What is a bond? and their specific standard for bond

hello friends, in today’s, article, we see the specific standard for bond investment from chapter 8 of the security analysis book and also what is a bond, how we invest in them, and what are the problems come while investing in bonds.

Previous Chapter 7

What is a bond
Principle 4: Definite standard of safety must be applied:-What is a bond

In principle 4, we talk about those states, they have their own laws and rules on those that are saving banks that can invest in specific areas.

or

they have to satisfy their criteria of states

So the author (Benjamin graham and David dodd’s) use the New York Status, because, he thinks it’s a good point to start.

After that, whatever its criteria, the author criticism them and if need to neglect them or reject them also and they modified them if required.

So there are 7 criteria prescribed by New York Statutes:

In the Coming 4 chapters we explain the 7 criteria in this, we see only two criteria.

So firstly the author explains, what the new york statute says, and what author explains his own view if they are right or wrong

General criteria prescribed by New York Statute:-(what is a bond)

  1. Nature and location of business or government business
  2. Size of enterprise, or the Issues
  3. Terms of the issues
  4. Record of solvency and dividend payments
  5. Relation of earnings to interest requirement
  6. Relation of the value of property to funded debt
  7. Relation of stock capitalization to funded debt.

Criteria 1: Nature and Location

1 ) New York Statute says, ”  You can invest in U.S. government bond, state bonds, municipal bond”

but You can not invest in foreign government and foreign corporation bonds.

2) You can invest in Railroad, gas, and telephone industry, b

but you can not invest in street railway and water companies and also in debentures of public utilities.

3) You can invest in the first mortgage on a real estate bond,

but you can not invest in all industrial bonds and also financial companies’ bonds, investment trust, and credit concern companies also.

so for this author give some problems with New York statutes

Problems with New York Statute on Criteria 1:

1 ) In any industry, we can’t invest, so this is not talking about practically way because, in the industry also, there are some companies that perform well in bad times also and we can select them.

If we neglect whole industry segment then, what remain only railroads and public utility and government bond according to the New York Statutes.

So it’s happening,  if we can’t find good then don’t go for bad.

so this is like we are doing narrow and it’s not right, so we can include the industrial also.

2) Water companies neglect the public utility by the New York Statutes and don’t give a good reason and other states include the water company and we also include them.

3) In 1938, One commitment that happens in the banking sector is in that they do the consortium of banks can waive as many rules as it sees fit, and they decide which criteria can remain and eliminate and also do modifications according to them by doing a simple variation.

so for this, the author says, ” Until now there is not any problem of consortium bank, but happen problem in future.”

so we don’t have to take tension because, nowadays, no consortium bank, that told us to do this or that.

4) Foreign government restriction is a good restriction according to the author, because, the foreign government pays or does not pay. If they don’t pay you, so you can’t force them to pay and you can’t take their asset, and revenue source,

the author gives examples of some countries that full fill the obligation and some more countries that don’t fulfill the obligations.

like those fulfill obligation country are Canada, Holland, and Switzerland, etc.

after that, the author talks about foreign company bond investment.

So many cases, present there, those fulfill the obligation by a foreign company but not that time government doesn’t fulfill it.

but sometimes the company is able to pay but the government restricts them.

So sometimes exchange is restricted on the company by the government.

so the foreign company has the ability to pay but they can’t pay, because the government does not allow it.

Criteria 2: Size of company

The author says those are a small company that is very much vulnerable at unexpected changes.

so those are big companies, they can go easily and unexpected harsh condition goes easily. means, they can pass easily in dangerous situations also.

Because, they have good relation with bank and they have lots of resources, that deals with that situation.

so New York statute, what say, about this criterion is

In railroad, in that much amount of mine is spread over the area, and in municipal bonds, that much amount of population is required and in public utility, they say different types of criteria, but in this point that much is not important, if you want to know about them then, buy a book by clicking above image of book.

So come here directly and what author reconnects

The author says, ” buy municipality bonds when the population is 10 thousand or by public utility when gross revenue is about $2 million and on the railroad, the gross revenue is $3 million

and lastly, in the industrial, the gross revenue is $5 million.

Industrial is not included in New York statute, because they don’t say, to b buy or avoid them

and author says, ” invest in industrial also.”

So large size does not mean to have safety

so it’s may happen those are the largest companies that are the weakest company.

if they have maximum debt.

So large size criteria are not affected in this municipality, railroad, and public utility,

so small and large both are the same.

but in industrial, have an effect, those are large size, they are more stable than small size.

So this is all about the two criteria for specific standards for bond investment.

