Bernard Hickey: Avoiding bad bonds

Investors rushing into corporate bonds for higher returns should ask their advisor 10 key questions.

What is the bond's credit rating?

A BBB- or higher rating from Standard & Poor's is judged to be investment grade. Ratings from Moody's and Standard & Poor's are deemed more useful and reliable than those from Fitch and AM Best. Avoid anything without a credit rating. Some investors have been burned by the AAA credit ratings assigned to toxic mortgage-backed bonds from the US, but these ratings are still the best independent and expert assessment of credit risk we have.

What does the company do and who owns it?

If the company is a monopoly or part of an oligopoly such as the power generators, any revenue stream will be more reliable. The bond is stronger if it's from a state-owned enterprise such as Genesis Energy or a monopoly such as Fonterra that can rely on either the Government or wealthy shareholders to bail it out in an emergency.

How will it use the money?

Using the money for expansion or an acquisition is risky. If the answer is "working capital", then do some more digging. Avoid a company using the money to fill a black hole of ongoing losses.

How much debt does the company have and when is it due?

This is an important question to ask in an age when it is often difficult to roll over debt on wholesale markets or with nervous bankers. Good companies are being tripped up at present by stressed financiers. This might last a long time.

Can it pay the interest and repay the capital on maturity?

It's worth looking at how much free cashflow is regularly generated and how much "coverage" it has in terms of multiples of free cashflow to interest payments. Also, will the company be able to pay out on maturity? Could some business or regulatory roadblock stop that?

Is the bond guaranteed by the Government?

Some financial institutions are offering Government-guaranteed bonds, but the guarantee expires in October next year. Government-guaranteed bonds that mature before then are safer than those that don't and safer than unguaranteed bonds.

How does the interest rate compare to other issues of similar risk?

This is a key question. Does the return compensate for the risk? Currently, even investment grade corporate debt is much riskier than Government or bank debt because of the prospect of a long global recession. I would demand at least 5 per cent more than the safest Government debt at present for the lowest grades of investment grade bonds.

Anything with a junk or sub investment grade (below BBB-) should be returning more than 7 per cent above the Government bond yield. Given 5-year Government bonds are currently around 4 per cent, I think BBB- bonds should be offering at least 9 per cent. This means the 8 per cent offered by the unrated Tower is insufficient to compensate for the risks. It should be closer to 11 per cent. The iTraxx index, which measures the "margin" for Australian investment grade corporate debt above bond yields, is around 4 per cent. New Zealand debt should be about 1 per cent higher.

What fee is the broker/advisor receiving?

The advisor should be telling you up front.

Where does the bond rank?

If it is subordinated it ranks behind other debt holders, such as banks. A senior or unsubordinated bond is first in line for cash should the company go belly up. A secured bond is directly connected to an asset owned by the company, such as a mortgage, although this didn't provide much protection for finance company investors.

Is it convertible into equity?

Convertible bonds are riskier than pure bonds and should receive a much higher interest rate. Look at the conditions of the conversion and whether interest payments can be stopped in times of trouble.

* Bernard Hickey is the managing editor of www.interest.co.nz, a website for investors and borrowers wanting free and independent news and information about interest rates, banks, finance companies and the economy.