Corporate Fixed-Income: An Introduction

  1. INTRODUCTION

I should make several points at the beginning of this article series.  First, this article series is relegated to the analysis of corporate fixed-income securities.  I will mostly focus on corporate bonds and will use the terms corporate bonds and fixed-income securities interchangeably.  Second, this article series will focus on analyzing the credit worthiness of issuers, to the exclusion of important concepts such as fixed-income portfolio management.  The final point is a caution to investors: although I believe sophisticated individual investors (“enterprising” investors) and smaller boutique investment firms have an enormous advantage over larger institutions when it comes to stock investing, these same small investors are generally at a large disadvantage when it comes to investing in corporate bonds.  This disadvantage mostly arises from unfavorable pricing offered to smaller purchasers.  In a low interest rate environment, these pricing differentials can be significant.

There are, however, several reasons to learn how to analyze corporate bonds, even for those not looking to regularly and directly invest in these instruments.  For stock investors, the claim debt holders have on the cash flows and assets of the company is senior to that of equity holders.  Therefore, prudent stock analysis requires an assessment of a company’s ability to meet interest and principal payments on debt.  Another reason for small investors to understand corporate bond analysis is that occasionally a corporate debt security will become available at a favorable price.

  1. OVERVIEW OF BONDS

Many companies raise capital from investors by issuing bonds.  A bond is an instrument which obligates the company to pay the bond holder a periodic interest payment.  Bonds have an explicit maturity date, at which time the company will redeem the bond at the bond’s stated face value.  Most corporate bonds have a stated face value of $1,000.

2.1.  Bond Indenture

The corporate bond indenture is the legal document which establishes the terms between the bond issuer and the bond holder.  The indenture is legally binding on the issuer until the bond’s face value has been repaid.  Bond investors should read and understand the bond indenture as it contains details on key features of the bondi

.  These features include the bond’s interest payments, maturity date, call and refunding provisions, and other provisions.  The bond issuer must appoint a corporate trustee to act as a third-party to the indenture contract.  The trustee’s main responsibility is to ensure the bond issuer is complying with the terms of the indenture.

2.2.  Coupon Rate

The term “coupon” is carried over from when bonds were in “bearer form”.  Bearer bonds were disallowed in the U.S. in 1982, but such bonds are issued in limited number outside of the U.S.  With a bearer bond, the company does not maintain records of bond ownership.  Thus, interest payments are made to whomever is in possession of the bond (the “bearer”).  Attached to bond certificates was a coupon book, containing one coupon for each payment date.  The bond holder would receive her interest by clipping the appropriate coupon and presenting it to the bond’s trustee.

Almost all bonds are now issued in book-entry form, in which no certificate is issued.  Rather, record of bond ownership is kept electronically.  The term “coupon” in current usage refers to the interest payment on the bonds.  The bond’s coupon rate is the payment as a percentage of the bond’s face value.  Most coupons are paid semiannually.

2.3.  Call Provisions

Some bonds contain a provision in the indenture which allows the issuer to “call”, or redeem, the bond before its maturity date.  Bonds which contain such a provision are known as callable bonds.  Callable bonds can be redeemed by the issuer either in whole or in part on or after a specific date.  The price and the date(s) at which the bond may be redeemed are contained in the indenture.

The call provision benefits the issuer when interest rates fall, thus allowing the bond issuer to issue new bonds at lower rates than the existing bonds.  Call provisions, however, expose bond holders to reinvestment risk, i.e., the risk of having to invest the proceeds at lower rates.  Call provisions are a common feature of corporate bonds.

2.4.  Bond Yields

Interest rates change regularly, and bond prices will fluctuate accordingly.  Bond prices move inversely with interest rates: as rates rise, bond prices fall; as rates fall, bond prices rise.  This relationship holds because investors discount bond cash flows based on market interest rates, not coupon rates.

All bonds will “settle” or redeem based on some future event.  The redemption event may be the bond’s maturity, a call from the issuer, or a settlement from a restructuring.  Thus, the bond’s cash flows are the coupon payments and the redemption amount.  The yield is the rate which equates the bond’s cash flows with the bond’s current price.

2.4.1.  Yield-to-Maturity

The most often quoted yield measure is the yield-to-maturity (YTM).  The YTM assumes the bond is held to maturity; thus, maturity is the assumed redemption event for this measure.  The YTM is thus the rate which equates the bond’s price with the bond’s periodic coupon payments and the bond proceeds received at the bond’s maturity.

Generally, the YTM can only be precisely calculated with the use of a financial calculator or spreadsheet program.  However, a rough approximation for YTM can be derived using the following formula:

(Annual Interest + Annualized Discount) ÷ ((Price Paid + Par Value) / 2)

2.4.2.  Additional Yield Measures

A bond’s redemption event may be an event other than the bond’s maturity.  For example, the bond may contain a call provision which allows the issuer to retire the bond before maturity.  In this case, the yield is referred to as the yield-to-call.

The most conservative yield measure is the yield-to-worst.  This yield measure assumes the bond is redeemed at the earliest possible event specified in the bond indenture.

2.5.  Bond Prices and Par Value

Par value refers to the bond’s stated face value.  When a bond’s price is greater than its par value, the bond is said to be trading at a premium.  When a bond’s price is less than its par value, the bond is said to be trading at a discount.

