security analysis book

Hello friends, in today’s article we see Investment Grade Corporate Bonds and their specific standard for bond investment ( criteria 3, 4 & 5) from chapter 9 of the Security Analysis book. so let’s see one by one criterion

Previous Chapter 8

Specific Standard for Bond Investment continued ( criteria 3, 4, and 5):-Investment Grade Corporate Bonds

In this chapter we see the three types of criteria and what told by the New York statute and Benjamin Graham what advice us. so let’s start with this

Criteria 3: Provision of Issues :-Investment Grade Corporate Bonds

In these provision means, what are the Characteristics of Bonds, and what condition that affect the interest rate and what happens effect of maturity on bond character and their price.

so those things come in bond Indenture that come also inn this means provision of issues

and What is the seniority of bond, and what are their mortgage debenture, so this all comes in the provision of issues.

Those are the New York Statute, that we talk earlier,

so they only allow mortgage secure bonds from public utility groups and not allowed debentures.

so debentures are allowed only for railways but not a public utility.

On this point, the author says, ” Unsecured bond issues of any groups without any reason, reject them is not right, whatever the lien on the company, so nothing happen.”

The debenture is also one type of liens like unsecured debt, and junior lien, and above this, the mortgage bond is also present. (Investment Grade Corporate Bonds)

then the author says, ”  those are investors they are more attachment with maturity debt. so those are short maturity”

they are safer Because your maturity comes near, and those are long maturity people they are a risky bond investment.

but the author says, ” this type of thinking is very wrong”

Because, of that, so those are short maturity, they have to refinance and the company needs good cash to repay for those are short maturity that comes as an obligation to the company.

or if they have strong financial and good earning power, then they can issue new bonds and raise the fund.

so some companies do issue short maturity because they don’t have a good credit rating to issue long-term maturity bonds. (Investment Grade Corporate Bonds)

so this type of company, most of the time gets the trouble for investors.

then author discusses some examples in that author takes the short and long issue of the same bond.

For Examples.

In 1932,

the Bond is First 5s, this bond short maturity in 1934 and long term maturity in 1944.

so in this bond, only maturity difference occurs all rating and coupon rates are the same.

First 5s means,  they are first in seniority of bonds, and 5s means 5% coupon rate, if 5s instead that 6s means 6% coupon rate.

Debenture means, they are unsecured

So Due to 1934 means, maturity in 1934

Due to 1944 means, maturity in 1944

I hope basic terminology you understand

let’s come with examples

so those short bonds which mature in 1934, their price is $96.5, and those 1944 long term mature bond price is $35.

means those are mature in 1934, they, you can buy on $96.5 and those are mature in 1944 their price, so you can buy is $35. (Investment Grade Corporate Bonds)

so what happened in 1934, the company pay off the short-term maturity bonds by the company.

so those issue of 1944, their price increases up to $91.

so this long-term bond ( 1944) is a good opportunity because in this principle profit we get.

the author gives another example

Secured 6.5s, and their maturity in 1933 and secured 6.5s, their maturity for the long term in 1935.

The price of the short-maturity bond is $94 and

Long maturity bond price is $43

so this both issues, company payoff at maturity

so in this also long term issue is a good opportunity to investment

because you get the cheap price of a long-term maturity bond.

Other issues

In 1938 First 5s bond, price is $99.88 and they mature in 1944

First 5s bond, for long term maturity in 1954 bond price is $45

so both are default in 1939, before his maturity. (Investment Grade Corporate Bonds)

those are price is $99.88 decrease to $36

and the price of long term maturity bonds decreases to $20

so those are very expensive and short term maturity bonds, their price is highly falling than long term maturity bonds.

so like this author gives the two and three examples

the author also says, ” Is this is not meaning to buy maturity bond that is cheap and long term bond, just because they are cheap.”

so seeing Safety is important, if safety standards, we have to satisfy, if the company does not satisfy with the safety standard, then we don’t have to buy that bond, because we are not benefiting and taking the risk of losing principal.

this is all come in criteria 3

so let’s see criteria 4

Criteria 4: Record of interest and Dividend payments :-Investment Grade Corporate Bonds

so start with as per the New York Statutes

• The bonds of state say, ” those are bond, they don’t have to be default in a single year of a 10-year lifespan
• The Municipalities says, ” Not default for previous 25 years.”
• The bond of Railroads says, ” Not defaulted for previous 6 years”
• The bond of Public Utilities says, ” not defaulted for previous 8 years”

So after this new york statute rules, then the author says, ” suppose there are new municipalities establish, then according to them then, don’t get the finance, and they can’t wait for 25 years, so those are new states, they can’t wait for 10 years if they follow the rules of New York statutes. means, they don’t get finance.”

