower rates as compared to lower credited companies. Credit assessments will vary over time, subject to the market’s perception of business conditions and as a company’s fundamentals might improve or worsen.
The potential erosion of the future payments from inflation
When investors purchase bonds, they exchange present payment for a series of future reimbursements. Inflation erodes those future payment’s purchasing power. Higher or lower expected inflation generally calls for higher or lower yields.
The basics of how one chooses the right bond
Interest Coverage Ratio
The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest on its outstanding debt such as bonds. It measures how many times a company can cover its current interest payment with its available earnings.
The interest expense could be calculated by taking Net Profits/ Interest Expense. It should be greater than 2.75 for conservatism purposes.
Net Profit Margin
Net profit margin is equal to how much net income is generated as a percentage of revenue. Investors can assess if a company’s management is generating enough profit from its sales and whether operating costs and overhead costs are being contained. This also determines its ability to pay interest payments as well as the initial principle when the bond matures.
The Net Profit Margin of a company you are looking to invest in should be higher than or equal to the sector average.
Positive Operating Cash Flow for the past 3 years
This ensures that the company is able to generate positive cash flow from its operating activities, thereby allowing it to be able to make its coupon payments timely and aptly.
Debt to Equity/ Gearing Ratio should be ideally near/at industry average.
A high debt/equity ratio vs industry is often associated with high risk; it means that a company has been aggressive in financing its growth with debt. A higher debt-to-equity ratio could also signal trouble if the company has insufficient free cash flow to cover its debt.
Interest Coverage Ratio
The Net Profit or Interest Expense should be more than 2, as this shows that the company is able to fulfil its coupon payments for at least 2 years.
The holding period of the bond also affects the default risk and interest rate risk. The shorter the duration, the lower the default risk and the lower the interest rate risk, and vice versa.
These are some of the basic analysis one can conduct when looking at corporate bonds.
If you are still confused about some of the terminology used in certain websites and articles, here is a complete bond dictionary by POEMS.