How to understand whose securities are worth buying and whose not, and how not to invest in bonds that will default
By lending to Gazprom or lending to small growing companies, a private investor is always at risk. Together with a representative of a rating agency and a credit analyst, we figure out how to properly assess the risks of different categories of borrowers, are there universal algorithms for analyzing issuers, what to look for in the first place when choosing bonds in your portfolio yourself and how not to invest in securities that will fall into default …
READ IN THE ARTICLE:
✔ Three echelons of borrowers
✔ Types of risks: what should a bond investor be afraid of?
✔ Credit risk: ratings to help
✔ Small cap companies: fast analysis algorithm
✔ How not to buy bonds that will default: tips from a credit analyst
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Three echelons of borrowers
The corporate ruble bond market in Russia is a popular source of capital raising for a variety of companies. Among them there are large quasi-government issuers , strong medium-sized borrowers, and small-cap companies. All issuers that borrow on the market with bonds are often divided into three echelons.
The largest stratum of issuers is the first echelon of borrowers , which include large backbone companies, as a rule, with state participation. For example, Rosneft, Gazprom, Russian Railways, Sberbank and others. Their bonds are highly liquid and low-risk. It is these “blue chips” that account for the bulk of trading on the secondary bond market in the corporate segment.
Borrowers in the second tier are inferior in terms of business scale to high-class issuers: as a rule, these are smaller non-state companies with strong transparent business and good positions in their industries. The second echelon of issuers can include, for example, Magnit, Uralkali, KAMAZ, etc.
But the business of third tier issuers is often associated with even higher risks than those of the second tier. This group usually includes small, fast-growing companies that actively invest in development using borrowed funds. Therefore, such companies, as a rule, have a high debt burden and increased refinancing risks, which the issuer compensates for investors with a higher yield on its bonds.
Types of risks: what should a bond investor be afraid of?
When purchasing bonds of a company, whether it is a first or third tier borrower, an investor always assumes certain risks to varying degrees: credit risk, market or interest rate risk, liquidity risk and even political risk, which bond investors increasingly have to take into account in last years. Now about each of them in a little more detail.
When investors expect rates to rise, they start selling bonds, as a result, the yield (to maturity) begins to increase, and prices begin to decline (due to the inverse proportionality). Conversely, when expecting a decline in rates, investors start buying bonds, and yields to maturity begin to decline, while prices rise.
Market (interest rate) risk is associated with a sharp change in interest rates. Bond prices and interest rates are inversely related (if the coupon on a security is fixed for several years in advance), that is, when interest rates fall, the price of bonds traded on the market rises. Conversely, when interest rates rise, the price of bonds tends to tend downward.
The longer the security, the higher the interest rate risk that the investor takes on. This should be taken into account when buying, for example, long bonds of reliable first-tier issuers.
Another type of risk that can trigger in the bond market is liquidity risk . It lies in the fact that at a certain point in time, you, as an investor, will not be able to buy or sell a bond at the effective price. The liquidity of a security is influenced by the volume of the issue in circulation (the larger the volume of the issue, the higher the liquidity), the diversification of the investor base: the more investors, the higher the activity of buyers and sellers in the secondary market, the greater the number and volume of transactions with bonds on the secondary market, which means the chances of getting a fair price when buying or selling a bond in secondary trading is much higher.
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Sometimes, in order to solve the problem of low liquidity of bonds, the organizers of the issue and the issuers of bonds attract market makers who support two-way quotations of securities in the auctions. The most liquid are bonds of the first echelon – these are, as a rule, large issues, the buyers of which are large institutions, for such securities large volumes of trades pass.
In general, liquidity risk is not particularly relevant for investors who purchase securities to maturity. But if the need arises to urgently sell the bond, getting money back, then low liquidity can cost the investor losses.
In recent years, the political risk associated with investment losses that can arise as a result of radical political decisions or changes has taken on a new dimension for bond investors . Political risks include, for example, the risk of imposing sanctions on individual borrowers in the bond market. As a result of such news, the quotes of the company’s bonds may collapse sharply. This happened, for example, with investors in Rusal bonds, which came under severe sanctions in April 2018.
Last on the list, but perhaps the most important is the king of risks in the bond market – credit risk or risk of default , that is, default on the issuer’s obligations. By buying a bond, you are effectively lending to the issuer. At the same time, there is always some possibility that this debt will not be returned to you. The lower this probability, the lower the bond yield. Conversely, the higher the level of credit risk, the higher the yield of the security.
