Corporate bonds are issued by companies and create a number of obligations the issuing companies must fulfill that are more stringent than when companies
issue stock. With corporate bonds, issuing companies pay bondholders interest semi-annually. For example, suppose you owned a bond that
paid a 5% coupon and you owned 10 bonds. For each bond you owned, you would receive $50 of interest each year and that interest income would
be split into two semi-annual payments of $25 each.
Below is a very basic introduction to individual corporate bonds. Please watch this video, which is a soup-to-nuts explanation of how corporate bonds work.
What is the face value of a bond?
The face value of a bond is $1,000. This is also known as the par value of a bond. At a bond's maturity date, the issuing company is obligated to repay the bondholder the face value of the bond.
How are corporate bonds quoted?
Individual corporate bonds are quoted as a percentage of their face value. Therefore, if a bond is quoted at 95.00, that bond is being valued at 95% of the $1,000 face value, or $950. Bonds that are quoted at less than their par value are said to be trading at a discount. Bonds trading above par value are said to be trading at a premium.
How much will I pay when I buy a bond?
Suppose you execute a trade today where you buy 10 bonds at a price of 90. Here's how the math works: First, each bond you bought cost $900. Since you bought 10 bonds, you will pay $9,000 in principal. In addition, you owe accrued interest since you will receive the full interest payment the next time the company pays interest. Bonds pay interest semi-annually on either the first or the fifteenth day of a month. For example, a bond may pay interest on a) February 15 and August 15 or b) on March 1 and September 1. Suppose you bought the 10 bonds on July 15 and it last paid interest on February 15. Let's assume the coupon of the bond is 5%, so the 10 bonds would pay the investor $500 of interest annually. In this example, interest will have accrued for five months plus two days, as interest accrues until the day immediately before the trade settles, which is two business days following the trade date. Interest typically accrues based on a 360-day year with 12 30-day months. Five months and two days of accrued interest is equal to: ((30 days*5 months)+2 days) / 360 = 42.2% of total annual interest or $211.11. On August 15, the investor who just bought the 10 bonds will receive $250 of interest, which is why she needed to pay the $211.11 in accrued interest to the selling bondholder.
What are covenants?
Bond covenants are effectively the do's and don'ts bond issuers must follow to stay in compliance with the bond indenture, a contract between issuer and bondholder. They govern the behavior of a company to help ensure bondholders are paid interest and receive a return of principal at maturity. An example of one financial covenant is the "Leverage Ratio," which limits the amount of debt a company can issue relative to its EBITDA, or earnings before interest, taxes, depreciation and amortization. Some investors believe covenants add 'complexity' to bonds, but, once investors understand them, they will see how they are in place for the benefit of bondholders. Be sure not to look for similar covenants in a stockholders' agreement, as you will never seem them in there.
Bond ratings scales represent the opinion of credit rating agencies as to the likelihood of a bond issuer defaulting. As shown in the following bond
ratings scale table, bond ratings begin at the top, with the Aaa / AAA rating, the highest rating a bond issuer can achieve. In fact, it's so
high that only two corporate bond issuers have the coveted Aaa / AAA rating: Johnson & Johnson and Microsoft. For bond investing newbies,
these bonds are called "triple A."
As you move down the bond ratings scale, Moody's and S&P believe bonds have a potentially higher default risk. Before we dive deeper into the bond ratings scale, it's important for investors to understand that the bond ratings scale only tells a very small part of the bond investing picture.
Bond ratings only tell investors part of the story
Bond ratings only provide the opinion of the leading credit rating agencies as to the likelihood of a bond defaulting. This is known as "credit risk" or "default risk." What bond ratings do not tell investors is whether an individual corporate bond is a potentially good investment. Bond ratings don't contemplate the price at which a bond is trading or its yield. Bond ratings don't speak to the relative value of a corporate bond investment since they do not factor in the corporate bond prices of an issuer's bonds, how they stack up to comparable bonds, and how investors should compare the risk / reward opportunity of different corporate bonds. In addition, bond ratings don't contemplate the interest-rate risk of a bond, or how sensitive the corporate bond's price will be to changes in underlying Treasury yields.
