Want to invest in public companies but worried about the increased risk and volatility associated with the stock market? Then corporate bonds might be what you’re looking for. Corporate bonds can be thought of as a loan made to a corporation by investors. Just like your auto loan or mortgage has a payment schedule and interest rate so do corporate bonds – but corporate bonds can be traded among investors. Let’s take a look at some of the key features and what to look for in corporate bonds.
Basics of Corporate Bonds
Corporate bonds have many of the same characteristics of other bonds such as U.S. Treasuries or municipal bonds. They pay a coupon payment (typically semi annually) and have a maturity date. Most corporate bonds are rated by Moody’s, S&P, or Fitch. Think of their credit ratings as the equivalent of a FICO rating for an individual.
A high FICO score indicates a history of timely debt payments, a higher amount of assets relative to the amount of debt (net assets or equity), and enough cash coming in to continue making debt payments. These are some of the same credit metrics we review with corporations.
Let’s go over a few key corporate bond terms.
CUSIP: CUSIP stands for Committee on Uniform Securities Identification Procedures. It is a combination of letters and numbers used to identify a specific bond or security.
Maturity Date: This is the date the bond will mature and pay par (100) plus the final interest payment.
Coupon: This is the annual rate of the interest payment on the bond. Most bonds pay interest 2 times a year or semi-annually. A 5% coupon bond will pay $25 for every $1,000 invested on each coupon date. 5% x $1,000 = $50
Price: The bond price is a function of the coupon payment and the maturity date. It is the present value of the future interest and final payment of par. Bonds trade in increments of $1,000 and the price is quoted in percentage terms.
For bond price, par is equal to 100. A bond priced below 100 is at a “discount” and a bond price above 100 is at a “premium”. That doesn’t mean discount bonds are always a good value. Instead, discount bonds are priced below par because market interest rates have risen above the coupon rate of the bond.
Yield or Yield to Maturity: This is the annual rate the bond is paying based on the current market price. Bonds will be offered by listing the price or yield.
Why Invest in Corporate Bonds?
Bond investors choose corporate bonds for the additional yield they receive above the risk-free U.S. Treasury yield. The additional yield corporate bond investors receive is called spread. Spread is measured in basis points and one basis point is equal to .01%. If a U.S. Treasury yield is 2% and a corporate bond yield is 3%, then the spread is 1% or 100 basis points.
Spread is a measure of credit risk therefore the lower the credit rating of the bond, the higher the spread should be. A bond that is rated AAA would be expected to yield less than a bond rated BBB.
The chart below shows the difference in the yields (spread) between AT&T bonds and U.S. Treasuries.
The top panel is yields with the green line showing AT&T yields and the blue line showing treasury yields. The bottom panel shows the spread (AT&T bond yield minus the treasury yield = spread).
This chart tells us an investor willing to buy a 5 year AT&T bond should receive around 2.83% while a 5 year U.S. Treasury yields only 1.77%. The additional spread received would be 1.06% or 106 basis points. Is 106 basis points enough to take on AT&T credit risk for 5 years? That’s where credit analysis comes in.
Credit Analysis for Corporate Bonds
Corporate bond credit analysis is the process of determining a corporation’s ability to make debt and interest payments. Credit research would include reading quarterly earnings reports, financial statements, and earnings calls. This is some of the same work that must be done when analyzing a stock except the analysis has different goals.
The goal of credit analysis is to determine the company’s capacity to make debt and interest payments. The goal of equity analysis is to determine the present value of future cash flows of the company. Over time, profitable companies can reinvest in their business and increase their asset base or return capital to shareholders through dividend payments and buybacks.
Since management can either use capital to pay off debt or return it to shareholders, debt holders and equity holders have competing interests. In the case of a bankruptcy proceeding, the debt holders rank higher than equity holders for claims on assets.
Here are a few key aspects to consider when looking at a corporate credit.
The maturity schedule tells the investor when upcoming debt maturities are coming due. It’s important to note the timing between debt maturities as well as the size of the maturity. Ideally, debt maturities will be staggered evenly over a number of years so debt payments per year remain relatively stable and predictable. This makes it easier to forecast the company’s ability to service their debt.
Sales and Earnings
It’s important to review the company’s recent revenue and earnings trends in addition to forecasting future expectations. If sales are deteriorating then the company will face additional financial pressures to make debt payments.
In terms of earnings, for credit analysis purposes, it makes sense to use EBITDA – that is earnings before interest, taxes, depreciation & amortization. That is because we want to know how much the company is earning before the ITDA part because that tells us the total amount of earnings that can be used on debt service.
We can then determine the interest expense coverage ratio. This tells us how many times EBITDA exceeds the amount of annual interest payments on debt.
For 2016, AT&T generated $50,194 (mm) in EBITDA. Their annual interest expense was $4,910 (mm). The interest coverage ratio is $50,194 divided by $4,910 and is equal to 10.22x. That is certainly an investment grade level of interest coverage and tells us AT&T should have not problems continuing to make interest payments on their debt.
It’s also important the company has access to liquidity, either through cash on hand, commercial paper, or a revolving line of credit. Going back to the maturity schedule, if we know that $500mm in debt is coming due in 3 months, but there is only $100mm of cash on hand, where is the money going to come from to make the debt payment? This can be done through new debt issuance and refunding the outstanding bonds, through borrowing on the line of credit, or through internal cash generation. It’s always better to have good liquidity from a bondholder perspective.
Companies with a manageable maturity schedule, stable or growing revenue and earnings, and good liquidity should be granted higher credit ratings. Likewise, a lumpy maturity schedule, falling revenue and earnings, and poor liquidity will lead to downgrades in the credit rating. Full credit analysis requires a thorough understanding of the company’s financial position and expectation on how the company will evolve over the investment horizon.
Corporate Bonds Summed Up
Corporate bonds provide a lower risk method of investing in corporations than the stock. The yield of the corporate bond should compensate for the credit risk. Riskier credit and lower rated companies should be charged higher interest rates. This means their bonds should trade at higher yields.
Proper credit analysis allows investors to make good decisions on the appropriate risk and the corresponding return requirement for their investment in corporate bonds.