Fundamental Fixed Income Analysis Techniques?

Hi all,

I've recently wanted to learn how to invest in fixed income and was wondering what models, etc. are used to evaluate these types of securities. For example, in valuing equities from a bottoms-up perspective, we use either comps or DCF analysis and I was wondering if the same ideas are used for fixed income or if it's different.

Even though I'm not sure I want to invest in fixed income professionally, I want to learn how to do it as a hobby, which is why I'm asking this. How would I go about, for example, evaluating whether a speculative/junk bond from a company like Nokia would be profitable if held to maturity? Additionally, would I even need to worry about an increase in interest rates if I'm holding securities till maturity and am basically looking to make sure that the yield I'm getting from interest and principle paydowns is secure, or do changes in interest rates still need to be monitored for an objective like this?

Thanks!

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Comments (9)

Jun 19, 2013

It can be a lot more exciting if it is distressed or in bankruptcy; however the most common ratios to look at are leverage and debt coverage (i.e. do they make enough $ to cover current portion of debt obligations).

Also,, on more technical levels, some funds use cap structure arbitrage, such as if the debt is mispriced in comparison to the equity, so on so forth. Check out website for distressed stuff: http://www.distressed-debt-investing.com/

Also check out Fabozzi Fixed Income book.

Regards

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Jun 19, 2013

Your analysis will depend on whether or not you hold bonds to maturity or buy and sell before that. Bonds have contractual coupons so you know the cash flows in advance. If you buy and hold your concern is can this company generate sufficient cash from operations to service it's debt? This involves basic fundamental analysis and cash flow modelling like that done by an equity analyst. If you're planning on actively jumping in and out on bonds you are likely going to be using relative value and comparing spreads of various bonds with similar credit characteristics. For example, 2 bonds issued by wall mart and cosco might trade at different spreads and you think they should trade at the same spread, so you might go long the bond with the wider spread and sell when it converges.

Jun 19, 2013

You care about different things with fixed income (i.e. will you get paid back with interest?). So to the extent you can quantify that via leverage and coverage ratios you should. Bond prices and yields are pure math. The amount of work you have to do to feel comfortable with a debt investment is a lot lower than an equity investment IMO (with the exception of distressed-type situations). You still want to look at the financial statements and overall business.

If you are going to hold to maturity, then you don't really care about interim moves, unless you're using leverage and have to monitor prices for calls. You do care about moves caused by changes in the underlying business, though, which could signal a change in the likelihood of the company's ability to take out your debt.

One thing to always do is analyze the entire capital structure to see where your prospective investment falls in terms of seniority and collateral. Also, understand where the securities are trading that are both junior and senior to yours to see if you're missing anything, or to identify capital structure arbitrage opportunities.

Jun 19, 2013

I am an analyst at a fixed income firm. Like others mentioned we look at coverage ratios, free cash flow, and attractiveness of the debt, ie spread over the curve. We also focus on consistent revenues and operating margins.

Jun 19, 2013

Wow, thanks everyone for responding so quickly. Let me attempt to further clarify my goals with FI investments. Essentially, I'm looking to hold the bond till maturity and am mostly looking to analyze speculative/junk grade companies that would have a fairly decent yield. Therefore, I'm mostly looking at how I would go about analyzing whether or not a firm (maybe even countries if I ever decide to look into public debt) will be able to pay me back with the interest. A lot of you already mentioned this, but I just thought I'd clarify once and for all.

Looking at firms such as Microsoft aren't that exciting to me (seems pretty safe and thus would have an unattractive yield) , so for my own sake, I'd probably venture more into companies that are struggling but still aren't extremely risky either (hence why I mentioned the example of Nokia). If I ever did this professionally, I too would hope to work on the distressed/hyper-risky type of securities, but I'm not sure at the moment if I want to pursue investing professionally as a career (we'll see if I change my mind).

Are there good books on analyzing securities with my goals? One person mentioned a book by Fabozzi, which I will look into, but any others?

Thanks again!

Jun 19, 2013

The Bond King by Bill Gross will be excellent if you're interested in FI.

Jun 19, 2013

Once again, go to distressed-debt-investing.com: has lists of books, other blogs, legal rulings implicative to distressed investing, company reviews, etc.

Jun 19, 2013

In a nutshell:

Fixed Income (IG or HY) = Equity + Interest Rate + Default Probability + Technicals = Fundamentals + Macro + Idiosyncractic + Investor Psychology + Capital Flows

You're welcome.

Jun 19, 2013