Luckily, BondSavvy factors in all of these investment considerations when we make bond investment recommendations to our subscribers.
Apart from the bond rating weaknesses mentioned above, there are two others. First, many bond ratings can go years with never changing, so investors waiting for a bond rating agency to upgrade or downgrade a bond and to use that as a 'signal' as to when to make an investment could be waiting a long time. Second, bond ratings methodologies are flawed, as they reward big companies with 'well-diversified' product lines. Large companies often have inflated bond ratings whereas the bond ratings of smaller companies are often underrated. We discuss this issue in greater detail in a blog post called "Why We Are Pouring Ketchup on Bond Ratings."
The Bond Ratings Scale
As we move down the bond ratings scale, we eventually get to bonds that are rated BBB, or "triple B." Hardly a day goes by where a pundit or some bond investing luminary talks about the BBB bond bubble, saying the leverage of these companies has reached unsustainable levels. The truth of the matter is that most companies rated BBB have leverage ratios (total debt divided by the company's EBITDA for the last twelve months) of 3.0x and less. If such companies have a responsible capital allocation policy that avoids spending billions on share repurchases, focuses investment on growing the company, and leaves some cash in the kitty for a rainy day, these companies will generally be okay and do not pose significant default risk.
It's the Investment-Grade-in-Name-Only or "IGINO" bonds that cause the biggest problem. As we discuss in this blog post, Kraft-Heinz bonds had been rated investment grade even though Kraft-Heinz's financials have been terrible and substantially worse than bonds rated below investment grade. The Kraft-Heinz bonds were beneficiaries of a bond ratings methodology skewed in the favor of global behemoths at the exclusion of smaller, nimbler, and better-run companies.
This brings us to the 'line of demarcation' in the bond ratings scale, which splits investment-grade bonds with bonds rated below investment grade, which are also known as 'high-yield bonds.' Some refer to them as 'junk bonds,' but we have never used the word 'junk' to refer to a bond. Many bonds rated below investment grade are great companies, but they are often small or the rating agencies could have a bias against the company's industry or management team. For instance, until late 2019, Moody's had rated Expedia below investment grade even though the company has a history of strong growth and had more cash than debt. Moody's reason for its ratings was that the company was controlled by Barry Diller, and that factor could result in higher leverage at some point. Talk about grasping at straws and ignoring fundamentals.
As shown below, bonds with ratings above the green line are rated investment grade, and those below the green line are rated below investment grade. The lowest investment-grade bond rating is Baa3/BBB- and the highest rating below investment grade is Ba1/BB+. In certain cases, bonds could be rated investment grade by one rating agency and below investment grade by another. Bonds rated this way are said to be "split rated."
Bond Ratings Scale for Moody's and S&P
To put bond ratings into perspective, it's helpful for investors to see examples of corporate bond issuers and the ratings of each company:
Corporate Bond Ratings as of March 19, 2020
Microsoft: Aaa / AAA
Apple: Aa1 / AA+
Wal-Mart: Aa2 / AA
Pfizer: A1 / AA-
PepsiCo: A1 / A+
Caterpillar: A3 / A
Comcast: A3 / A-
Verizon: Baa1 / BBB+
Kroger: Baa1 / BBB
Ford Motor: Ba2 / BB+
Lennar: Ba1 / BB+
Albertsons: -- / B+
Keep in mind that bond rating agencies will assign different ratings to corporate debt with different levels of seniority. For example, senior secured bonds would generally have a higher bond rating than senior unsecured bonds. Term loans and revolving credit facilities that are secured by specific collateral such as real estate, inventory, or other hard assets would typically have higher ratings than unsecured bonds. The above ratings are for the issuing companies' unsecured debt, which is typically the level in the capital structure in which we invest.
Why Bond Ratings Are Important
While bond ratings have many shortcomings, they are important for two key reasons: first, a bond's credit rating will determine how sensitive a corporate bond is to changes in underlying interest rates and, second, bond rating upgrades and downgrades can have a big impact on the price of a corporate bond.
