The Lost Art of Bond Investment

There are a couple of bonds and preference shares listed on the Singapore Exchange (SGX). Due to their scarcity, it is rare to find discussions on how these should be selected for investment. Last Christmas, I had the opportunity to reread the Security Analysis, written by Benjamin Graham and David Dodd. In it, there are 2 sections devoted to how bonds and preference shares should be selected for investment. It listed 2 criteria, namely, the minimum average earnings coverage and the minimum current stock value ratio.

The minimum average earnings coverage ensures that earnings are more than adequate to cover the fixed charges from bonds and preference shares for a sufficiently long period of time. The minimum current stock value ratio ensures that there is a sufficiently large pool of shares to cushion the bonds and preference shares in the event of financial distress. The values for the 2 criteria are listed as follows:

	Bonds	Preferred Stocks
Public Utilities	1.75x fixed charges	2x (fixed charges + preferred dividends)
Railroads	2x fixed charges	2.5x (fixed charges + preferred dividends)
Industrials	3x fixed charges	4x (fixed charges + preferred dividends)

Table 1: Minimum Average Earnings Coverage

	Bonds	Preferred Stocks
Public Utilities	$2 bonds to $1 stock	$1.5 (bonds & preferred) to $1 stock
Railroads	$1.5 bonds to $1 stock	$1 (bonds & preferred) to $1 stock
Industrials	$1 bonds to $1 stock	$1 (bonds & preferred) to $1.5 stock

Table 2: Minimum Current Stock Value Ratio

The reason for the more stringent requirements for preference shares compared to bonds is because preference shares have some contractual disadvantages. As an example, it is mandatory to pay bond coupons and principal as and when they fall due, failing which the company might enter into bankruptcy. In contrast, preference dividends are not mandatory and subject to the discretion of the company directors. If the preference dividends are omitted, nothing serious will happen to the company. Hence, to compensate for these shortcomings, the safety margins are higher for preference shares. 

To explain how the earnings coverage and current stock value ratio are computed, we use Hyflux as an example. The table below shows the income statement of Hyflux for the Financial Year (FY) 2012.

Table 3: Hyflux's Income Statement for Financial Year 2012

For FY2012, Hyflux reported a Profit before Tax of $77.0M. Adding back the finance cost of $28.5M and subtracting the share of profits from associates of $4.3M, there is $101.2M available to cover fixed charges. The fixed charges comprise the reported finance cost of $28.5M plus preference dividends of $24.1M, making a total of $52.5M. The earnings coverage is thus computed as $101.2M / $52.5M or 1.93.

On the stock value ratio, Hyflux has 825.2M of ordinary shares and 4.0M of preference shares. The last traded prices are $1.165 and $106.85 respectively. The market values work out to be $961.4M and $427.4M respectively. The stock value ratio is computed as $961.4M / $427.4M or 2.2.

How do the existing bonds and preference shares listed on SGX compare based on the 2 criteria mentioned above? The results based on the latest FY are shown below:

Company	Coupon	Earnings Coverage	Stock Value Ratio	Type
CMA	3.800%	4.01	13.6	Bond
Olam	6.750%	1.92	3.7	Bond
SIA	2.150%	5.37	39.3	Bond
DBS	4.700%	373.22	50.3	Pref
Genting	5.125%	7.33	34.9	Pref
Hyflux	6.000%	1.93	2.2	Pref
OCBC	4.200%	32.05	4.9	Pref
UE	7.500%	6.45	No Info	Pref

On earnings coverage, all the bonds and preference shares passed the criterion for Industrials with the exception of Olam and Hyflux. On stock value ratio, all the bonds and preference shares passed. Hence, all except Olam's bond and Hyflux's preference shares qualify as good fixed income investments.


See related blog posts:

• Is Benjamin Graham's Art of Bond Investment Outdated?
• Does FCL's 3.65% Bond Have Sufficient Margin of Safety?
• Does Aspial's 5.25% Bond Have Sufficient Margin of Safety?
• Does Perennial's 4.65% Bond Have Sufficient Margin of Safety?
• Does Oxley's 5% Bond Have Sufficient Margin of Safety?
• Does Aspial's 5.30% Bond Have Sufficient Margin of Safety?
• Do Hyflux's 6% Perps Have Sufficient Margin of Safety?
• Does SIA's 3.03% Bond Have Sufficient Margin of Safety?