How to invest in bonds from security analysis book

Hello friends, in today’s, article, we see how to invest in bonds, from chapter 7 of Security analysis. while investing in bonds, you can consider some principles of that, in we see the two principles( second and third) of investing in bonds, from chapter 7 of security analysis.

so let’s see one by one steps of investing in bonds.

Previous Chapter 6 on Investment bonds

How to invest in bonds
The Selection of Fixed-Value Investments Second and Third principles:-How to invest in bonds

This explains the two principles of investing in bonds.

so let’s see one by one

Principle 2: Bonds should be bought on a depression basis.

In Good conditions, every bond performs the great, but when depression comes, then we know which bond is strong or weak.

So in depression, the bond will be safe or not

on these two views come forwards

Two Views:

  1. The character of Industry e.g. Water, electricity
  2. Amount of protection e.g. Steel, automobiles companies

so you have a question What is the means of Character of the industry?

it means, Company comes in those industries, that industry has some immunity in depression condition.

for example, Light companies, Water supply companies, the telephone company. (How to invest in bonds)

and another question, What are the means of Amount of Protection?

it means, having a good Margin of Safety

means, Margin of Safety is high as much as that can not affect depression also.

In bond Context, the Margin of Safety is the Interest Coverage ratio ( times interest earned, Earning multiples)

so in this chapter whenever word comes coverage ratio, that means earning multiple, interest coverage ratio.

The Amount of Protection required those companies like steel companies, Automobiles, etc.

You need a maximum amount of protection because they fluctuate more.

So The author ay,s ” Those companies are good companies that perform well in depression also.”

The author says, ” Character of Industry is more important than the Amount of Protection because those companies perform good in depression, then minimum safety is considered as good.

Because In depression Maximum safety is also eroded.

So the author also, says, ” Not any industry is resistance to the depression, so the quest on is how much difference occurs in that industry’s company.”

That much percentage of the company is stable in depression as compared to competitors, then we can get maximum protection also. (How to invest in bonds)

This means the Minimum coverage ratio is sufficient for us

So if Maximum unstable company, then that much amount of earning multiple then, we ask for a good margin of safety.

If in some companies the Instability is more then, don’t buy this companies bond, whatever the maximum coverage ratio.

so Coverage ratio calculated formulae are

          Coverage ratio = Earning before interest Tax / Interest expense ( interest charges)

Suppose a company pays $1 interest on a bond, and company earnings are $10 so then the coverage ratio is 10.

or Earning multiple 10.

Means, How much multiple companies generate the earning on an interest basis. so the company does a maximum coverage ratio then the company is safe and they give the regular payment of bonds.

The character of Industry reflects the difference in stability and required coverage ratio.

so the author says, there are three types of company, we can classify

  1. Public Utility
  2. Railroads
  3. Industrials

These are different, because, these companies have different stability

1 ) Public utility is stable, and the railroad is less stable than public utility and Industrials is very less stable than Railroads.

So in these three types, we required different coverage ratios, that much minimum required to buy that company, so that’s why they are different. (How to invest in bonds)

So Public Utilityis more stable, so for this less Coverage ratio is sufficient

The railroad is only stable, then they required more coverage ratio, than a public utility.

Industrial companies required a maximum coverage ratio than railroad companies because they are unstable.

Then, The author talks about industries, why bonds collapse in depression

so which companies bond collapse in depression,

so let’s talk about public utility.

Reasons for bond Collapses during the depression:

  1. Public Utility was failed not because earnings disappeared, but because of Excessive debt on companies. so Interest charges were maximum and the coverage ratio is very less, that debt was not handled the small fluctuations, those companies do not have maximum debt, and their coverage ratio is maximum and they perform well in depression also.
  2. Railroads: In railroad stability of Earning was overrated and margin of safety also decreases because insufficient in depression. So the author says, ” People have to observe before, for example, Country grow in 1920 but railroad, companies did not increase the earnings, so this is clear that industry was weak. so this reason, Investors have to increases the margin of safety criteria minimum requirements. In railroads cases, those people getting the same minimum requirement criteria of margin of safety and they know after they failed in depression.
  3. Industrial: in industries, the sudden disappearance of earnings even for companies with a high Margin of Safety and also doubt on business survive or not in this depression. so in this, the author says, How much margin of safety whatever let’s consider 50, then in depression companies have problem with operation cost, then all are going erode. (How to invest in bonds)

the author observed that the large size companies, that do a good deal in depression time, then small companies so small and mediocre companies do very bad in depression.

so in big companies in their problem is, large-size companies present very little. and their debt outstanding is not more because they retire the bond issues.

So is that not means, if you don’t get the good company, then buy bad companies bonds.