Corporate bonds rated investment grade can be sensitive to changes in Treasury yields, as, on professional trading desks, these bonds are quoted as a spread to their benchmark Treasury. As we discuss beginning at minute mark 1:37:38 in How Do Bonds Work?, a corporate bond that matures in, let's suppose, 2035, will trade as a spread to a US Treasury bond that also matures in 2035. If the corporate bond has a yield to maturity of 3.5% and the benchmark Treasury has a yield of 0.75%, the corporate bond would have a 'credit spread' of 2.75% or 275 basis points. The credit spread represents the extra yield (or compensation) an investor receives for taking credit risk that is greater than Treasury bonds, which many believe have no credit risk.
As the Treasury yield moves up and down, so does the yield to maturity of the corporate bond, assuming the credit spread has not moved. This is a crucial point for corporate bond investors to understand, as, while investment-grade corporate bonds generally do have a lower risk of default than high-yield bonds, they are generally more sensitive to changes in Treasury yields. This is especially true for longer-dated bonds.
The other reason why understanding the bond rating scale is important is because most large bond funds can only hold bonds that have a certain rating. For example, if the bond fund's charter says a bond fund can only own corporate bonds rated investment grade, if bonds in the fund are downgraded to below investment grade, that fund must automatically sell that bond. This results in forced selling since many large bond funds must now sell a downgraded bond even if the bond is still a compelling value. Bonds that are downgraded from investment grade to below investment grade are called 'fallen angels.'
Investors in individual corporate bonds must be mindful of the existence of ratings-driven investing. When we consider bonds rated BBB and BBB-, we like to understand the downgrade threshold for that particular bond. We want to know how badly the company can perform before its ratings are downgraded to below investment grade. It's important to know this as a bond investor because, in the event of forced selling by large bond funds, fallen angels will fall in price, and sometimes the price reductions can be significant.
Often times, we find compelling bond investment opportunities in corporate bonds rated just below investment grade. These bonds are not sensitive to changes in underlying Treasury yields and, if these bonds are upgraded to investment grade, it can have a very positive impact on the bond price, as now a wider range of bond funds can buy the bond. Of course, these bonds can still be downgraded from BB to B, but investors won't witness the level of forced selling that occurs when a corporate bond becomes a fallen angel.
There are many advantages of corporate bonds relative to other investments. Individual corporate bonds offer investors strong returns but with less downside than stocks. They offer greater transparency than bond
funds and ETFs, as you know precisely the security in which you are investing and can invest according to your risk tolerance and investment returns
objectives. If you own an individual corporate bond, you pay a fee when you buy it and if you sell the bond prior to maturity. This fee
structure can offer considerable savings to the recurring fees investors pay when investing in bond funds and bond ETFs.
We believe there is far greater financial reporting transparency for corporate bonds compared to municipal bonds, as corporate bond issuers are required to report their financial performance quarterly and have other reporting requirements when material events occur at the company. Municipal bond issuers have far less stringent financial reporting requirements. Taken together, we believe investors can better assess the value of a corporate bond than a municipal bond since there is a far greater level of financial information available to corporate bond investors. This presents opportunities for corporate bond investors to achieve strong capital appreciation, and, as a result, after-tax returns that can exceed those of municipal bonds.
Please click here for a detailed comparison of the advantages of individual corporate bonds vs. municipal bonds.
Many bond investors believe a bond's yield is the only return you can achieve. Further, many media outlets such as CNBC often say "with the 10-year
Treasury yielding 3%, why would you ever invest in bonds?," implying the only bonds one can buy are Treasurys. Payment of a fixed coupon is one
of the many advantages of owning corporate bonds; however, we focus just as much on buying bonds that can increase in value and achieve a strong total
return. Our goal is to recommend corporate bonds that, over a two- to four-year period, can achieve annualized rates of return of 7-9% for investment-grade
corporate bonds and 10-15% for high-yield corporate bonds.
With strong capital appreciation, after-tax returns from corporate bonds can often exceed investment returns from municipal bonds given the more favorable tax treatment of capital gains compared to interest income.
When evaluating investment performance, investors should be wary of the prices they see on their brokerage statements, which do not show the bond's total return and often undervalue the bond held. The price shown on an investor's statement is called "an evaluated price," which is an estimated price at which a large institutional money manager could sell the bond. Investors owning smaller quantities can often achieve better price execution than investors needing to sell $1 million plus of bonds, so always check a bond's depth of book to see what the current market price of your corporate bond is.
