Security Analysis Part 2: Fixed Value Investments

“An outstanding record for a long period in the past, plus strong evidence of inherent stability, plus the absence of any concrete reason to expect a substantial change for the worse in the future, afford probably the only sound basis available for the selection of a fixed-value investment.”

Fixed value investments are securities with limited returns, all analysis begins there. In exchange for limited participation in the future profits of the enterprise the holder obtains a legal promise of seniority. The promise itself does not matter though, rather the ability and willingness of the issuer to maintain its promise.

Following from this, and unlike equities, bond investment should be undertaken as a process of negative screening. Whereas stock returns are skewed to the right, bond returns are skewed to the left. This means that no one overwhelming bond can lead to a positive scenario (leading to the investor ‘missing out’), but it can lead to a negative one. Given this, bonds need to be sized conservatively and diversification matters much more than in equities.

Given the sacrifices asked of the fixed-value investor, he should never pursue marginal securities. Only those of unquestioned strength are worth the sacrifice of a limited upside. There are four main principles for selecting bonds:

1. Safety is measured not by legal claim, buy by the ability and willingness of the issuer to meet its obligations.
2. This ability needs to be considered under distress as it will inevitably hand and test the value of the bonds.
3. Deficient safety cannot generally be compensated for by an abnormally high yield (for it to qualify as an ‘investment’, as a ‘speculation’ this may be the case.
4. All bonds should be subject to stringent quantitative tests and rules of exclusion, allowing for a substantial margin of safety.

Moreover, bonds are not permanent investments which can be put in a drawer and only remembered on the day interest is paid. The financial health of issuers can and will deteriorate across time and investors should be willing to sell their issues and accept losses before these snowball into default.

“The owner’s natural reluctance to accept a large loss is reinforced by the reasonable belief that he would be selling the issue at an unduly low price, and he is likely to find himself compelled almost unavoidably to assume a speculative position with respect to that security.”

Precedent Matters More than Promise

Unlike equities, fixed value investments tend to give the holder very specific sets of rights, which can lure the investor into complacency. Time and again it has been shown that covenants, seniority, and collaterals matter much less than the success of the enterprise. That being said the bond holder should insist on strong covenants and understand the details of the issue as these matter the most in times of distress.

For preferred shares it is unadvisable to purchase non-cumulative shares as the directors can disproportionately favor common stock over the preferred by refusing to pay dividends even if this is justified. There are some occasions where management has consistently paid out but again this is a scenario of the precedent of the security rather than the legal rights.

In the case of collateral, this is generally worth little as the value of the collateral is tied up in the success of the interest (there are certain exceptions such as rail cars where there is a clear market for the collateral). Collateral values tend to have high tail dependence and are worthless just when they are needed. Moreover, it is generally difficult to assert these legal rights and they are fraught with delays and fighting in the courts. Even if the collateral is sound the fact that when a company becomes distressed all securities drop, even those sufficiently reserved for are likely to depreciate causing price risk to the holder. If there are large differences between collateralized and non-collateralized securities the investor must first assess the soundness of the business, and if this is so then purchase the non-collateralized as he would otherwise likely be overpaying

In essence all fixed value investments should be considered claims against the business not against the indenture or property.

All-in Coverage Ratios

When calculating quantitative tests such as interest coverage ratio one should include all payments senior to the security as well as quasi interest payments, excluding these would be an analytical error. An example is looking at a preferred stock that is small relative to a senior bond. Even if the earnings left over after paying the bond are large it may be that the coverage of the bond is small and thus the coverage of the preferred is small as well.

A numerical example will make this clear:

EBITDA: 100

Bond Interest: 70

Preferred Dividends: 5

In the above case, net of interest, the coverage of the preferred is 6-to-1 ((100–70)/5), yet we can see it is in a precarious position as the bond is barely covered 1.4 times. The correct calculation for the preferred should be gross, i.e. 100/75.

Quasi-interest payments should also be taken into account in coverage ratios. Rent and leases are merely forms of off balance sheet financing that need to be accounted for. A retail business cannot function without paying tis rent, so this operates as quasi-interest and should be included in al coverage calculations.

Guarantee Race to the Bottom

Many times guarantees on fixed value investments will lead to unsound competition amongst the guarantors exposing the whole system. This has happened several times in history the latest being the 2008 real estate crisis. In the beginning legitimate guarantors (say insurance companies) provide a real service. With time, others enter the field and slowly relax standards and charge lower price causing the established names to ‘race them to the bottom’ to maintain market share. Eventually the whole system blows up as the guarantors were unsound.

Three conditions are needed for a sound guarantee:

1. Mortgages are conservatively financed in the first place.
2. The guarantor is a large agency independent of the mortgage originators, with a diversified business outside of real estate.
3. Economic conditions are not undergoing intense conditions.

Distressed Situations

Distressed situations tend to lead to the fear of the common stock getting wiped out and much uncertainty to the debt holders. This will many times lead to aggregate prices that are significantly below the value of the distressed assets. In this case the investor should buy both securities to assure a profit.

Bankruptcy is an uncertain affair with many competing interests. If one is not clear as to the incentives of all parts (courts, directors, stock holders, bond holders, trustees, etc.) it is advisable to stay away as information asymmetry exists and one party can take advantage of the other.

Investment Advisors

One should never rely on the advise of investment bankers. Their business (not a profession) is the selling of securities and thus is carried out as such.

Problem with investment counsel is that fees are substantial, especially in the area of high grade bonds where they represent a large proportion of the expected yield. Moreover in order to justify the high fee, advisors instead of looking for good issues (that which is knowable) will profess to forecast the trend in market and bond prices (that which is unknowable) to appear like they are doing work worth getting paid for.

“In the purely speculative field the objection to paying for advice is that if the adviser knew whereof he spoke he would not need to bother with a consultant’s duties.”