A bond’s total return comes from a number of factors, but the three largest are Coupon, Credit and Curve.  If you can remember these, you can help your chance of buying the right bond at the right time.

Coupon –

Coupon is the rate that the borrower agrees to pay you, and historically, it is the largest contributor to total return (See graph on Left).  The coupon on a bond is determined at the time the loan is originated.  Most bonds are issued with a fixed coupon.  This coupon defines the cash flow you receive over the life of the loan.  Since this coupon is set at the time the company issues the bond, the coupon reflects the credit worthiness of the company when it issued the bond.  Obviously, credit worthiness of companies improves or deteriorates over time – but the coupon doesn’t change (in some rare instances bonds have coupon steps where the coupon increases based on a rating agency’s rating, but these are few and far between).  Therefore, the way the market adjusts for any changes in a companies’ credit worthiness is through the price.  If a company was very credit worthy at the time of issuance but has declined in credit worthiness, an investor probably will expect a higher return (lower price) for that stream of future coupon payments.

Credit –

Credit refers to the ability to repay a loan.  Rating agencies have a rating system where the highest (most credit worthy) companies are triple A (Aaa  for Moodys and AAA for S&P & Fitch) and moves lower to AA, then A then BBB.  These ratings represent companies that have strong metrics in categories such as their business position, operating margins, leverage, management financial policy and whatnot.   If a company has a very strong ability to repay you, you would expect them to borrow at a lower rate versus a credit where repayment risk is higher.  The most credit worthy companies are grouped in a category called ‘investment grade’.  Less credit worthy borrowers are in a category called ‘high yield’.  High yield borrowers might have strong metrics in some categories, but they may have less credit worthy metrics in others.

 

This ‘C’ is the most important C of the bunch – since it doesn’t matter what your coupon is unless you have confidence your principal is being repaid.  The last thing you want is to generate 4% – 5% in income for 2 or 3 years – and then lose 50% of your capital.

Curve –

Curve refers to the length of maturity of the bond.  The treasury curve is usually positively sloped – which means that a borrower can expect to pay a higher rate if they want to borrow your money for a longer period of time.  The longer the maturity, the more time there is for something to go wrong with the company.  Therefore, when lending money for a long period, we prefer either to ‘move up in credit’ (which is lend to companies that have a bigger safety margin to their risk profile) or move down in price (find bonds that trade at steep discounts [see below] that mitigate the risk of principal loss but provide some upside opportunity).

 

This C is out of your control, and as treasury rates move (‘yield curve’), the price off the bond will move up and down.  However, our philosophy in Core Fixed Income is to buy bonds and hold until maturity. Therefore, we are less concerned with this factor as long as we get the right coupon and right credit.

What does all this mean?  For Ballast, it means a couple things:

• Targeting Yield – We can control the yield on a portfolio by a number levers – a couple of which are ‘down in credit’ (1) lend to more risky companies or (2) ‘go out on the curve’ and buy a 10 year bond versus a 5 year bond. In either case, the yield is higher.  However, since at Ballast we control exactly what bonds go into a portfolio, we can solve for a number of different cash flow requirements.  Unlike a bond fund (which tends to own all the bonds in an index – or at a minimum tries to mirror that index), it ends up owning a lot of bonds that as a lender you likely would not have chosen.  For example, we had one client who transferred in a bond fund, and the fund owned a negative yielding bond.  We are not big believers in paying others to hold your money – regardless of what academic literature might say.

• Finding Opportunity – Since credit quality changes over time AND a rating agencies’ ratings affect not only the price of bonds (borrower) but also the economics of those who own them (regulated investors like banks, insurance and index managers) – the price sometimes reflects other factors besides the credit worthiness of the issuer. For example, if a bond gets downgraded from investment grade (IG) to high yield (HY), it likely means that the corporation has become riskier due to some fundamental reason.  However, it also means that accounts that owned the bond when it was IG could be forced to liquidate, or they are charged more to hold that bond (risk based capital).  In both scenarios, you have what we call ‘forced selling’.  We believe – and research supports this belief – that forced selling presents opportunities.  Therefore, we constantly scour the capital markets for this type of situation. See Study here.

The three C’s of bonds are simple things to think about, but below the surface there is quite a bit that goes on. However, that is why finding an investment advisor with experience in the capital markets is valuable, and it can make a very big difference on one’s portfolio.