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Credit Research: Invest into Bonds

Bond Analysis

"I used to think if there was reincarnation, I wanted to come back as the president, or the pope, or a .400 baseball hitter. But now I want to come back as the bond market... You can intimidate everybody".

- James Carville, 1993, Clinton campaign strategist

What Is a Bond

A bond is a loan given by an investor ("lender") to a bond issuer ("borrower") against coupon ("interest"). Borrowers may be companies or states. Accordingly, two types of bonds exist:

• Corporate Bonds help companies finance long-term corporate investments;

• Sovereign Bonds help states finance public services and governmental spending.

What Are the Risks of Bonds

Bond investors directly relate their own financial health to the financial health of the issuer. In particular, investors face the risk that (i) the issuer cannot pay (in time) coupon (entailing an event of "default") and (ii) that the issuer cannot return (in time) the principal at maturity (also entailing default).

In the wake of a default, the original investment may only be partly recovered (the so called "recovery value"), or may not be recovered at all (as the case may be with unsecured, subordinated, or hybrid bonds).

What Are High-Yield Bonds

Corporate bonds rated below a credit rating (here) of BB are alternatively referred to as ”high-yield”, ”non-investment grade”, or “junk bonds”. However, due to their interesting yield, they have attracted increasing attention among investors in recent years.

High-yield (HY) bonds have the following characteristics:

• Lower credit quality (that is, a higher default rate): only rated BB – CCC.

• High-yield bonds are usually not traded on public exchanges but over the counter ("OTC"). Put differently, secondary market liquidity is not always guaranteed and can make frequent trading a costly exercise (due to wide bid-ask spreads).

• High-yield bonds should be held for longer time periods – they are "buy-and-hold" investments, ideally held until maturity.

• We advise caution with leveraged high-yield portfolios (that is, when Portfolio 1 serves as collateral for credit which is then invested into Portfolio 2). When bond markets fall, banks typically decrease (or nullify) the bonds’ lending value (loan-to-value, also called ”LTV”). Lower lending values are followed by margin calls, forcing investors to sell the bond positions in Portfolio 2 at the worst moment, when valuations are at their lowest point.

• Lengthy bond prospectuses with sometimes complex call features make in-depth research compulsory, as potentially special contractual provisions are allowed as long as they are sufficiently explained in the bond covenant.

• High-yield bonds are often issued as callable bonds. Such bonds can be bought back ("called") by the issuer before maturity. Over 60% of all high-yield bonds are callable. Issuers typically call bonds in an environment of falling interest rates in order to refinance at a lower interest rate.

• The average default rate of high-yield bonds since 1980 was 4.4%, whereas the average recovery rate was 40%. In other words, the average credit loss on a high-yield portfolio was 2.6%. However, during a recession, default rates may increase up to 20%.

• Conversely, high-yield bonds have provided on average a total return of 9.2% per annum since 1990.

Our Bond Research Methodology

Our analytical approach combines bottom-up insights on issuers to identify opportunities we believe are undervalued by the wider market, in addition to tactical top-down calls depending on macroeconomic signals.

When lending our clients’ assets to companies or states, our priority is to make sure investors get their money back - while earning a decent return.

When studying and assessing the financial health of bond issuers we conduct fundamental credit research into the following sources:

• Country risk / industry risk / competitive position;

• Financial statements / cash flow forecasts / debt structure / coverage ratios / liquidity / management & governance / financial policy / sector performance;

• Rating reports / views of investment banks;

• Specialized financial press / market intelligence.

Daily indication and data surveillance help us identify risks at an early stage and take the necessary steps to adjust and protect our clients’ portfolios.

The ABC of Bond Rating

The ABC of Bond Analysis

ACSM | The Alternative Coupon Settlement Mechanism is a scheme under which non-cumulative bonds must meet skipped coupon payments in an alternative way. Usually, this means the issue of shares to the value of the skipped coupon.

ACCRUED INTEREST | The interest amount that has accumulated on a bond between coupon payments.

BASIS POINT | An expression used among securities traders: 100 basis points (bps) are 1%.

BOND | A bond is a loan that an investor makes to a corporation (e.g. Coca Cola, Microsoft) or to a state (e.g. Germany, Italy, Mexico), known as the "issuer", whereby the issuer promises to repay the bond’s principal (or "par value") at a future date ("redemption", "maturity") and to pay interest ("coupon") periodically (mostly annually or bi-annually). In essence, a bond is nothing else than a loan agreement between an investor (creditor) and an issuer (debtor). For convenience, bonds are typcially issued and redeemed at "par value" (which is always 100). However, over their lifetime, bond prices may vary and give rise to trading and speculation. Toward redemption, bond prices slowly approximate their par value again.

BOND RATING | Bond rating is a forecasting method consisting in evaluating the quality of a bond, based on its issuer’s financial strength (balance sheet, earning power, etc.) and the likelihood that the issuer will meet the promised coupon payments. International rating agencies mainly based in the US (such as Standard & Poor's, Moody's, Fitch) regularly issue credit ratings according to a score list (see below). Bonds with a high rating are deemed "investment-grade", whereas bonds with a lower rating are deemed "non-investment grade", "high-yield" or "junk bonds".

CALLABLE BOND | A special type of bond that can be redeemed (that is, bought back by the issuer) ahead of its maturity at the discretion of the issuer or, as is usually the case, on agreed "first call dates".

COUPON | The percentage amount of a bond’s nominal value typicall paid out (bi-)annually.

