Corporate bond investors contemplate exposure to both interest rates and the company issuing the bonds. We believe bond investors’ company analysis is not dissimilar to that performed by share investors albeit through a different lens.
Shares versus bonds: A background
Shareholders are owners of a business. They can typically vote on matters such as the appointment of the board of directors, receive discretionary dividends, and benefit if the share price increases.
On the other hand, a bond is a contract akin to a loan to a company. For many retail investors it is similar to a term deposit in a bank. Bond holders (i.e. lenders) receive fixed interest payments and the promise from the company of their money back at a predefined date, known as the maturity date.
Importantly, should the company fail, bond holders come before shareholders in claims on the company’s assets, the value of which can support the repayment of the bond.
It is primarily the contracted nature of interest and repayment at the maturity date that makes bonds a less volatile form of investment than shares, where dividends are discretionary and shares need to be sold to realise the investment return.
Shares versus bonds: Analysis
Before investing, both share and bond investors need to understand a company’s fundamentals, its purpose, financial position, management quality, shareholders, industry dynamics, and forecast future performance.
However, relative to share investors, bond investors focus more on risk assessment rather that future earnings potential. A bond holder needs confidence a company can:
- Generate sufficient cash to meet interest payments, and;
- Have enough funds available to repay the bond at its maturity date.
Shares versus bonds: Documentation
Unlike shares, each bond is a unique contract. In addition to understanding the company issuing the bond it is important to also understand the bond’s terms and conditions.
Bond documentation includes details such as the interest rate, maturity date and if any asset security is provided. It also contains other important terms that can protect bond holders.
Reiterating the difference between bond and share investing, such terms, often known as covenants, frequently benefit bond holders over shareholders. For example, documentation may restrict the cash a company can pay out to shareholders, restrict the amount of additional debt it can borrow, and/or put in place financial ratios that it must meet. A recent example is Fletcher Building which is currently in negotiations with its lenders after it breached certain financial ratios.
The two key takeaways for investors are:
- The typically lower risk provided by a bond investment is important within a diversified portfolio.
- While there are many similarities between bond and share investment analysis, bond investors have a different focus – centred on risk analysis of the company and each bond’s specific terms and conditions.