I was asked this question not too long ago by a fellow investor during a coffee session, and when I first heard it, I was like “Okay…is it going to be something complicated?”
After hearing out his explanation, I had gotten what he is trying to say. Basically and in gist;
a. Corporate bonds are considered long term liability, i.e. debt, and;
b. One of the rules of value investing is to find low debt or no debt companies.
So his question was if I follow (b), then investing in (a) would contradict my rule in (b).
This is a very interesting question.
A Little Bit On Corporate Bonds
A corporate bond is issued by a company, and like its government bond counterpart, it has a maturity date and a coupon rate. Unlike government bonds, however, corporate bonds tend to be shorter in nature (within 10 years or so) and pay a slightly higher coupon rate to compensate for the possibility of default risk. The main reason why companies issue bonds is to get additional funding for their business operations or large projects.
Some corporate bonds are rated by credit ratings agencies (the big three: Standard & Poor’s, Moody’s and Fitch) while others do not. Rated bonds tend to be safer than unrated ones, although the “do your own due diligence” and caveat emptor (buyer beware) logic apply.
In accounting terms, bonds are placed under the “long term liabilities” in the company’s balance sheet, since the debt is to be repaid years later. If the bond maturity is due within the same financial year, then it will be termed as “current liabilities”.
Corporate bonds have different classifications as well, using these four words for categorization; secured, unsecured, senior and junior (or sometimes called subordinated), thus we have:
a. Senior secured debt
b. Senior unsecured debt
c. Junior secured debt
d. Junior unsecured debt
These are priority levels of payout should the company goes into bankruptcy or liquidation (after other priority creditors are paid off), with the holders of senior debts (bonds) getting paid first before the junior ones. For your information, share (equity) holders of a company are ranked below junior debts.
Debt And Value Investing
Value investing is simply the purchase of equities that are undervalued with relative to their current market price, using fundamental analysis in determining the value.
Most value investors dislike debts, especially long term ones, in a company’s balance sheet, for they could be a potential time bomb; when the debts are due, a substantial amount of cash is needed to cover this, and if not enough forecast is done or the maturity date meets up with a very bad business year, then it is bad news for the company. Some companies resort to raising additional capital (through equity rights issues, bank loans or more bonds) just to cover this debt hole, and this definitely does not sit well with shareholders and bondholders alike.
The Bedokian Answers The Question
There are a few ways to answer this question, depending on one’s investment mandate, philosophy and style. The simplest answer would be a “yes, so I shall not touch any corporate bond”, and we can close off this discussion. However, we could keep an open mind and further discuss on whether there would be a middle ground, so we could give ourselves an answer phrased as “it depends”.
Fundamental analysis is still key in looking out for good and value companies, even though they may take in long term debts. Taking into account the debt nature of bonds, we could view from the dimension of a company’s sustainability of these instruments and their proportion to its assets and equity. Some of the financial ratios you can consider using for your analysis would be:
Interest Coverage Ratio (Earnings Before Interest and Tax / Interest Expense) – A measurement of the company’s ability to pay down its expense of debt, i.e. interest. The larger the ratio, the better.
Debt Coverage Ratio (Net Operating Income / Total Debt Serviced) – This ratio calculates the company’s coverage of its debt, which includes interest and loan principal. Same as interest coverage ratio, the larger it is, the better.
Leverage Ratios (Debt / Equity; Debt / Assets; Debt / Debt + Equity) – These ratios look at the portion of debt over the various components that form up the Assets = Liabilities (Debt) + Equity equation. Looking at the equation, it is preferred to have the debt portion kept small, hence for these ratios the smaller they are, the better.
To complement the ratio analysis, you could also look at the company’s free cash flow, which is cash flow from operating activities minus capital expenditure. Then you could put the free cash flow against its debt obligations for analysis.
Another point to make would be: if you buy a company’s corporate bond, try not to buy its equities, and vice versa. This is to avoid overconcentration on the same company. Also, if the company is in bad shape, both its share and bond prices would go down together, thus there is no correlation to speak of even though they are different asset classes.
With so much points made above, back to the question, to me in some ways investing in corporate bonds does not contravene value investing, but ultimately the investor must know what he/she is doing and getting into.
Happy National Day!