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Home > Asset Management Checklists > Trading in Corporate Bonds: Why and How

Asset Management Checklists

Trading in Corporate Bonds: Why and How


Checklist Description

This checklist outlines why and how corporate bonds are traded.

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Definition

The term “corporate bond” is, from time to time, used to refer to all bonds except those issued by governments in their own currencies. However, it should actually be applied only to longer-term debt instruments that are issued by corporations.

Corporate bonds promise a higher return than some other investments, but the higher return comes at a cost. Most corporate bonds are debentures, which means that they are not secured by collateral. Investors in these bonds must take on not only the interest rate risk but also the credit risk, which is the chance that the corporate issuer will default on its debt. It is important that investors in corporate bonds know how to weigh up credit risk and its possible payoffs. Rising interest rates can reduce the value of your bond investment, and a default can almost eliminate it. The total yield on a bond is all gains from coupons and price appreciation, and current yield is that from coupon payments.

Corporate bonds are like no other bonds in that they carry an implied risk. Takeovers, corporate restructuring, and leveraged buyouts can change a corporate bond’s credit rating and price. Institutional investors use credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch IBCA to check credit risk. However, many investors also use interest-coverage ratios and capitalization ratios. The interest-coverage ratio tells one how much money the company generates each year to fund the annual interest on its debt. The higher the ratio the better, but a company should at least generate enough earnings to service its annual debt. The capitalization ratio shows the company’s degree of financial leverage. The lower the capitalization ratio, the better the company’s financial leverage.

There are also other risk factors. If the bond is callable, the company has the right to buy it back after a period of time, while the poison pill provision permits shareholders to buy stock at a heavily discounted price to prevent or hinder takeovers. Putable bonds have a feature designed to protect against interest rate fluctuations, which allows the holder to return, or “tender,” the bond to the issuer at par before the bond’s maturity date. With junk bonds (i.e. those rated below S&P’s BBB) the risk of losing everything is high and investors should consider the diversification of a high-yield bond fund, which can support a few defaults while still giving high returns.

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Advantages

  • Corporate bonds offer higher yields than their treasury equivalents. If you can spot the right investment, the compounding interest over the life of the bond can be quite astounding.

  • The default risk on corporate bonds can be quantified using spread analysis, which seeks to determine the difference in yield between a given corporate bond and a risk-free treasury bond of the same maturity.

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Disadvantages

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Action Checklist

  • Assess the bond’s credit risk rating in lists published by Standard & Poor’s, Moody’s, and Fitch IBCA.

  • Analyze the credit risk and remember that bonds may have multiple issuances; each of these issues will receive different ratings from the credit agencies due to the fact that they have different repayment structures and conditions.

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Dos and Don’ts

Do

  • Use interest-coverage ratios and capitalization ratios to back up the ratings given by Standard & Poor’s, Moody’s, and Fitch IBCA.

  • Think about investing in a high-yield bond fund, which can support a few failures yet still provide high returns.

Don’t

  • Don’t take on credit risk or default from a single corporate bond issue unless you are receiving enough extra yield to cover the risk.

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Further reading

Books:

  • Crabbe, Leland E., and Frank J. Fabozzi. Managing a Corporate Bond Portfolio. New York: Wiley, 2002.
  • Swensen, David F. Unconventional Success: A Fundamental Approach to Personal Investment. New York: Simon & Schuster, 2005.
  • Wilson, Richard S., and Frank J. Fabozzi. Corporate Bonds: Structures & Analysis. New York: Wiley, 1995.

Article:

  • Investment Adviser. “The complete James Bond guide to investing.” (May 21, 2007). Online at: tinyurl.com/64brvgj

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