Bonds: Risk, yield and spreads (article)

Bonds: Risk, yield and spreads
Patrick Bloomfield. Canadian Shareowner. Windsor: Mar/Apr 1999. Vol. 12, Iss. 4; pg. 56, 2 pgs
Abstract (Summary)
When buying bonds, look at market risk and credit risk. Market risk in the bond market is the fear that accelerating inflation, a credit crunch or central bank intervention will send interest rates higher and the prices of debt securities lower. Credit risk is the potential for the credit ratings of the company issuing the bond being reduced or eliminated, should the company's perceived ability to service its debt either diminish or disappear. To best fit the need to diversify a pure stock portfolio, the best quality of all are Government of Canada bonds.
» Jump to indexing (document details)
Full Text (1041 words)
Copyright Canadian Shareowner Magazine Inc. Mar/Apr 1999
STOCKS
Though you may not be consciously aware of it, when you study a stock using the Stock Selection Guide you are also assessing two kinds of risk - market risk and stockspecific risk.
You run your eye over the growth record of the company to evaluate the risk of that growth petering out. You also use the price/earnings and dividend yield evidence to assess the price you are being asked to pay, which is, in turn, a reflection of the degree of risk that investors as a whole are currently prepared to take by committing money to stocks.
BONDS
When you buy a bond, you go through much the same exercise. Only this time you are looking at market risk and "credit risk."
Market risk in the bond market is the fear that accelerating inflation, a credit crunch or central bank intervention will send interest rates higher and the prices of debt securities lower.
Credit risk is the potential for the credit ratings of the company issuing the bond you intend to buy being reduced or eliminated, should the company's perceived ability to service its debt either diminish or disappear.
The word "perceived" is italicized simply because a company or an individual's creditworthiness has to be a matter of judgment.
MEASURING CREDITWORTHINESS
There are many statistical measures of creditworthiness. In the case of corporations, the number of times that annual interest payments are covered by earnings before interest and taxes is an obvious and simple one, and one that readers in the securities business will have diligently slogged through as part of the Canadian Securities Course.
When it comes to governments, one is looking at a somewhat different set of measurements, including the strength or otherwise of the revenue base, the existing debt load, the state of the economy, and politicians' spending (or saving) intentions.
CREDIT RATING
In each case, the four rating agencies covering all or part of the Canadian debt markets - the Dominion Bond Rating Service (DBRS), the Canadian Bond Rating Service (CBRS), Standard & Poor's and Moody's - do a lot of very detailed investment math.
When it comes to corporate debt, they also take into account the outlook for the business sector in which a company operates, management strength, the impact of coming acquisitions, and profit potential (or lack thereof).
That is why a change in rating can have a pretty significant effect on the rate at which a country, province or corporation can raise money in the capital markets.
For corporations, a downward revision can have a particularly drastic effect, because it may well lower the rating to a point where the corporation's bonds are no longer either suitable or eligible for institutional investment.
The highest rating is pretty nearly always the debt of a central government.
In most countries outside Russia it is the central government that has the taxing power to raise taxes (and, hopefully, revenues) whenever there is any threat that interest payments will no longer be adequately covered.
BOND YIELDS
Thus Ottawa's domestic debt gets the highest rating from Standard & Poor's (triple A), DBRS (triple A) and CBRS (AA+). Even here, however, opinions differ. Moody's rates our federal government's domestic debt at its second highest notch (Double A1).
In turn, Government of Canada bond yields (4.90% for five-year maturities, 5.01% for 10-year and 5.32% for 30 year at the time of writing) are the yields against which the rest of the market is priced.
For instance, the Ontario government's ratings (double A from CBRS and single A, high, from DBRS) are a notch or more lower than Ottawa's - and an Ontario bond with 30 years to run was priced the same day at a yield of 5.76%.
Progressing further down the ratings scale, and further up the yield pattern, corporate bonds generally have lower ratings and higher yields.
YIELDS SPREADS
Loblaw Companies Ltd. has a low A+ from CBRS (indicating pretty good quality) and a high A from DBRS (indicating satisfactory quality). Its bond with a shade less than 10 years to go was priced the same day at 6.51%, something more than a percentage point higher than the Government of Canada 10year level.
These, however, can never be absolute comparisons. In practice, there are other significant differences between the federal, provincial, municipal and corporate bond markets.
The Government of Canada market is the largest and most liquid of the four.
One portfolio manager responsible for the bond holdings of a bunch of sizeable private clients argues that there is often little reward in seeking a modestly higher yield for the additional risk of venturing outside Government of Canada's.
Like others of the same view, he might include provincial bondholdings - if he were satisfied that his clients were being correspondingly rewarded. John Grundy, a seasoned bond hand well known to the Toronto community and now living in Regina, argues in his set of web pages that the time to buy corporate bonds is when there is an international flap on and investors are stampeding for the best investment quality they can find.
He cites the flight to quality last fall as a great example. Yield spreads, which had been unusually narrow, widened to the point where there was an unusually high reward for doing the opposite to the crowd and buying good-quality corporates.
Since then, the yield spread has narrowed, but by no means universally, suggesting there are still opportunities out there.
DIVERSIFICATION
Whether they are ideal opportunities for readers of this publication is another matter. In most instances, the need will be to achieve some diversification of the risk of a pure stock portfolio. In that instance, the best quality of all, Government of Canada bonds, would seem to fit the bill better than most.
A complaint I have also heard is that it is a tough task finding the necessary diversification for the relatively modest proportion of a private investor's portfolio that would typically be allocated to the corporate bond market.
That is likely to change as governments pay down their debts and corporate borrowers increase their share of the market.
On the other hand, that same process will likely put a greater premium on a reduced supply of Government of Canada and provincial issues.