CORPORATE BOND | A bond issued in regular intervals by a corporation to raise money for capital expenditures and general refinancing purposes.

CREDIT RISK | The risk that the bond issuer (i) may default on interest payments ("failure to pay") or (ii) may not be able to return the principal at maturity ("bankruptcy", "default").

CUMULATIVE COUPON | Hybrid bonds (see below) often provide for optional coupon whereby coupon may be skipped in a given year. If coupon is cumulative, skipped coupons are accumulated to be paid at a later moment. Accumulated coupons may bear interest at a rate set out in the prospect. However, in most cases no additional interest accrues on deferred coupon.

DEFERRABLE COUPON | The prospectus of hybrid bonds (see below) often gives the issuer the right to defer (that is, skip) coupon payments without defaulting. Such deferred coupon payments are either cumulative (that is, they must be paid in full later) or non-cumulative (that is, they are lost).

EQUITY CONVERSION | The prospectus of hybrid bonds may provide, under certain conditions, for conversion into equity of the nominal value of the bond.

FLOATING-RATE BOND | A bond with a coupon linked to a short-term market rate (such as the Libor).

HIGH-YIELD BOND | A bond issued by a non-investment grade issuer with higher risk - and paying higher returns.

HOLDING-PERIOD RISK | The risk that better investment opportunities may emerge during time to maturity or that any other unforseen events may occur.

HYBRID BONDS | Hybrid bonds (also called "Tier 1 bonds", "junior subordinated bonds", or "perpetuals") are defined as a bank’s regulatory capital acting like a "safety net" which, through loss absorption, allows a bank to remain viable even when stressed and protect more senior creditors. Such bonds rank only senior to equity and often come as perpetual structures with the issuer’s discretion to call (that is, redeem) the bond at specific dates. In addition, coupons of such bonds may be deferrable and non-cumulative. In some cases, even the principal can be written down (that is, reduced) to absorb the losses a bank incurs. It is noteworthy that Tier 1 bonds are designed to absorb losses on a going-concern basis, that is, while the bank continues its business operations in an orderly fashion. In other words, Tier 1 bonds are designed to protect a bank's activities as well as its higher-ranking creditors without triggering a default of more senior-ranked bonds.

INFLATION RISK | The risk that a bond’s returns may not keep pace with inflation, thereby eroding purchasing power.

INTEREST-RATE RISK | The risk that a bond’s price will fall when interest rates rise (that is, due to so called "rate hikes" by Central Banks).

JUND BONDS | Another name for high-yield bonds.

LIQUIDITY RISK | The risk of not being able to execute a trade when selling the bond, or of having to sell at a significantly lower price, due to a lack of buyers on the market.

PAR VALUE | The bond’s nominal amount (typically 100) at issuance and maturity (also called "face value").

PERPETUAL BOND | A bond with no set redemption date unless called at agreed call dates.

PRINCIPAL | The original amount invested.

PRINCIPAL WRITE-DOWN | The prospectus of hybrid bonds of financial issuers sometimes provides, under extreme conditions of market stress, for partial or full write-down of the principal value of the bond.

PROSPECTUS | A lenghty legal document drafted by the investment bank of the bond’s issuer in which the bond’s terms and conditions are described in detail ("bond covenant").

PUTABLE BOND | Putable bonds include an embedded put option allowing the bond holder to demand early repayment of the principal.

RECOVERY RATE | The recovery rate is the extent to which principal and accrued interest of a bond in default can be recovered, expressed as a percentage of the bond’s face value.

REGULATORY CALL | If regulatory changes disqualify a financial bond from counting as regulatory capital, its issuer (usually a bank or an insurance company) has the option to call the bond. In the event such a bond trades above par value a "regulatory par call" can significantly reduce the bond’s yield, as it will automatically redeem at par, i.e. at 100, even if the bond traded above 100 before).

SINKABLE BOND | A sinkable bond is backed by a fund that sets aside money to ensure principal and interest payments. Enhanced payment protection attracts investors seeking more stability. The downside of a sinkable bond is the risk of early redemption.

SUBORDINATED BOND | Subordinated bonds (also called "Tier 2 bonds") rank below other loans of the same issuer. In the event of the issuer’s default, subordinated bondholders will not be paid until senior bondholder are paid in full. Often not much is left. While subordinated bonds are riskier than senior bonds, they are less risky than shares. Subordinated bonds may take various forms, and issuers may use different levels of subordination. Banks issue the most regulated form of subordinated bonds, as they can be used as regulatory capital. However, investors should be aware that subordinated bonds may have separately defined contractual features and, in theory, any clause is legally possible as long as it is appropriately explained in the prospectus.

YIELD TO MATURITY (YTM) | Yield to maturity is the real return earned by the investor when purchasing a bond on the market at any point during the bond’s lifecycle - and holding it until maturity. The yield to maturity is precisely the bond’s outstanding coupon payments plus the bond’s nominal discount (or mark-up) compared to its par value. Accordingly, yields increase when bond prices fall (thus enabling the investor to purchase the bond at a discount) – and vice versa, yields fall when bond prices increase (due to higher demand).

YIELD TO WORST (YTW) | The lowest yield an investor can expect when investing in a callable bond.

YIELD TO CALL (YTC) | The indicative annualized yield under the assumption that the bond will be called (that is, redeemed by the issuer) at the next scheduled call date.

ZERO COUPON BOND | A bond without coupon payments, but only one (bullet) payment at maturity.