Companies often need to raise capital – it may be for the acquisition of a competitor, an expansion of research and development or an investment in plant or equipment. Whatever the reason, a company can raise capital by issuing shares (equity) or corporate bonds (debt). Read more about why companies issue bonds.
For any one company, there are two key differences between its equity investors and bond investors:
Because the company that issues the bond is legally required to make regular interest (coupon) payments and repay the face value of the bond upon maturity, investing in a company’s bonds is generally considered lower risk than owning its shares.
Equities versus bonds
An equity investor has a lot to consider:
On the other hand, a bond investors tend to focus on the core financials and have one primary consideration:
Will this company pay its coupons and repay my principal at maturity?
Equity investors need to constantly monitor companies and markets in which they invest – after all, there are so many disparate influences on a company’s share price. Some factors have less to do with the company’s core financials and more to do with markets and sentiment.
Although assessing a company from the perspective of a bond investor is more focused on core financials and therefore simpler than for the equity investor, it still requires some consideration. A positive answer to that all important question – will the company still be around when the bond matures – will provide you with a degree of comfort that you’ll reap the benefits of a bond investment. Regular interest (coupon) payments provide a steady and predictable source of income, and at the end of the bond’s term, the face value ($100) is returned. Our list of 5 key considerations should help you to answer that question.
5-step plan to evaluate corporate bond issuers
Irrespective of the low probability of ASX 100 companies defaulting, it’s always good practice to understand the company central to your investment, whether you’re an equity or bond investor. For bond investors, there are five key criteria to consider.
Is the company likely to be around for the term of your bond?
While it is rare for an ASX100 company to go into liquidation, it is not unheard of. A large company, with significant assets, a strong business model and competitive advantages is more likely to last the distance. They are more likely to be able to make regular interest or coupon payments and repay the bond’s face value upon maturity.
Do you understand where the bond sits in the capital structure?
The capital ranking of securities indicates the order of when you get paid back, relative to other creditors. It also indicated its price stability, with higher ranking investments tending to be less volatile than lower ranking investments. Corporate bond prices and yields are generally far less volatile than securities ranked below them in the capital structure. In the unlikely event of default, if you hold corporate bonds, you will be repaid before investors in those lower ranked securities. To learn more about capital structure, read ‘Location, location!’
In the event of a company going into liquidation, equity investors are first to lose their money, followed by investors in hybrids and subordinated debt; investors in these securities must be wiped out before bondholders incur a loss. It’s good practice to know the value of the securities ranked below corporate bonds, as they provide a buffer between default and your bond investment.
Has the company previously issued bonds and have all payments of interest and face value been met?
Australian companies issuing bonds are legally required to make all payments to the bondholder as set out in the offer document for the issue. Legality aside, there may be circumstances where a company is unable to pay and defaults. Although there is always a first time, a history of default sounds warning bells. XTB’s focus on Australia’s 100 largest companies, which considerably reduces this risk.
What is the business environment like for the company? Does it face competitive pressures, regulatory change, geopolitical or macro-economic risk?
Factors that impact a company’s financial performance or influence its business strategies can affect its cashflow and profitability. It’s important to understand the business risks that could impact a company’s ability to service its debt.
Does the company have good credit? Does it meet its liabilities on time?
A company’s financial statements can provide a wealth of information about the business – cashflow, profitability and liquidity. It’s important that the cashflow generated by the company can service all of its debt.
A profitable company that consistently generates positive cashflow generally has a good financial position from which to service its debts, including interest payments and repayment of principal. That, of course, is what every bond investor wants!