how to invest in bonds in zerodha Archives

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

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:

The character of Industry e.g. Water, electricity
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

Public Utility
Railroads
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:

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.
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.
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

Bond issues, when supposing as weakness of the company and that’s why bond issued.
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

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.
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