Be Your Own Financial Advisor



November 7, 2012

While it is completely valid for an investor to rely his investments on recommendations from professional financial analysts, in the current economic condition, it would not hurt to learn how to go about searching for an investment opportunity yourself. PIMCO recently wrote an article on how to conduct Credit Research.

Before delving into details, investors have to realize the importance of top down macroeconomic analysis. Especially with fixed income securities whose values are heavily influenced by a few major indices such as LIBOR and 10-yr US Treasury, investors need to understand the current monetary policy to gauge where the interest rate will be during their investment horizon. Another important note about top down macroeconomic is that such analysis provides guidance to determine which industry sectors are growing, stagnating, or declining. For example, economic indicators such as GDP, Employment Situation, Consumer Price Index, Industrial Production and Housing Starts provide invaluable insight into major industries on a macro level. Below GDP data shows consumption trends across industries,

After top-down macroeconomic analysis, PIMCO suggests four building blocks of their Credit Research: Business fundamentals, Issuer analysis, Security analysis, and Recommendation.

Business fundamentals: First, the analyst acquires a deep understanding of the issuing company’s business fundamentals, including the competitive position and operational performance as well as wider industry trends.

Issuer analysis: The next step, a central concern of the analysis, is to assess the credit quality of a specific issuer: What is the probability and severity of default? To this avail, the credit analyst will thoroughly analyze the financial performance of an issuer, including profit/loss, balance sheet and cash flow statements, and also review the liquidity situation and potential off–balance sheet liabilities (pension liabilities, etc.)

Security analysis: Thirdly, one has to analyze the specific security and understand how different positions in the capital structure and documentation details affect a particular bond issue.

Recommendation: Finally, the best analysis is pointless if not accompanied by a specific recommendation, which takes into account the analysis from the first three building blocks and combines it with credit metrics and price information from comparable issuers and securities.

Analysis on business involves more of qualitative information than highly technical quantitative analysis. Applying Porter’s Five Forces may be one way to position a firm within an industry in terms of competitiveness, threats of new entrants or substitute products, and bargaining powers of customers and suppliers.

Moving onto issuer analysis, the goal is to thoroughly examine the financial performance and healthy of the issuer to determine if the issuer can meet the payments on bonds. Two key measures are financial flexibility and liquidity. The following metrics further detail a company’s financial position.

  • Rating
  • Net Debt
  • Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA), last 12 months
  • EBITDA Interest Coverage
  • Net Debt/EBITDA
  • Funds From Operations (FFO) /Net Debt
  • Debt/Cap
  • Five-Year Credit Default Swaps (CDS)

Source: PIMCO

In analyzing the specific issue of security, investors need to examine the capital structure and bond indenture which contains covenants of the bond.

The position in the capital structure is critical for assessing resilience to shocks and ultimately the recovery prospects. In a typical capital structure that contains both bonds and secured bank loans, bank loans have historically seen recovery rates of about 60%–70% vs. 30%–40% for unsecured bonds according to Moody’s.

Subordinated bonds and bonds with equity characteristics, including PIK (payment in kind) notes and hybrids, have suffered over-proportionally in the current downturn. Falling asset values have eroded the “equity cushion” and have thus depressed the assumptions for potential recovery values of these subordinated securities. Understanding this effect is critical, as falling market values of assets can quickly erode the higher coupons offered by these “equity-like” instruments.

In addition to the capital structure, it is important to understand nuances in the bond documentation. Guarantees and so-called covenants are critical to help protect bondholders against unwanted actions by an issuer: outsized dividend payments, the transfer of valuable assets or subordination behind other claims. The subtle details in the bond documentation can have serious consequences for corporate bond investors.

Finally, after these steps of analysis, you should have formed an opinion whether the bond is a buy or a sell.However, one thing to keep in mind is that Rome wasn’t built in a day. Individual investors may want to build up experience by learning from trial and error in virtual markets before moving real funds to real markets.


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The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.





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