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Bond Analysis: Science or Numerology?

There are more methods for analyzing bonds than there are bonds, or so it seems. Even so, some are clearly essential to evaluating risk and potential returns. We'll look at a few here.

Part I - EVALUATING RISKS

Bond investment risk comes in a variety of forms, including credit risk, interest rate risk, inflation (one form of asset erosion), liquidity and maturity risks.

Credit Risk

Even the most secure bond investment has some credit risk. In 1995, U.S. Treasuries, considered the gold standard of bonds were close to default for the first time in history. For corporates and municipals the risks are even greater, running everywhere from the AAA/Aaa to B and below ('junk' bonds). For any of these there's the real and not negligible risk that the principal may not be repaid at maturity.

Since capital preservation is one of the first fundamentals of prudent investing, evaluating credit risk is among the foremost tasks to be undertaken. Fortunately, many of the same tools available to stock investors are applicable.

Look at future earnings potential, current Earnings Per Share, dividend payments, amount of outstanding debt and foreseeable relevant technological changes. Study current management track records and possible legal entanglements. All these, and many more, give an overview of a particular issuer's credit risk, beyond the available major agency ratings, which should be studied as well, of course.

Many of these considerations apply to municipals and other government issuers as well. For example, consider current management practices. Not too many years ago, Orange County California in the U.S. - one of the most credit worthy and financially prudent municipalities in the country before and after the crisis - found itself in dire straits for a period because of one official's fondness for investing tax receipts in junk bonds.

Dividends paid leaves less money for investment in R & D and current productivity improvements. As debt loads grow, the amount of interest paid increases, reducing the amount for such investments as well as bringing a company closer to default on existing debt, since only so much can be sustained by current revenues.

Technology

Technology and other large scale social changes eventually obsolete any product or service in a growing economy. Companies adapt or eventually fade as the result of new companies coming into being to meet the new demand.

General Electric no longer makes the largest portion of its revenue from selling light bulbs, as it did 100 years ago. In a few years, those that do will either adapt to light diode bulbs or face loss of revenue as tungsten filament bulbs become museum artifacts.

Interest Rates

Interest rates change, for reasons that are complex and difficult to predict with confidence. There are grown men who attempt to pick apart every phrase uttered by the FOMC (Federal Open Market Committee - the body that determines Fed Funds and other rates that heavily influence U.S. interest rates in general). Others spend considerable time using advanced statistical techniques (which we'll examine later), to bring some science into the mix. The bottom line, however, is that no one knows with any high degree of certainty what rates will be in a year, five years or longer.

A large number of bond issues have maturities with 5-30 year periods. Any change in the prevailing interest rates affects unmatured bonds in two ways. A rise in rates depresses the price for those considering selling prior to maturity, since investors can get a better rate with a new instrument. And the pressure to sell rises, since the bondholder can himself get a higher rate with a new instrument. The longer he holds the older one, the more opportunity costs he incurs.

Inflation

Inflation reduces the amount of real return on any bond. Even ignoring tax issues, an 8% bond in a 4% inflation environment is worth half its coupon value. Historically, inflation tends to increase more than it decreases. When it does decrease the general economy tends to suffer, worsening returns for all investments.

Inflation expectations are often built into investment decisions. Those who borrow even in a relatively low 3% inflation environment, know that the money they pay back costs less when paid back 5 or 10 years hence. If inflation rates decrease, they pay back with more valuable money than they expected.

Liquidity and Maturity

Bond investors tend to have greater exposure to liquidity risk than stock traders. Bonds can be harder to find buyers for, since high-yields tend to be risky (particularly if the issuing company has failed to meet expectations first formed at issue date), and low-yields may have to sell at deep discounts to attract buyers in a rising interest rate environment.

Information about the value of bonds can be harder to obtain or analyze. Bond trading is inherently more complex than stock trading, while at the same time bond yields and cash flow have inherently more tools to make predictions owing to their (usually) fixed coupon and maturity.

Maturity is one of the fundamental attributes used to measure those cash flows, but some bonds are issued with a 'callable' feature which permits the issuer to redeem them at face value prior to maturity. That overthrows expectations and calculations made at the time of purchase. That introduces a form of risk.

One way to offset some of that risk is to employ a technique known as 'bond ladder' investing. The investor calculates the cash flows from a set of bonds having different maturities, purchasing ones with 1-year, 3-year, 5-year or more in order to minimize interest rate change and other risk by offsetting it with staged maturity dates.

In Part II, we'll look at some of the tools available to evaluate risks and rewards quantitatively.