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Bond Analysis & Report Card
Barrons Roundtable Picks (5/7/11)
|Market Rating||B||Market price based credit rating|
Your Market Rating score is B, that means your portfolio contains bonds, as a group, that may have moderate exposure to default risk. Default risk is the risk that an issuer will not be able to pay investors their coupon payments or repay the principal at maturity. You should determine how you can restructure your portfolio to include less credit risky investments. For example, replacing low credit quality bonds that mature with higher credit quality bonds.
Research has shown that bond rating systems based on recent bond pricing, using actual trade data, are more accurate than the ratings based solely on company research. Many researchers and analysts in the financial community believe, and have shown using statistical techniques, that the market price, reflected in recent bond prices, is a more accurate indicator of the current and future value of a bond.
A bond's rating should be based on the bond's risk and monetary return. That is precisely how the Market Implied Rating is calculated. (In this case, the risk is related to the risk of default by the issuer, not interest rate risk, which is dealt with by duration.)
Each bond's % yield, that is Yield to Maturity (YTM)*, which is its rate of return, is calculated based on its recent price, coupon payments, and maturity date. The bond's YTM is then compared to the yield of a treasury bond of equivalent maturity. The yield of the treasury should always be lower than the yield of the bond, since the treasury is considered (default) risk free. Otherwise, why should an investor buy a bond, which has a degree of risk, if the investor could buy a treasury with no risk and a higher return?
The bond yield is subtracted from the yield of the treasury of equivalent maturity, the resulting spread represents the extent to which the market perceives the bond is risky. The larger the spread the greater is the perceived risk.
Bonds are rated from five stars (best) to none. Bonds with lower spreads (less risk) are given more stars than bonds with higher spreads (more risk). Ratings are calculated frequently to ensure they reflect the most current market factors.
* Some bonds are subject to a call date by their issuers that is earlier than the original maturity. The yield, called the Yield to Call (YTC), is generally lower than the YTM based on the original maturity. When this occurs, the rating will be based on the lower of the two returns, called the Yield to Worst.
|Duration||A||Long dated bonds are usually subject to more volatility as interest rates change.|
Your Duration score is A, that means your portfolio contains bonds, as a group, that have short durations, and consequently may have low exposure to interest rate risk. Interest rate risk means that rate increases could result in lower bond prices that reduce the value of your portfolio. You should seriously consider restructuring your portfolio to include bonds that have shorter durations.
Duration is the time it takes for an investor to be repaid the price for a bond by the bond's total cash flows.
For example, suppose the current price of a bond is $970, maturity is in three years, the annual coupon payment is $50, and the current market interest rate is 7%. The present worth of the coupon payments and payment of the $1,000 principal is $2,686.23. The duration, calculated by dividing the present worth by the current price is:
$2,686.23 / $970 = 2.77 years
Bonds that pay coupon interest will always have a duration less than maturity. Zero coupon bonds, with no coupon payments, have a duration equal to maturity.
Using duration, it's possible to approximate how much a bond's price is likely to rise or fall when interest rates change. As interest rates increase, a bond's price decreases.
Duration measures how quickly a bond will repay its price. The longer it takes, the greater exposure the bond has to changes in the interest rate environment. Therefore, the longer the duration, the higher is the interest rate risk (as opposed to default risk).
Here are some of factors that affect a bond's duration:
Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways:
|Income Stream & Maturity||A-||It's always a good idea to have a regular income stream paid out periodically.|
Your Income Stream & Maturity score is A-, that means your portfolio contains bonds, as a group, that have coupon payments that should provide a relatively good revenue stream.
For a bond investor seeking a stable income, bond laddering is the best strategy. A ladder strategy minimizes the effects of fluctuations in interest rates on the value of the portfolio. It also provides a steady cash flow.
A bond ladder is a portfolio consisting of bonds with different maturities.
For example, suppose an investor has $100,000 to invest. With the ladder approach, the investor could buy 10 different bonds with face values of $10,000. Each bond, however, would have a different maturity. One bond could mature in one year, another in two years and the others every year spaced out evenly over the remaining eight years. It is called a ladder strategy because the maturities appear to be spaced out like the rungs of a ladder.