WIIL YOU ADOPT QFR

Financial professional, it’s time to give the public as much accurate financial information as you can

THE TRADITIONAL REPORTING MODEL
“Have been conceived and implemented in concert with the naïve assumption that capital market depend on totally on managers to provide public information”
»Traditional model: generally accepted accounting principle (GAAP) emerges from a political process that’s too contentious and compromised to deliver to useful information that the market need.
» QFR: likewise try to build better relationship with the capital markets by providing tha best financial statements you can
SOLVING THE PROBLEM
“Capital markets have needs and desires for financial information that aren’t addressed by traditional public report”
» lack of information à make 3 outcomes possible
lack of useful information in a company’s financial statements may cause the markets to pursue other investment opportunities
the markets may decide that the company’s investment potential is great, even though the reported information inadequate
sophisticated investors and credit will turn elsewhere for private information that’s more useful than GAAP financial statement
» more complete information à higher security prices
Incomplete information à lower security prices
QUALITY FINANCIAL REPORTING – A SUPERIOR STRATEGY
“Adopting QFR has positive effect for essentially everyone directly or indirectly involved in the market “
» Have benefits for: managers, stockholder, all investors and creditors, the economy operates, and society as a whole
» Two groups will lose:
Those who have somehow fooled in the markets.
those who successfully cheat the markets with illegal insider information
THE HIGH ROAD
There are three “high road”
doing what the FASB has recommended instead pf merely doing what it has permitted (the save one)
to engage tough auditors and do what they say instead of picking cheap and easy auditors who do what to you say
To branch out into new areas based on your own market research and common sense as to what helps statement readers make better decisions.
AN OBJECTION
“Honestly when we applied QFR you might allocate more cost because higher preparation cost created by additional reporting and auditing effort, but when we see this from “cost and benefit” poin of view, we still can get more benefit from applied QFR”
ARE YOU READY
“Permanent improvement in accounting practices and in methods of corporate reporting cannot be brought about by legislation or by government regulation.”
The big question is “are you ready to improve the quality of your financial reporting policies has come.