Credit risk: rating to help
Unlike political or market risk, which in principle is quite difficult to insure against, there are very specific instruments for assessing and protecting against credit risk. We are talking about the system of credit ratings of international (Standard & Poor’s, Fitch Ratings and Moody’s) and national rating agencies (Expert RA, ACRA and others).
Credit ratings are the most common way to assess an issuer’s credit risk (we wrote about this in detail here ). Rating agencies have a whole range of credit ratings, but in general they can all be divided into two large groups: investment grade ratings and speculative ratings. Rating agencies evaluate the issuer of bonds according to a number of criteria and, based on the results obtained, assign him a certain credit rating: the higher the rating, the more reliable his bonds and the cheaper the issuer has the opportunity to borrow.
Source: Central Bank
Mikhail Tkach, Leading Analyst of the Corporate and Sovereign Ratings Department, Expert RA
– What information can the issuer’s rating give to a private investor?
– The rating level reflects the reliability, stability and creditworthiness of the issuer. The higher the rating of the issuer, the less a private investor can worry about the return on investment.
– What basic rules should a private investor follow when choosing which bonds to buy and which not?
– Each investor chooses the ratio of income and risk of non-return of invested funds for himself. The rating in this case is a measure of risk – a benchmark that an investor can rely on. Obviously, with similar yields, it is better to choose bonds of an issuer with a higher rating level. Also, comparing several issuers with each other, an investor, by the difference in rating levels, can understand how much the risk is offset by profitability. For example, for a company with a pre-default / low rating level, profitability that is 1-2% higher than that of reliable issuers is hardly a sufficient premium.
– What is the essence of the rating agency’s credit risk assessment methodology: what questions should an investor first of all answer for himself when evaluating a particular bond in terms of credit risk, if using the rating agency’s approach?
– The rating agency’s methodology is divided into three main blocks: business risks, financial risks and corporate risks. As a rule, the block of financial risks has the greatest influence on the rating level. Nevertheless, it should be understood that all blocks are interconnected with each other, and when assessing financial indicators, the agency takes into account both possible changes in the environment of the enterprise and the specifics of its management. Therefore, if you do not go into the possible parameters of bond issues, but make a decision purely based on the issuer’s creditworthiness, then first of all you need to assess the level of its debt burden, the availability of funds to service short-term obligations, business profitability, competitive positions and prospects for the development of the industry, as well as the level corporate governance in terms of transparency and openness of beneficiaries.
– What, from your point of view, is the fundamental difference between the assessment of the credit risk of first-tier companies and small-cap companies? What to look at first when assessing risks in the first tier and risks in the third tier?
– From the point of view of the analyzed factors, there is not much difference when evaluating a first or third tier company. Companies of the first echelon in most cases are characterized by a high level of corporate governance and disclose all aspects of their activities in sufficient detail in the public space. The likelihood that you will encounter any catch in the financial statements of a first-tier company is much lower, therefore, in this case, more attention should be paid to the market situation, the competitive environment and other macro factors. Small-cap companies are less exposed to external risks, but they are more likely to notice certain dubious transactions that can greatly distort financial performance and the true picture. Lacking additional information that the agency finds out in the course of interaction with the rated person, the private investor may draw the wrong conclusions. In this connection, as already mentioned, the rating can act as a valuable guideline when making a decision.
Credit ratings are a very convenient way to distinguish “bad” from “good”, but they are by no means universal. First of all, not all borrowers have this rating in principle. Obtaining a credit rating is a rather lengthy and costly procedure, so some issuers, even of quite tolerable credit quality, do not always consider it necessary to receive it. What can we say about small growing companies, for which the costs of rating are often quite unaffordable.
However, these mid-sized companies also desperately need capital to fund their growth. Therefore, their interest in the bond market as a source of borrowing has been steadily growing in recent years, however, as is the demand from private investors for high-yield instruments: rates on securities of quality companies are decreasing, and new borrowers on the market are ready to pay a premium for debut.
However, it is important to understand that it is up to a private investor in each case to analyze such borrowers and figure out whose bonds are worth buying, and whose bonds are definitely not. We will tell you how to solve this equation with the least loss.
Small-cap companies: fast analysis algorithm
Against the backdrop of clear and transparent issuers in the first tier, the borrower in the high yield bond (HDB) sector is a dark horse of sorts. Each such issuer is a separate story about a separate business, which has its own market with its own rules. To get a realistic portrait of such a company and get an idea of the potential risks, you will have to analyze not only the issuer’s reporting, emission documentation and presentations for investors, but also understand the regulation of the industry in which the borrower works, follow the news about the company in the media, as well as how consumers perceive the brand and its products. Such work takes time and certain knowledge. This does not mean that in order to analyze the issuers of high yield bonds, You definitely need to be a professional credit analyst and have a financial education, but you still have to master the basics of analyzing financial indicators and learn how to distinguish revenue from profit. Here are the basic rules that you definitely should not neglect if you decide to try to figure out who is who among the issuers of high yield securities.