Public says, ” those are secondary companies, how they get capital, if you only buy large companies bonds and finance them, so this activity affect the small and mid-size companies.”

so for this, the author says, ” We don’t take their responsibility and save them while sacrificing our capital, so in this type of securities not take in this type of securities not come in Class I of Fixed-value type investment.

If they want funds from us, then they have to give us a good chance of making profits on principal money, if we have principle loss risk.

So on bond financing, people view as following

  1. Bond issues, when supposing as weakness of the company and that’s why bond issued.
  2. The company doesn’t issue stocks, that why issues bonds.

that’s both are generally accepted views of people.

so from this, we get the message is only weak companies have to issue the bond.

so for this message, the author says, ” If only a weak company issues the bond, then we don’t have to buy that bond.”

then the author told, their view on Bond Financing

  • if a Business is profitable, then they get the profits while issuing bonds, because business profits give an infinite percentage and only little percentage have to pay on bonds, means fixed payment and whole profit of that company. If we are stockholders, then only we can participate in profits.
  • So bond issues, the benefit is very cheaply you raise the capital

so let’s understand with examples, (How to invest in bonds)

Suppose loan is 2, 3% and you make the 20 and 30%, then you can easily ready to take a loan, so just like that of the company also.

the company gets the bond for 4,5% and they make 50 or 60% profits.

After that, the author talks about unsound practices that are followed in the industry.

1 ) Railroad company issues bonds because their earning is poor and then stock, sales fluctuate, then the author says,” don’t buy this type of Bonds.

2) Some strong companies, issue bonds to pay the debt. so during this activity management problem is solved, but shareholders’ problems increases and their dilution starts, and companies free from debt.

So from this principle 2

we learn two things

  1. If we don’t get good companies bond, then don’t go for bad companies bond so this is no good reason then don’t buy, if not available.
  2. The industrial segment buys the bond of those that have the dominant size and have a good margin of safety ( means earning multiple has maximum.)

so let’s talk about principles 3

Principle 3: Unsound to sacrifice for yield

means, if some companies bonds, have risk to lose principle, but company give you high coupon rate and give you high yield but you can lose principal money.

so buying this type of bond is not good.

Because there is no relation between yield and risk.

Because, that the risk of loss is indefinite and no one is predicting and you can’t says, while seeing that past to handle risk. (How to invest in bonds)

Just like Life insurance, fire insurance in that you can see the previous data and people’s mortality rate and doing actual computation and from that, we can say, about the relation of risk and yeild.

but in this we can’t  says about risk and yeild relation.

because in this the loss is not defined uniformly they are concentrated at particular intervals, like depression everyone gets lost.

And the author says, ” while accepting principle lose, instead of high coupon rate just like become an insurance company.

In an insurance company, you pay the premium and if you have lost like, fire in the house some life-death, so then you get the payment from another side.

you can say like principles because you pay the premium on that.

so if lose events happen then only you get the money.

So in this situation, you become the insurance company and the company pays you a premium on a risky bond, and they take your principle money first, and then they give you a premium on each 6 month interval time.

and if you have lost, then forgot the principles money.

so the author says, ” this is not a good idea, because those are individual then, can’t distribute money like an insurance company. if they distribute like an insurance company but when college, they lose everything in depression. (How to invest in bonds)

so that’ why not good idea

then the author says, ” If you have to take the principle to lose risk, then you can’t offset by the high coupon rate instead of that, offset of risk, you have to get a good chance on that principles to get good profits.

For example, ‘ if you buy bond then buy very much at a discount of par value.

so in this, you have profits possibility and also have lost possibility.

both have a chance or instead that but the conversion bond that converts in stocks, in future.

For example, if you invest $100, and you can lose $100, so in this situation, you have to be possible is that $100 becomes $1000, then only benefited, if not benefited.

Then the author says, ” while selecting bond how people select and how we have to select.

How people select bonds:

So they start with a first-lien bond( senior security) and they think, this is very safe and after that, they see the taking risk of the percentage that increases yield.

so this is not the right way

because the first lien, you think it’s safe.

so the author says, ” The right way  to select”

The company has to satisfy the minimum standard of safety, after that, we consider which have to choose.

If the lowest seniority (highest yield) bond is not secure and the minimum required of safety not satisfy, then you don’t have to see that company bond and issues failing to meet the minimum required should be disqualified.

means don’t buy that company bonds.

so you have to see from the bottom of the bonds hierarchy and overall debt of the company are satisfy the minimum requirement. (How to invest in bonds)

if they do, then you have to see above of bond seniority for additional safety and you have sacarifying yield.

so we have to do like this, not like people way.

so this is all about how to invest in bonds from chapter 7 of the security analysis book