Corporate Bond Analysis: What to Consider
by Jason Brady
Many investors have become more focused on the fixed-income market in the past several years.
While bonds have been around for centuries, the most recent surge in activity has come from investors who are searching for the age-old combination of safety and income. Many individual investors have some experience with equity markets, but those returns have not been stellar over the last decade. At the same time, very high–quality fixed-income markets like U.S. Treasuries are near all-time lows in yields.
In this article
- Why Take Risk?
- A One-Bond Portfolio
- Bond Metrics and How to Think About Them
- The Four Cs of Bond Analysis
- When It All Goes Wrong
- Credit Ratings: Meaning and Default Probability
- Margin of Safety
- A Final Key
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As a result, many folks are beginning to look at “credit.” Credit can be broadly defined as any bond that has a risk of lack of payment, but we’ll restrict ourselves in this discussion to one of the largest credit markets, corporate bonds. Because these bonds reference companies, investors who have experience with evaluating stocks should find many of the terms and tools used in the analysis of corporate bonds easy to grasp, though there are very important differences that we’ll discuss below.
The obvious, but important, question investors are trying to answer when looking at corporate credit is the extent to which a company will be both willing and able to pay coupon and principal. Clearly the risk of default is a big part of why you, as the investor, are getting paid more in yield to own a corporate bond than supposedly credit risk–free assets such as U.S. Treasuries.
Nevertheless, when times are good and trouble seems to be a long way away, it can be easy to lose sight of the things that can go wrong. I distinctly remember a very well-regarded sell-side credit analyst (whose job is to look at the risk of default in every investment he analyzes) discussing Enron in 2000. His incredulous statement about the company when queried about the complex financials was, “What are you worried about? You think they’re not going pay you back?” Though at the time the company was a well-respected high-flier, the answer to that question is always “Yes.”
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