When market interest rates increase, such that the coupon of a new, similar bond is greater than that of an existing bond, traders will sell off the existing bonds so its price will be at a discount.  When the bond is trading at a discount, the bond’s YTM will be higher than the coupon rate.  Thus, the discount compensates the bond holder for the below-market coupon rate.

When market interest rates decrease, such that the coupon of a new, similar bond is less than that of an existing bond, traders will buy the existing bonds so it price will be at a premium.  When the bond is trading at a premium, the bond’s YTM will be lower than the coupon rate.

Bond prices are quoted as a percentage of par value.  For example, a bond quoted at 95.25 has a price of .9525 x $1,000 = $952.50.

2.6.  Accrued Interest

A bond which trades at a date falling between coupon payment dates entitles the bond seller to the interest which has accrued since the last coupon payment date.  This accrued interest is added to the bond’s price, thus compensating the seller for this amount.

The calculating for accrued interest is:

Accrued Interest = (Days between last coupon and settlement ÷ Days in coupon period) x Coupon Rate

For corporate bonds, most dealers use a 360-day year for calculation purposes.

2.7.  Basis Points

A basis point represents 1/100th of 1%, or .01%.  Thus, 1% is 100 basis points.  For bond yields, one basis point would be the difference between a bond yielding 5.25% and 5.24%.  Bond traders and market commentators will often quote yield differences in bonds in basis points.

  1. TYPES AND CHARACTERISTICS OF CORPORATE BONDS

Corporate bonds are bonds issued by corporate entities.  Bond markets offer corporations several advantages over borrowing from traditional commercial banks.  These advantages include fixed-interest rates and longer maturity dates.

In the event of a default, bankruptcy, or liquidation, bondholders have legal priority (known as seniority) over stockholders.  In other words, bonds are higher up in the company’s capital structure (ranked by claims on assets and earnings).

3.1.  Bond Collateral

Most corporate bonds have no specific collateral, but are rather backed by the general credit of the issuing companies.  Such bonds are known as debentures.

Some corporate bonds, however, are collateralized by specific pledges.  The main types of collateralized bonds are described below:

  • Mortgage bonds: Bonds which are secured by a claim on real estate or other real property.
  • Collateral trust bonds: Bonds which are secured by financial assets (such as stocks and bonds).  These financial assets are held by a trustee on behalf of the bondholders.
  • Equipment trust certificates: A type of bond which is explicitly secured by specific equipment.
  • Guarantee bonds: Bonds for which repayment is guaranteed by a third-party.

3.2.  Credit Risk

Credit risk is central to understanding corporate bond yields.  Credit risk refers to the possibility that a company will not be able to satisfy the terms of the bond.  A company with high credit risk generally has inadequate cash flows and assets to cover the bond payments.

A bond’s credit rating is a key determinant of a bond’s price and yield.  A credit rating ranks a company’s ability to satisfy its debt obligations under various operating and economic conditions.  Credit ratings are assigned by three major rating organizations:  Moody’s Investor Services, Standard & Poors’, and Fitch Ratings.

Bond investors must understand the bond’s lien position.  The lien position refers to the bond’s place within the firm’s capital structure in the event of default.  The higher a security is positioned within the firm’s capital structure, the higher the potential recovery in the event of default.

3.3.  Convertible Bonds

A convertible bond is bond with both debt and equity features.  This type of bond gives the bondholders the right to exchange the bond for a specified number of common shares in the issuing company.

A convertible bond offers the investor several advantages over non-convertible bonds.  First, the convertible bond gives the bondholder the ability to convert the bond into equity and thus participate in the stock’s upside potential.  Second, the bond offers the holder protection from a stock price decline.  If the investor does not convert the bond into shares, the bond will still pay a regular coupon and principle repayment (assuming the company maintains the ability to service the debt).

Because the conversion provision is valuable to the convertible bond holders, the price of a convertible bond is higher (and the interest rate lower) than that of a similar bond without the conversion feature.

Companies issue convertible bonds primarily because they pay a lower interest rate.  Another benefit to companies of issuing convertible bonds is the ability to reduce debt should the bonds be converted to equity.  However, the issuance of additional shares as a result of conversion dilutes the ownership of existing shareholders.

The bond’s conversion price is the per-share price at which the convertible bond can be converted into shares.  This price is specified in the convertible bond’s indenture.  For example, the indenture may specify the conversion price at $25 per share.  The conversion ratio is the number of common shares into which each bond can be converted.  The conversion ratio is calculated by dividing the bond’s par value by the conversion price.  If the bond’s par value is $1,000 and the conversion price is $25, then the conversion ratio is $1,000 ÷ $25 = 40.

The conversion value is the stock’s current price times the conversion ratio.  If the stock’s price is $18 and the conversion ratio is 40, then the conversion value is $720.  The conversion premium is the difference between the convertible bond’s price and the conversion value.  If the convertible bond’s market price is $1,020 and the conversion value is $720, then the conversion premium is $300.

The convertible bond is at conversion parity when the bond’s market price equals the conversion value.  The parity price can be found by dividing the bond’s market price by the conversion ratio.  In the above example, the parity price is $1,020 ÷ 40 = $25.50.  Generally, convertible bond holders will only exercise their conversion privilege when the stock’s market price exceeds the parity price.

Sources:

Crescenzi, Anthony.  The Strategic Bond Investor, 2nd ed.  U.S.:  McGraw-Hill, 2010

i Key terms of the bond are also summarized in the bond’s prospectus.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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