Fundamentals of Bond Analysis | Barita Insights | November 7, 2022

 

Analyst Insight

Introduction
A bond is a financial instrument that generally includes two parties, the party seeking to borrow funds (issuer/borrower), and the party who has funds that are willing and able to lend (lender). Bonds are a sub-group of the fixed-income/credit market. While most persons may be more familiar with stock markets due to the coverage they receive, the global bond market is larger than the global equities market. According to the Securities Industry and Financial Markets Association (SIFMA), At the end of 2021, the global bond market stood at an estimated value of US$126.9 trillion, while the global equity market capitalization stood at US$124.4 trillion. Therefore, it is likely that at some point in your investment journey you will encounter a bond investment opportunity and it will be necessary to understand how to analyse and assess the attractiveness of the offer. Fixed income/credit analysis can get complicated; however, this article will focus on the basics of credit analysis. Also, there are different groups of issuers but for this article, we will be focusing on corporate issuers and more specifically, bonds issued by businesses.

A simple way to remember the basic items/areas to assess when looking at a fixed income opportunity is to remember the 4 C’s of credit, Character, Collateral, Capacity and Conditions.

Conditions
This speaks to the management team of the business. In examining a corporate bond, it is important to assess the people who are in charge, i.e, the executive officers such as Chief Executive Officer, Chief Operating Officer, Chief Financial Officer, etc. These are the individuals who will be making the decisions to allocate the capital you decide to lend them and ultimately determine the direction of the company. In assessing management, one can do research on the individual executive and assess, amongst other factors, their qualifications, experience, tenure at the company etc. One important way to assess management is to look at past reports and see what goals they had set for the business and then look at the business today to see if they have hit those goals or if they are on track to hit those goals. An important part of assessing management is determining if they do what they say they are going to do. Corporate bonds are either secured or unsecured. A secured bond is backed by a specific asset or a specific group of assets, which means that if the issuer defaults and is unable to repay the principal and/or interest, the holders of the bond would be able to receive those assets and sell it to recoup all or a portion of their losses. On the other hand, an unsecured bond is backed by the general assets of the company, which means in the event of default, the holder of the bonds would have a general claim on the assets of the company. Depending on where the bondholders rank in the capital – Analyst Insight Character Justin Burke Research Analyst structure, they may have a higher or lower priority claim on the assets than other capital providers. In assessing collateral, if it is a specific asset or group of assets investors can assess the marketability/liquidity of the asset(s) to determine if they are comfortable receiving that asset in the event of default. In addition to marketability and liquidity, another factor investors can assess is the volatility of the price of the asset being used as collateral. In the event that the collateral is shares of a publicly listed company, investors would want the stock price to not be too volatile, maintaining relative stability.

Capacity
Capacity deals with assessing the company’s ability to repay its debt. The number one risk fixedincome investors face is credit risk, which is the likelihood of a loss resulting from the borrower being unable to repay the amount owed. To assess capacity, multiple ratios are used with one of the most common ratios being the Interest Coverage ratio. It is calculated using the following formula: Operating Profit/Interest Expense. This indicates how many times the company can use its operating profit to pay its interest expense, therefore, the higher the ratio the better. This figure for the company can be compared with peers as well as against itself across multiple time periods. Another common ratio is the Debt Service Coverage Ratio which is calculated using the following formula: Operating Profit/(Current portion of debt/principal + Interest expense). This ratio indicates how many times the company can use its operating profit to cover both the interest expense and the amount of principal that is due in the next twelve months. There are other ratios that can be used to assess capacity, such as the Debt-to-Equity ratio and its variations

Conditions
This is typically covered in the bond’s covenants. In general, there are two types of covenants, affirmative and negative covenants. Affirmative covenants are actions that the company promises to do. An example of an affirmative covenant is presenting financial statements periodically. Negative covenants are actions the company is restricted from doing, for example, entering into a merger agreement. Investors can assess the covenants of the bond agreement and determine whether they are comfortable taking part in the investment given these restrictions and promises.

Conclusion
Fixed income analysis can get more complicated, with other areas to look at such as valuing the bond, comparing yields and spreads against comparable bonds, economic and industry analysis, etc. However, this is a good base to understand and assess the fundamentals of a fixed-income investment opportunity. Investors can do this analysis on their own, however, there are investment companies, such as Barita, with investment professionals, who are here to provide value by researching and analysing these opportunities, to publish recommendations to existing and prospective clients.

 

Written by Justin Burke
Research Analyst

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