PEER PRESSURE

PEER PRESSURE
Industry group impact on stock evaluation precision and contrarian strategy performance
INTRODUCTION
» stock valuation and portfolio—two core activities for equity investment managers
» stock valuation practitioners talk in term of the price/ book multiple
Academic researcher prefer analyzing this ratio in its inverted book-to-market form
Simple way: practitioner use of the ration for individual company, and academic researcher use for portfolio construction concern the universe of stock considered
» effectiveness of contrarian portfolio strategies:
1. short over a universe of all listed stock
2. generally focus on a narrow group of firm drawn from the same industries
» test whether the peer group perspective actually improvement upon assessment of relative value:
· first Examine the usefulness of book-to-market, cash flow-to-market, earnings-to-market ratios in explaining the cross-section of observed individual stock values
· Second we analyze the predictive power of an individual firm’s initial peer group valuation ranking for subsequent moves in its own ratio.
· Finally, we specifically highlight industry effects on portfolio design and returns to contrarians strategies
LITERATURE REVIEW
» lie and lie {2002} Apply the multiples-based firm valuation model in a peer group setting where industry peers are determined by SIC groupings
Interest lies in determining an individual firm’s initial value classification for its predictive power for future value ratios and stock return
» Dremen and Lufkin {1997} Analyze returns to contrarian strategies using relative-value rankings and compare them to returns from corresponding rankings based on aggregate market wide sorting.
DATA AND PEER GROUP CONSTRUCTION
» use monthly return, prices, and adjustment factors from the centre for the research in security prices monthly file
» Financial statement data come from the comp stat
» use firm’s market equity
» Kim and Ritter (1999) emphasize investment bankers use valuation via median peer group characteristic multiples for prospective IPO
USING CHARACTERISTIC MULTIPLE TO VALUE STOCK
» Lie and Lie (2002) by presuming that forming industry peer groups improves valuation precision
» industry based median ration approach significantly reduce stock pricing error compared aggregated median ratio approach
» using estimate from both equation that tell consistent story: currently observed stock prices cheapness or richness based on peer group ratio analysis tend to pesist over a one-year based.
DO RANKING PROCEDURE EXCESS RETURNS IN HEDGE PORTFOLIO
» the basic pattern found earlier tends to hold here as well: the industry-sorted peer group outperforms the aggregate approach.
RESULT FROM DECILE PORTFOLIO
» Our two key equal-weighted portfolios have been created by drawing the cheapest stocks and the richest stocks in each industry
“This hedge portfolio has no net exposure to industry effects”
CONCLUSSION
“Industry effects have material a material impact on portfolio risk”“ contrarian strategy portfolio performance is significantly improved in risk-adjusted term, when implemented in its industry-neut

Bonds: Risk, yield and spreads (my job)

STOCK
Assessing two main risk: market risk and stock specific risk
BOND
Assessing two main risk: market risk and “credit risk”
Market risk: Market risk in the bond market is the fear that accelerating inflation, a credit crunch or central bank intervention will send interest rates higher and the prices of debt securities lower.
Credit risk is the potential for the credit ratings of the company issuing the bond you intend to buy being reduced or eliminated, should the company's perceived ability to service its debt either diminish or disappear
MEASURING CREDITWORTHINESS
Corporate: many statistical measures
Government: somewhat different set of measurements
CREDIT RATING
4 rating agency Dominion Bond Rating Service (DBRS), the Canadian Bond Rating Service (CBRS), standard & Poor’s, and Moody]
A change in rating can have a pretty significant effect on the rate at which a country, province or corporation can raise money in the capital markets
The highest rating is pretty nearly always the debt of a central government
BOND YIELDS
Corporate bonds generally have lower ratings and higher yields.
YIELDS SPREADS
Yield spread, is depend on the investors decision. Because, there are different return and also different risk.
It can never be absolute comparisons. In practice, there are other significant differences between the federal, provincial, municipal and corporate bond markets. DIVERSIFICATION
In most instances, the need will be to achieve some diversification of the risk of a pure stock portfolio