Algorithm for the rapid analysis of the issuer VDO
- Positive cash flow sufficient to service bondsThe most important element in analyzing the financial viability of an issuer is its cash flow . If the company generates losses, then the issuer will clearly not have enough cash flow to service the bonds. This means that such a borrower should clearly not place bonds, he must finance the business with his own funds, attract investments that do not need to be serviced every quarter. Otherwise, the company itself drives itself into a trap: due to insufficient financial flow, it constantly has to attract new creditors in order to repay debts to the old ones. This is how a real pyramid appears.
- Presence of covenants in the releaseCovenants are the obligations of the issuer to play by certain rules that give bond investors additional protection and comfort. A lot of different covenants are used in financial practice.For example, changing the controlling shareholder . If a new controlling shareholder comes to the company, then the bondholder should have the right to present the securities for redemption ahead of schedule.The second popular covenant is the leverage level . For operating companies that have a B2B or B2C business, debt / EBITDA should not exceed 3x.Cross-default is also a fairly standard option for investor protection. If the company has other bond issues or loans, then a default on these obligations means a cross-default on the current issue.The list of covenants is different in each case. Here it is the very desire of the issuer to agree to special conditions and to ensure the protection of the interests of investors in order to gain access to the public capital market.
- Non-afflation of the issuer, organizer and air defenseWhen the organizer announces the placement of an issuer, this should automatically mean that the organizer has no conflict of interest. And there are such cases in the market when the organizer of the HDO places the securities of a subsidiary. This is a direct conflict of interest. In this case, the organizer is interested in hiding from investors some information about the issuer or distorting some data that may negatively affect the assessment of the issuer’s risks by investors.SAR is the market release of the organizer incurs huge reputational risks. If he sells a security to an investor, which subsequently defaults, then the next time buyers are unlikely to come to him. The organizer’s reputation is an important factor in the valuation of securities. By evaluating a bond, you are evaluating the issuer as well.Affiliation of the issuer and the air defense system is completely prohibited by law.
- Purposeful use of fundsIf the borrower is no longer a newcomer to the bond market, then while analyzing his reporting, you should pay attention to where the funds from the placement of previous issues were directed: if the company did not use the funds to invest in expanding its own business, but issued funds in the form of loans to affiliated structures, it is unlikely whether this is a reason to lend her again.If the borrower is placing bonds for the first time, it is worth paying attention to whether the issuer discloses in a presentation for investors for what purposes he plans to spend money from the placement: when, for what and in what volume.
- Offer or amortizationAn offer is an obligation of the issuing company to redeem bonds from investors after a certain period of time at a predetermined price. For an investor, the presence of an offer in the issue is an additional bonus from the borrower, which helps to reduce the risks of owning bonds, especially when it comes to long-term securities. If the financial position of the issuer deteriorates or the market situation changes, with an offer, investors always have the opportunity to exit the security before the maturity date.
- Reducing the placement price Sometimes the placement of an issue of a VDO issuer does not take place in one day, but over several weeks and even months. If the placement has not yet been completed, and the securities have already dropped in price, this means that the issuer and the organizers clearly misunderstood the pricing and are trying to sell the bonds at any price, since the issuer urgently needs the funds. Going into such an issue (despite the discount) is clearly not worth it.
- Redeemed bond issuesThe risks of running into a dubious borrower are much lower if they already have several successfully redeemed bond issues in their assets. This means that the company is far from a newcomer to the public debt market, investors trust it, and the borrower’s business is quite successful in servicing debt obligations.
- Information about the ultimate beneficiaries of the companyWhen agreeing to lend to a VDO issuer, it is better to figure out on the shore who you are lending to: what is the ownership structure of the issuer, who is nominally at the helm of the company, and to whom in reality the profit is distributed and what is the reputation of the ultimate beneficiaries of the borrower.
- Business transparency and reporting availabilityWhen looking at a new company, pay attention to how the business builds its communication with investors, whether the company has a special IR department, how fully the issuer discloses information about its financial results in the public domain, whether it regularly publishes full reports on its website ( and by what standards), whether management is ready to respond to investor inquiries.
- Availability of reports on quarterly resultsAn important element of a transparent dialogue between issuers and investors is the accurate publication of quarterly business results reports. It is good if the company regularly reports to the investment community on the dynamics of revenue , EBITDA and how the planned investment program is being implemented.
