What is Fixed Income?

Fixed income comprises of financial instruments where there is a known, contracted return. For instance, if someone purchases a bond with a face value of $100 and a coupon of 5% paid semi-annually, they know that they will receive $2.5 for each $100 he holds every six months until the contractual maturity date.

This does not factor in the risk of not getting paid if the counterparty (the debtor) defaults on their end of the obligation. Should the debtor be unable to pay interest, the investor may have principal paid off in whole if the underlying assets are enough to cover the debt, in-part or receive nothing at all.

The value of fixed income is inherently the contracted cash flows discounted by the expected loss on the instrument – or the default risk multiplied by the loss given default.

Characteristics of Bonds and Fixed Income

Bond returns have a more certain component to them than stock returns. Fixed income is contracted cash flow. An investor knows exactly what they will receive if the contract is held to maturity (there is a ceiling on return).

Unlike stocks, it is not a claim on ownership – as such, investors cannot participate in the upside of a business – or the risks and rewards of ownership. However, in any bankruptcy or liquidation scenario, fixed income has seniority over stocks. As such, fixed income is “safer” than equity and as such must offer a lower expected return.

As it follows, fixed income is much more predictable and less volatile than stock ownership and are an important component to balanced portfolios. The less risk an investor can take, the more of an allocation they should have in fixed income relative to equities. Generally, when unsophisticated investors invest in fixed income, it is usually a basket of short to medium term government bonds and blue chip investment grade company bonds – both of which are relatively safe investments.

Most people associate fixed income with bonds – however, fixed income as an asset class includes many other instruments.

Who Invests in Bonds?

The bond market is huge and several times larger than the stock market (although it receives much less attention in the news).

Investors in bonds include governments, corporates, financial institutions, individual investors, exchange traded funds (ETFs), pension funds, hedge funds, and bond mutual funds.

Risks with Investing in Bonds

• Spread Risk – Corporate spread versus the risk-free government bond; the flight to safety
• Interest Rate Risk
• Industry Risk
• Default/Company Specific Risk – this can be Liquidity Risk or Solvency Risk
• Sovereign/Expropriation Risk
• Inflation Risk – the loss of purchasing power
• Option Risk – Catastrophe bonds, call options
• Foreign Exchange Risks – If holding bonds in a different currency than the investor’s base currency

Investing in Individual Bonds

Investing in bonds as a profitable exercise is a mentally rigorous challenge that demands a fulsome evaluation of credit, legal structures, macroeconomics, industry trends and bond math to identify opportunistic purchases.

Unlike stocks, where an attempt is made to find the intrinsic value of a company, a bond investor is looking to value a stream of risk adjusted cash flows that incorporates:

• Entity Analysis
• Credit Analysis
• Industry Analysis
• Macroeconomic Analysis
• Capital Structure Analysis

Awareness of where the security lies in terms of capital structure and the legal avenues available should problems arise is paramount in looking at risk and reward. This includes an understanding of covenants afforded to bondholders and an understanding of change-of-control and cross-default provisions found in the bond indenture.

Currently, this is beyond the scope of this website, so stick with investment grade bonds and ETFs.

Credit Analysis for Bonds

Debt Capacity

How much debt an entity can reasonably support – this is a function of free cash flows to the firm versus debt service. Debt capacity affects the probability of default. The higher debt is beyond prudent debt capacity limits, the more likely the obligor will default.

Cyclicality – Cyclical industries have more volatile cash flows and cannot reasonably support as much debt as a company that operates in a stable industry. This is especially applicable for commodity producers such as oil and gas E&P companies. An oil and gas company may be stressed with 2-3x leverage whereas a company where cash flows are fairly certain such as a utility can support much more debt.

Operating Leverage – Where a company lies on its industry cost curve also affects the debt it can sustain. A company that cannot convert much of its revenue to EBITDA, and after, EBITDA to free cash flow is challenged if there is any sort of unforeseen negative event or margin compression.

Collateral/Security on Debt

Collateral does not necessarily affect the operating business (aside from possibly making certain debt pay lower interest because it is secured and therefore safer) and probability of default – however, it affects the loss given default.

Quality of collateral is important. If the collateral is a liquid and widely traded instrument, a creditor may not need to haircut this very much.

Cash does not get a haircut. Accounts receivable from creditworthy counterparties have a small haircut due to the cumbersome nature and time discount on servicing the receivables. If the counterparties are weak, this haircut grows.

Collateral is much more difficult to evaluate in terms of inventory or property and equipment. If the physical assets are not obsolete and easily saleable or salvageable (for scrap), this may be good collateral. If collateral is intangible, the value to the creditor may be difficult to ascertain.

In addition, creditors must also assess priority of claim. If another creditor has first lien on the collateral, a creditor will have to evaluate how much they can reasonably expect to see from it.

Debt Covenants

Covenants are good safety checks for creditors and help to protect against the probability of default. Covenants are restrictive, and as such there are companies that will prefer to have a covenant-lite structure – this directly affects the cost of debt. The more restrictive the covenants, the lower the interest rate (as the debt is less risky) and vice versa.

As a debt investor, it is important to remember that company management owes a fiduciary duty to their shareholders, and nothing to the bondholders. As such, bondholders must always be careful and assume that management will opportunistically hurt creditors for shareholder friendly initiatives – this has happened numerous times in the past, where bondholders fell victim to their own poor negotiation for covenants (lack of restrictions on asset sales or dispositions). Each time the courts sided with the debtors in landmark rulings.

With this in mind, bondholders should pay special attention to structural subordination and what they have recourse to in a situation of financial distress.

Related Reading for Investing

Investment Asset Classes

Fixed Income – An introduction to bonds and other fixed income instruments
Index ETFs – An introduction to index ETFs and why they make sense versus most mutual funds
Avoiding Exchange Rate Fees at Banks for Investing and Travel
Gold
Real Estate
Taxes – All investors have to deal with taxes but it is important to know how to minimize tax drag on your investments through understanding TFSAs and RRSPs

Commentary on Investing

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