BondSavvy Live is a bond investing education webcast exclusive to BondSavvy subscribers. Prior to each edition of BondSavvy Live, BondSavvy subscribers submit corporate bond investing questions to BondSavvy founder Steve Shaw, which he then answers during the BondSavvy Live webcast. Many BondSavvy subscribers are new to bond investing, so many questions are about bond investing basics. There are also a good number of questions about current corporate bond investment recommendations and other advanced bond investing topics. Please watch a previous edition of BondSavvy Live on this page. Please note that this webcast was previously known as BondSavvy Office Hours.
* CLARIFICATION: At 46:01, Steve meant to say “that’s why there are cases of some shorter-dated bonds having higher yields to maturity”
|0:43||3||Upcoming Subscriber Events|
|1:52||4||Update on Tiffany Bonds|
|4:11||4||Bond Information Sources|
|8:39||5||Blue Sky Laws|
|10:44||5||Recommended Quantities To Invest|
|14:21||6||Dividend Stocks vs. Bonds|
|17:00||6||Impact of Increase in Treasury Yields|
|18:59||7||Strategy for Rising Interest Rates|
|21:12||7||Does BondSavvy Consider Current Yield?|
|25:48||9||Why No Recommended Energy Bonds?|
|27:23||9||Impact of Recession on Recommendations|
|31:20||10||How To Navigate Callable Bonds|
|37:20||11||What Does Yield to Worst Mean?|
|38:58||12||Explaining Yield to Worst|
|43:23||13||Shorter-Dated Bonds with Higher Yields*|
|46:10||14||Deciding Among Bonds of Same Issuer|
|49:45||15||Timing of Bond Purchases|
|50:10||15||How Has BondSavvy’s Approach Changed?|
|53:18||16||How Use Bond Limit Orders|
|55:22||16||Understanding Quantities for Bond Quotes|
|57:07||11||Why Are Prices Shown on BondSavvy Not Real Time?|
BondSavvy provides CUSIP-level corporate bond research, which includes between 20-25 new corporate bond investment recommendations each year. Many
investors and investment advisors do not have the time to read 10-Ks and listen to company earnings calls and do the financial analysis necessary to
determine which corporate bond investments can outperform the market. We do all of this work for you and provide the information investors need
to make successful corporate bond investment decisions.
BondSavvy determines which investments present the most compelling risk-reward investment opportunities. After we make an initial investment recommendation, we monitor company earnings releases, SEC filings, and bond performance to determine if an investment recommendation has changed. We then advise subscribers to either buy more of the same bond, reduce holdings, or to sell all remaining bonds of that CUSIP.
Individual corporate bonds are a crucial component of income investing as they provide yields generally higher than Treasury bonds, muni bonds, and stocks.
Investors can choose from a wide variety of bonds based on their risk tolerance and investment return objectives.
Owning individual bonds helps income investors create a more precise investment plan than is possible with bond funds and ETFs. When you own an individual corporate bond, you have a contract with the bond issuer to pay you a fixed rate of interest and to return your principal at maturity. This enables investors in individual corporate bonds to build a reliable income stream, as compared to bond funds and ETFs, whose income streams are less predictable since the underlying holdings can change over time.
What's more, many income investors have used dividend stocks as a primary source of income investing. Unfortunately, with the COVID-19 health and financial crisis, scores of blue-chips companies have either suspended or significantly reduced their dividends. Companies that have suspended or reduced their dividends include: Disney, Boeing, Ford, Delta Airlines, Freeport McMoRan, Macy's, Darden, Anheuser-Busch, Nordstrom, and many more. All of these companies continue paying interest on their bonds, which shows why corporate bonds are such an important part of income investing.
A key benefit to BondSavvy's approach to corporate bond investing, is that we seek to complement the income investing portion of a corporate bond's return with capital appreciation by recommending what we believe are undervalued corporate bonds that can increase in price and achieve strong total returns, as we show in the BondSavvy returns summary.