Two reasons to use the ladder strategy are:
|Market Sector||F||Some types of bonds are better than others.|
Your Market Sector score is F, that means your portfolio contains bonds, as a group, that are in market sectors that have often had a poor history of not reliably meeting their obligations to bond holders. If you are a conservative investor you should consider restructuring your portfolio to determine where you can include bonds from the sectors that have had a better payment history and fewer defaults.
There are basically two types of municipal bonds issued by state and local governments: 1) General Obligation Bonds and 2) Revenue Bonds. These are defined in detail below.
Each type of bond has a higher or lower risk of default, that is, non-payment of interest or principal, based on the way the debt is supported.
While a bond's status can change from good to bad due to a credit downgrade, it can also change due to positive market events like a refinancing which results in the best of status of all, the gold plated Pre Refunded bond.
Pre-Refunded bonds are the safest of all since they are not backed by their issuer, but are backed by U.S. Treasury bonds.
Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. This is analogous to a consumer refinancing their home mortgage when interest rates drop. Once the refinancing is completed the issuer uses the proceeds of the new issue to purchase collateral, such as U.S. Treasury securities, and places these securities in an escrow account. The income from the collateral is then used to pay interest and principal on the original debt until the bond is called. The call date and price are set when the refinancing is completed.
Since they are backed by Treasury instruments, they are as safe as but generally pay a higher premium than Treasuries. An additional advantage over other bond types is that they are generally exempt from federal and state taxes, which, in effect, increases their return.
Next in order of default risk are General Obligation (GO) bonds. These bonds are backed by the full faith and credit of the states and localities that issue them.
While the issuers in theory have "unlimited" taxing authority, in reality, it may be a problem to enact these taxing powers and defaults while rare have occurred. For example, New York in 1975 defaulted on its GO Bonds, as did Orange County in California which declared bankruptcy in 1994.
GO bonds give municipalities a tool to raise funds for projects that will not provide direct sources of revenue, such as roads and bridges, parks and equipment. As a result, GO bonds are typically used to fund projects that will serve the entire community.
Next in order of default risk are Revenue bonds which are used to fund projects that will serve specific populations who provide revenue to repay the debt through user fees and use taxes, such as hospitals, universities, airports, toll roads, and public utilities.
These bonds are considered riskier than GO bonds since they depend on the revenues from the projects they fund to repay the bond debt, rather than the taxing authority of state or local government.
Revenue bonds are backed can be categorized into:
A) Basic infrastructure such as gas & electricity production and transmission, water & sewer infrastructure, or transportation infrastructure (i.e. toll roads, tunnels and bridges).
B) Specific purposes such as higher education, multifamily housing, hospitals, nursing homes, congregate care retirement communities, assisted living facilities, sales tax revenue, cigarette/liquor tax ("sin tax" collections), tobacco settlement proceeds, or for-profit entities using conduit financing to encourage local economic or environmental improvements.
Because they are not backed by the full faith and credit of a municipality, the way GO bonds are, they carry a somewhat higher default risk, but pay higher yields in return. To evaluate a revenue bond, it is important to understand the type and cash flow of the project that will be providing the revenue.
|Diversification||B||It's not wise to have too many eggs in one basket.|
|Yield||A-||Biggest bang for the buck|
Your Yield score is A-, that means your portfolio contains bonds, as a group, that are in the highest one-third of yields for bonds of similar maturity, market rating, type (General Obligation or Revenue), and state tax treatment.
Yield is considered a key factor in investing. While an investor should evaluate several factors that constitute his financial objectives including risk, steady income stream and diversification - the return, or yield, on a bond investment is a primary concern. All other investment factors being equal, an investor should choose the higher yielding investment rather than a lower yielding investment. But evaluating those “other” factors makes comparing the yields of different bonds complicated.
To evaluate yields, bonds were grouped together into equivalency classes to ensure yields are compared to other bonds with similar characteristics. Just as we wouldn’t expect the prices of two homes in different neighborhoods to be a fair comparison, we can’t compare bonds that have different characteristics. The main characteristics chosen to provide an “apples to apples” bond yield comparison include:
1. The market rating – equal number of assigned stars.
2. The type of bond - GO or Revenue.
3. The individual state tax treatment of municipal bonds categorized into various criteria.