Understanding Bonds (Part 2) So… How you do you go about valuing a bond and determine whether it’s a suitable investment in terms of overall return and risk? While stocks are measured by free cash flow, earnings per share, and sales growth, bonds are priced according to current interest rates, risk, and their ratings according to agencies like Moody’s and Fitch. While interest rates were largely covered in part 1, I’ll be focusing on risk and ratings in this section. The largest contrast in return between stocks and bonds come during what are known as bear markets, or periods in time when stocks experience nearly parabolic drops in prices that is usually due to a recession or other large (& negative) external event. For example, in the past 6 years we have experienced the Great Recession, whereby most stocks lost between 50-80% of their level, and the Debt Ceiling debacle of 2011 where the S&P 500 dropped 19.4% - just below 20%, which is the percentage that indicates a bear market itself. Both of these events caused what is known as a “flight to safety (or quality)” whereby investors dumped their stock holdings and used that capital to invest in bonds instead. This leads to an increase in demand of bonds, causing the prices to be bid up and interest rates on bond payments to decrease simultaneously. When a bond is initially issued, for a very short time period, it can be purchased at what is known as par value, before either being discounted if interest rates rise or bought at a “premium” if interest rates decrease. Of course, you want to purchase a bond that is either at par value with an attractive interest rate yield, or at a discounted rate since interest rates have gone lower. Remember, Interest rates and bond prices move in the opposite direction of each other. Thus, the risks involved in purchasing a bond include primarily inflation, which, when rising has historically had an incredibly positive correlation to equally rising interest rates. In addition, default risk, callable risk (which will be discussed in Part 3), liquidity, and so forth are also significant factors to consider. All of these areas are quantified by a rating from agencies like Moodys & Fitch who provide ratings ranging from C-AAA depending on creditworthiness. Its very similar to an individuals credit score in that the better the rating, the lower the interest rate businesses will be able to issue their bond offerings at. Anything above BBB- or higher is considered investment grade and anything below is considered a junk bond which dramatically increases the interest rate they need to offer as many investors require a high premium for the added risk. The final portion of this blog will explain the aspects of holding a bond based on time horizon and the agreements set up at the onset of the purchase. Stay Tuned & Stay Thirsty! Auzzi
Posted on: Mon, 25 Aug 2014 03:30:46 +0000
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