Bonds - An Introduction

From time to time I pick on the WSJ but, in general, they have a lot of solid and interesting articles. Last week they had an article titled "Debt-Driven Deals Shake Up Holders of Highly Rated Bonds" that led into a topic I wanted to cover in my investment series... bonds.

What Is A Bond?

In the simplest terms, you purchase a bond in multiples of $1000 on 1/1/07 and then you receive interest payments at a fixed rate throughout the term of the bond, say five years at 6%. In this case, the cash flows would be as follows:

1/1/07 - pay $1000
1/1/08 - receive $60 (year 1)
1/1/09 - receive $60 (year 2)
1/1/10 - receive $60 (year 3)
1/1/11 - receive $60 (year 4)
1/1/12 - receive $1060 (year 5)

In this example you pay out $1000 and receive $1300 over the five year life of the bond, for a net gain of $300. The different elements of the bond include 1) the principal amount (purchase price) 2) the maturity date (when the bondholder receives back his initial investment) 3) and the coupon rate (interest rate).

This example is dramatically simplified. Often bonds are not sold for their face value, they are sold at a discount or premium depending on the coupon rate being offered against the current interest rate. If you purchase a bond on the secondary market (i.e. not from the initial issuer) they generally will be purchased at a discount or premium. The bond can pay interest semi-annually, and may not pay interest at all (zero coupon bonds), rather you just buy them at a discount and receive the full principal at maturity. As usual, there is a decent overview at wikipedia...

General Types of Bonds:

There are three main types of bonds 1) municipal bonds 2) other government bonds (taxable) and 3) corporate bonds. Municipal bonds are generally tax-free except in certain instances (private activity bonds for the AMT) which allows them to be issued at a lower coupon or interest rate than equivalent government bonds (approximately 30% or so less for equivalent credit quality). Other government bonds, mainly US Treasury Bonds, are viewed as having no "default risk" because they are backed by the full faith and credit of the US Government (if the government fails, then we are all doomed anyways). Corporate bonds are taxable like US Government bonds and sell at an interest rate higher than government bonds because they do have a default risk.

Rating Agencies:

The rating agencies (Standard & Poors, Moody's) are firms that review bonds when they are issued and give them a rating based on their credit quality. While the two firms use slightly different rankings, generally AAA is the highest quality with very few members and they go all the way down to "junk ratings" which are perceived to have a very high likelihood of default. As issuers move from AAA down to junk, they pay a higher and higher interest rate "above" the Treasury rate; an AAA issuer like General Electric might pay only 1% above an equivalent government issue (or less) while a junk bond issuer might pay 5% above the government rate. In general, the long term debt of the US government is paying about a 5% coupon, the average for high quality corporate bonds is about 6%, high yield (junkier, but not junk) is paying about 7% and junk bonds are paying 9%. Thus the "risk premium" for holding the worst debt is only about a 4% spread (9% - 5%) over debt with no default risk.

The rating agencies look at many criteria when they make their decisions on how to rate the bonds. They look at the financial statements of the companies issuing the bond, they talk to management, and they look at the overall economic environment that the company is facing if it is unique to their industry.

Impact of Leveraged Buyouts:

When you buy a highly rated bond with only a slight premium over a government issued security that has a zero risk of default, you want that company to continue its prudent ways to minimize the chance that you will end up not receiving back your principal when repayment is due. Even though a bond may be highly rated, there usually is no guarantee in writing that the company won't change their business practices in a way that would cause their credit quality to suffer. The main way that a company would go from a good credit risk to a "poor" credit risk is through a leveraged buyout.

In a leveraged buyout, buyers from outside the company (or management, in some circumstances) feel that the stock is undervalued and they raise money to buy all the stock in the market and take the company private. For example, a stock may be trading at $30 and a group of investors (or a hedge fund) might come in and offer to buy all the stock for $40. In this case, the stockholders probably will tender their shares and the hedge fund will own the company outright, because they stand to immediately earn 33% on their investment ($10 profit on a stock trading at $30).

While the current stock holders do well, bond holders often get shafted. How does the hedge fund buy out the company? By issuing debt. If a company had $1 billion in debt and a stock market value of $2 billion, a hedge fund might raise $1.8 billion in debt financing, throw in $200 million of their own money, and take out all the stock. Now the remaining company has $2.8 billion in debt and a razor thin $200 million in equity (this is a hypothetical example). In this example, a "A" rated debt issue (when they only had $1 billion in debt outstanding, before the buyout) is now effectively a junk bond issue because the company is rated on all the debt outstanding, not just the original and incremental debt. If the company can't pay interest or principal on its debt, all of its issues suffer (some debt may be secured by assets, but even in this case credit quality suffers). Per the article, the value of bonds in some cases when a leveraged buyout occurred fell by as much as 8% (i.e. a bond that you'd pay $1000 for prior to the buyout is now selling for $920) - this is a big hit in the historically safer debt market.

In the current "easy money" environment, hedge funds are having no problem lining up massive amounts of financing without having to put a lot of their own money into the effort. The result of this is an explosion of leveraged buyout deals which kills the credit quality for the existing issues.

Another variation of the same theme is that conservatively run companies may "lever up" with debt in order to fend off a potential hedge fund raid. They might buy up stock in the market or issue a lot of debt and pay a special dividend to stockholders of record, which may increase the stock value but punishes existing bondholders. While this activity has always occurred in the markets, the easy availability of credit is making it more frequent.

Per the Article:

The article points out that some issues are including "change of control" provisions that protect debt buyers. In an example, if someone comes in and buys the company, the existing high quality bonds need to be paid off up front and then the company can issue junk for the rest of the debt. If you invest in individual corporate bonds, you should look to see (or ask your broker) if there is some sort of protection for bondholders in the event of leveraged buyouts, which are otherwise poison for your investment.

One point that wasn't really touched on in the article is that companies may be acting in a deceitful way when they talk to the rating agencies in a conservative manner in order to issue debt with a low premium (low default risk) and then they turn around and run the company in a riskier manner (issue a lot more debt that wasn't disclosed) in order to increase stockholder returns. In hindsight it is kind of amazing that any investor takes this sort of information on faith, without a written guarantee or protection of some sort. This wasn't as big a problem in the past because there wasn't easy access to debt financing and the hedge funds weren't able to accumulate enough money to take on large companies. Today there are scarcely any companies too big for the hedge funds to go after, except perhaps companies the size of Microsoft, GE or CISCO. When a company "screwed" existing bondholders (by claiming they were going to operate prudently while they issued debt previously and then came back and issued a bunch of high yield debt) they were essentially betting the company because this meant whenever they went back to the debt markets to raise money, they would be treated as a pariah or forced to borrow at high rates. This factor used to be a big deterrent but it isn't anymore...

Summary:

Describing the entire bond market in a single post is too much, so I was trying to hit the high points for someone with a general understanding of finance and to highlight a change in the market, which is that due to the prevalence of leveraged buyouts, some bond issuers are putting in "change of control" clauses that protect previous bondholders from dilution in credit quality. This is a new trend and something that is valuable to investors. Later I will go into various elements of the bond market in more depth, including describing how mutual funds that hold bonds behave differently than the bonds themselves.