- Payment disciplineCheck on the disclosure website how carefully the issuer previously fulfilled its financial obligations to investors, whether the company did not allow a technical default (if so, for what reason), whether it made payments on coupons, redemption of par value and redemption of the offer on time.
Egor Fedorov, Senior Credit Analyst, ING
– What are the main “golden” rules a private investor should follow when making a choice, whose bonds to buy, and whose not?
– Credit rating (if there is one, it is good, if it is not there, it increases the risks).
– Shareholders / beneficiaries of the company, the likelihood of shareholder support (transparent shareholder structure, availability of surety / security from the parent company).
– The size of the company, growth rates and prospects (dynamics and structure of the issuer’s revenue).
– Debt burden of the issuer and the prospects for its reduction. The Debt / EBITDA ratio of the Russian issuer above 4.0x should already be very alarming for the investor. This is the specificity of Russian risk. For example, Asian companies may have a high debt level – higher than 5.0x, and the cost of debt – no more than 3-4%. And the rating is A +. The reason is that they borrow very cheaply. In Russia, because of high rates, companies simply cannot afford high debt.
– Transparency of the company. How often does she report her financial and operating results, whether she has an investor relations department and how responsive it is.
– Can you formulate the main questions that an investor should answer when evaluating a particular bond in terms of credit risk?
– How has the company been developing over the past couple of years and what is its development strategy?
– What is the subjective probability of default on the investment horizon?
– What bad thing has to happen for the company not to pay off its debts?
– What good do we expect from the company in the next couple of years?
– How strong is the company’s position in the industry / industries where it is present?
– How freely does the company refinance debt from banks?
– What, from your point of view, is the fundamental difference between the assessment of the credit risk of first-tier companies and small-cap companies? What to look at first when assessing risks in the first tier and risks in the third tier?
– First-tier companies are accustomed to working with the market. They are transparent and ready to answer any question. In small companies, it is very difficult to obtain operational public information. After the placement of debt securities, the investor is in an information vacuum about this company. Reports are rarely published, often late … However, in general, small companies sometimes turn out to be more interesting from an investment point of view, despite the fact that they are followed by fewer analysts. The risks are higher here, but the risk premium is also higher.
– How accurate answers can a credit rating give an investor today? Is the presence or absence of a rating critically important today in making investment decisions – if we are talking about a private investor?
– Rating plays an important and useful role. The presence of a rating means that a number of analysts have already conducted an analysis based on their own standards. Thus, the rating can save a private investor time for conducting his own analysis, that is, searching and analyzing information. The rating can and should be trusted. But, nevertheless, I would not completely refuse to conduct my own mini-analysis. First of all, look at the company’s website, watch the company’s presentation for investors, the latest reporting data. Be sure to read the press releases of the rating agencies.
– How not to buy a bond that goes into default?
– The risk of buying a default bond is higher when it comes to a small, little-known, opaque company with no contacts for investors on the issuer’s website. The absence or presence of a low rating, high debt burden, a surge in negative publications in leading business media, social networks, stagnation or problems in the industry (for example, in air transportation, oil refining, construction, small banks) are all external signals that an investor who bought bonds such a company may in the future have serious problems with the return on investment.
The most important!
✔ There are different companies on the bond market: by “lending” to different borrowers, an investor assumes different risks. So, when buying bonds of a quasi-government issuer with an investment grade rating, it is hardly worth worrying about its credit quality, rating agencies have already analyzed it. But when buying long-term securities of high grade – borrowers increase the interest rate risk. In addition, when investing in the bonds of a state-owned company, one should not forget about the sanctions. Bonds of the third echelon are practically insensitive to changes in rates and do not react to news about sanctions, but credit risks for them increase many times over.
✔ Rating is a good benchmark that an investor can rely on when analyzing a company’s credit quality. The higher the rating of the issuer, the less it is worth worrying about the return on investment.
✔ There are many promising but unrated issuers in the small capitalization sector, they will have to be analyzed on their own, this takes time and certain knowledge: you need to learn how to read financial statements, issuance documents and presentations for investors, follow the regulation of the industry in which the borrower works, and follow the news about the company in the media. Only if you have sufficient information about the company, you can correctly assess how this investment fits your risk profile and whether you are ready to take this risk.
✔ When making decisions about investments in HLO, remember about the golden rule of diversification: the more diversification, the lower the risks. It is not necessary to keep more than 30% of all assets in high-yield bonds, while in the HPO portfolio, on average, there should be 8-12 issuers