Sunday 29 November 2015

Benchmarks for Retail Bond Pricing

There are a couple of retail bonds listed on the SGX. How do you tell whether the 5.25% coupon offered by Aspial's 5-year bond is too high or the 3.65% coupon offered by Frasers Centrepoint's (FCL) 7-year bond is too low? To determine the right pricing for these bonds, you need to know what is the credit rating of the bond and the Yield-to-Maturity (YTM) for bonds with similar ratings. Unfortunately, the majority of retail bonds listed on SGX are not rated. On the other hand, thanks to Bondsupermart, we now have benchmarks to determine the YTM and pricing for bonds with various ratings. The blue line in the figure below shows the YTM for bonds rated A3 by Moody's (equivalent to A- by S&P / Fitch), which is the lowest of all A-grade bonds. The red line shows the YTM for bonds rated Baa3 by Moody's (equivalent to BBB- by S&P / Fitch), which is the lowest of all investment-grade bonds. Also shown in the figure in green is the YTM for the Singapore Government Securities (SGS), which provide a risk-free return for various bond maturities. This green line is also known as the Yield Curve. The difference between a bond's YTM and the yield curve at the same bond maturity is known as the spread and is commonly used to measure the pricing of a bond. Actually, you can construct a different line for each bond rating, but for ease of discussion, we will show only 3 lines in this figure.

YTM for A3/A- and Baa3/BBB- Bonds

The YTM of retail bonds listed on SGX are plotted as purple points in the figure above. The YTM has considered any step-up coupon feature in the bond, which is why CapitaMallsAsia 3.80% bond has a YTM of 4.064% even though its coupon is only 3.80% (this step-up will only apply if the bond does not get redeemed early). Among the 6 retail bonds with maturities of less than 10 years, only CapitaMallTrust's (CMT) 3.08% bond is rated A2 by Moody's. Let us use this as an example to explain how bonds are priced. CMT bond's rating of A2 is 1 grade higher than A3 which is represented by the blue line. As shown in the figure above, CMT bond's YTM is slightly below the blue line. Since CMT bond is less risky than A3-rated bonds, it should have a lower YTM than A3-rated bonds. Thus, CMT's 3.08% bond is correctly priced.

All the other retail bonds do not have any credit rating. We have to estimate a probable credit rating for the bond and from there, determine if it is overpriced or underpriced. Using FCL's 3.65% bond as an example, the YTM is closer to the blue line (A3 / A- bonds) compared to the red line (Baa3 / BBB- bonds) as shown in the figure above. If we think that FCL bond's rating is closer to Baa3 / BBB- than A3 / A-, then its YTM should increase to that of Baa3 / BBB- bonds (i.e. price should decrease). 

How do you compute the price of a bond from its YTM and vice versa? There are simple tools to do so. One such tool is posted on the SGS website. Just enter the maturity date, coupon rate and YTM and compute the price (or vice versa). As an example, the price of FCL's bond is currently $0.990, which translates to a YTM of 3.826%. If we think FCL's bond should have a Baa3 / BBB- rating, its rightful YTM should be 4.216% as shown in the figure above. Based on this YTM, the price for FCL's bond should be $0.968.

Finally, although we do not know the credit rating of Aspial's 5.25% bond, Oxley's 5.00% bond and Perennial's 4.65% bond, they are all priced above the red line, which means that the market thinks they are not investment-grade bonds. This is consistent with the analysis based on Benjamin Graham's criteria of earnings coverage and stock value ratio, which showed that all 3 bonds (together with FCL's 3.65% bond) do not have sufficient margin of safety. Readers will have to assess for themselves if the higher coupons offered by the bonds are sufficient to compensate for the risks in investing in them. 

P.S. I am vested in FCL's 3.65% bond and CapitaMallsAsia's 3.80% bond.

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  1. I must salute for this excellent article on bonds. I learnt a lot regarding the relative pricing of bonds. Thank you for educating us!