Month: March 2019

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Corporate Bond Valuation

There are several considering points to figure out the relative value of bonds. Most of fixed income investors are using similar way to value bonds both in the secondary market and primary market. The way to evaluate the relative value can also be referenced by the way how the credit rating companies are rating the issuers. 

Above Figure shows a part of Standard & Poor’s Ratings Services’ corporate analytical methodology. (source: Corporate ratings methodology: Transparency. Comparability. Standard & Poor’s Ratings Services. (April 2004)) They classify the issuer as 1) country risk, 2) industry risk, and 3) competitive position as part of business risk profile, and 4) cash flow / leverage as financial risk profile, before adjusting these factors with their predefined modifiers. 

Investors’ thought process is quite in line with the Standard & Poor’s framework. The best comparable will be the bonds issued by same issuer and being traded in the market, but not many companies issue the bonds with similar maturity with similar conditions. Hence, the investors should compare the bonds with other issuers’ bonds being traded in the market. To compare, the criteria to peers will include the issuers’ 1) country of risk, 2) industry risk and 3) credit ratings & outlooks. After defining the comparable issuer list based on the criteria, the investors will compare the bonds to the bonds with similar maturity, mostly as spread versus interest rate swap level[1]. 

[1]For bond valuation, investors use spread versus interest rate swap level as the interest rate swap is matching the maturity with the bond. Comparing the yield level with benchmark U.S. Treasuries’ yield can be plausible as the maturity of benchmark U.S. Treasuries are frequently updated by new auctions, while the bonds issued are gradually maturing. 

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Bond Investors vs. Stock Investors

Various studies suggested (e.g. Shi (2003)), the investors’ recognition and value can vary by the type of investors. By nature of the investment format, the difference between bond investors and stock investors can be intuitive.

Stock investors are investing for the long-term performance of the company as the stock price is a function of the company’s long-term success. This does not change even if the investor is buying the stocks to hold for short period and take profits. The price of stock is a reflection and expectation of the company’s long-term performance, so if the stock investor wants to take profit by capital gain of stock price, the investor needs to evaluate the potential of the company’s long-term success. 

Meanwhile, the bond investors’ forecast horizon should be shorter. A bond, by its structure, is basically a series of coupon payments and principal payment, and the right of reimbursement without claim for the company’s profits. In the perspective of capital gain by outperforming of the bond invested, a company’s superior performance can be positive for bond investors by lowering the absolute yield or tightening the credit spread of the bond, but they still do not share the extra profit of the company as bond holders. The bond investors’ interests are more specific, whether the companies can repay their debt on time. Thus, the most concerned question of bond investors is the default risk of the company. In other words, the possibility that they will not get repaid by the company. Implicit / Explicit Guaranteed Bonds, Asset Backed Securities, Covered Bonds and Mortgage Backed Securities, all of these structured bonds are invented to mitigate the bond investors’ concerns on default risk of issuers or borrowers. Another example can be the bad banks were created and supported by European countries that are enjoying tighter credit spreads and lower debt financing costs due to the countries’ guarantee structures. No matter how the companies’ outlook changes, as long as they feel comfortable to expect they will be repaid up to the maturity of the bond, bond investors are relatively okay not like stock investors. [1]And they would not want the companies’ excessive investments at the cost of the companies’ solvency. 

[1]The bond investors can suffer from downgrade of credit ratings, especially when bonds get downgraded below BBB- to high yield bond, as they can get forced to sell at loss due to their investment mandate. In addition to this, a sudden underperformance of their invested bonds can impact on their mark-to-market value of the portfolio. The word “relatively” was used because of these reasons.