So those default in 10 years or 25 years, then they don’t get the finance if we follow the new york statutes.

Then for this, The author says, ” This is the different stringent rule, so what is a solution or so for this, buy the high coupon rate bond, then you have the risk of principal loss. (Investment Grade Corporate Bonds)

So the author says, “this is not a good idea just like before say so many times”

so right way is the author says, ” you have to stringent your own standard because those happen failure in 25 years of companies part to compensate with them your stringent standard.”

Like see this thing,

the city or state what if they rehabilitate, their and reduce the expenditure and increases the Tax rate to collect maximum revenue and also minimize the debt and reorganization of corporate in companies.

so this thing you have to see to invest in their bonds,

So then you ask for a higher yield is not because you have a loss of principle instead that to satisfy yourself.

So before is bad, and I take high yield, so this listening looks, weird.

but the author says, that

so let’s talk about dividend Record

Dividend Record:

Dividend record is company pay the dividend record before 5 years, in past.

so the myth is that those are companies that pay the dividend, they are strong companies

so this looks logically good, because if the company has money, then only they pay the dividend.

So the company has money and they issue a bond, and bond investment is also good.

so then the author says, ” company pays the dividend regularly, then we only know that companies financial strength is good, but those are bondholder,

they don’t have any direct benefit instead that they got the loss because, companies resources are used by the common stockholder, and companies cash is payable to the stockholder,

so in future, some difficulties come, then companies don’t have the cash to pay for bondholders.

so this thing, you can know from companies balance sheet that company is sound, so that necessary to pay a dividend, so they have money to pay dividend bu they not paying, so this thing is better than paying a dividend.

so in dividend-paying companies have this advantage is, if company cancel the dividend, then we know companies in the future have some difficulties so that line company concern the dividend because, their problem in future performance. (Investment Grade Corporate Bonds)

But, in this have difficulty is if some company perform bad and condition is weak bu they pay the dividend because, their credit rating is going low so this is very dangerous things, we have to stay attentive on that.

so summary of dividend criteria is those companies pay the dividend, they have some condition, we have to see that condition, and what benefited to the bondholder, then only you have to invest in that companies bond.

so let’s talk about criteria 5

Criteria 5: Relation of Earnings to interest requirement

This is also, interest coverage ratio, and this is also interest earing multiple)

to this is important, so this called as Margin of safety.

So what say New York Statutes

Railroad ( Mortage bonds):

on this, the New York Statute says, 1.5X of earning interest charges in past 6 years out 5 individuals year.

so means, In the past 6 years, in 5 years the interest coverage ratio is 1.5X

or

The recent year is important and there are the first year and remaining 5 years in that any 4 years.

so those are debentures or income bonds of railroads. (Investment Grade Corporate Bonds)
(on income bond we can talk later when we talk about the preferred stock)

so in this multiple is 2X in the latest year ( previous first year) and in past 5 years in that 4 years of any four years.

Those are Public utilities:- their earning is 2X in past 5 years average of interest charges

so we talk about in railroads of individuals year of past years,

but in public utility, we take an average of years.

So get the value of interest coverage ratio, you have to know about three things

* 3 things to consider for interest coverage ratio:

so for this author give the three things that help you to consider interest coverage ratio, so let’s see

1. Methods of computation of interest coverage ratio
2. amount of courage required
3. The period required for the test ( time period)

so let’s see the Method of computation of interest coverage ratio: in this author give three methods that people used in previous past time, and also suggest which is best

a) Prior deduction method

b) Commutative deduction method

c) Total deductions method aka. Overall methods

so all methods discussed while taking examples

a) Prior deduction Method

Suppose A company, $10 million worth of First Mortage 5% bond, and Debentures worth $5 million.

and companies average earning is $1,400,000

so the company have to pay interest on the first mortgage is 5% of $10 million is equal to $500,000

so coverage ratio is = $1,400,000/$500,000 = 2.8X

and remain is = $1,400,000 – $500,000 = $900,000

so those are junior debentures for this they have to pay 6% on $ 5 million of debenture

so interest on 6% = $300,000

so coverage ratio = $900,000 / $300,000 = 3X

The stupid thing is

those are senior bonds their coverage ratio is 2.8X and those are junior bonds and their coverage ratio is 3X

it means that junior issue is more protected than senior issues. (Investment Grade Corporate Bonds)

So these things are very stupid, 

Because obviously those are senior bonds they have more protection than the junior bond and they got first money when the company is failing. but in that not happen like that so

this method is a useless method and misleading method, but so many companies use this ratio in past and they fool the investor and investors also do stupid things and don’t think about this and they only see quantitative but not see qualitative.

So people forgot the figure and people go in calculation and say, this value is original whatever they come.

They forget also, whatever value comes, they are not checked for is sensible or not.

b) Commutative Deduction method:

In these, those are the first mortgage, and they are the same as above mentioned

because, on that method, no one is  superior

so the ratio is  for the First 5s = 2.8X is coverage ratio ( calculate above)

so come for a debenture,

for debenture, in this method, First of all, you have to pay first mortgages

so $800,000 , total interest charges

so debenture 6% ratio = $1,400,000/ $500,000 + $300,000   =1.75X

so this method is good, than the first method, because, it looks sensible

but the author says, ” we have to use the third method i.e. Over all method or total reduction method.”

This means whatever, you buy ( senior or junior) total debt safety is required.

so for both ( first and debenture 6s also)

for this, you have to add junior and senior interest charged i.e. $500,000 + $300,000

then ratio is = $1,400,000/ 800,000 = 1.75X

for both

because, if junior lien default, then, his effect also happens on senior in coming future.

If you buy senior issues ( mortgage bonds), they can also use this method

Add junior and senior interest charge for ratio

if you consider your own interest expense  then you get more than good things and have added in advantage

but don’t use that rule. (Investment Grade Corporate Bonds)

so for total, this rule and added advantages

now let’s talk about other points

2) Amount of coverage required:

in this author give the specif coverage ratio for each and every category

1. for public utility ratio is = 1.75X
2. for railroads ratio is = 2X
3. for industrials ratio is = 3X

so this ratio author gives from his experience and their practices and also see companies history in depression also.

3) Period Required for Test:

So New York Statutes says, you have to take a period of five years and also says, for utility take an average of five years and for railroads take an independent year of 4 in past and immediate precious year not in taht.

so for this author says, 7 years period is better than 5 years period

and we can also modify it by increasing or decreasing year by seeing previous year performance

Suppose, we invest in 1940,  in that time you can take 7 years, but year 1933 is in depression so for this, you can take only 6 years, by modifying according to the situation and that is very helpful.

If you invest in 1934 or 1935, so in this time, you can’t help with 7 years period, because in that 3 years in the depression, so for this you have to take 10 or 12 years of the time period to unusual things is average out the depression time freme. (Investment Grade Corporate Bonds)

so in this, you have two kind situation

in the first situation, you can take the actual earning in depression(whatever come -ve) year for interest coverage ratio, but interest coverage ratio is come very less, so for this author says, ” take the Zero earning of those years that are in a depression instead that taking whatever is coming.

and consider time period for 12 years and take their average and after that found the ratio ( coverage ratio)

so this author recommends, instead of separate,

the author says, after this all, we have to see other points also

” We have to see what are the average trends and minimum figure and also the current figure.”

so suppose earning profit increases means, a rising trend is going, then this is good and current showing figure is also good, then better and you get the good margin on that then also better in a rising trend.

If earning Trend is Unfavorable ( downward trend,) then you don’t have to accept until the first thing is the earning ratio is required maximum.

The second thing is the earning trend is downward, then you have to confirm that this trend is temporary ( instead is not only I think so it’s not like this reason) you have to good conviction reason why goes high this trend.

so these are all things we have to conclude while investing in bonds.