Sunday, 22 November 2015

Is Benjamin Graham's Art of Bond Investment Outdated?

There were 4 retail bonds issued this year, yet all 4 were assessed not to have sufficient margin of safety according to Benjamin Graham's criteria of earnings coverage and stock value ratio. Despite so, all 4 bonds have hovered around the par value since listing. Is Benjamin Graham's art of bond analysis as described in The Lost Art of Bond Investment outdated?

To answer this question, let us go back to the first principles. The safety of a bond depends both on the issuer's ability to pay and willingness to pay. The ability to pay in turn depends on the issuer's recurring earning capability and/or adequacy of assets to extinguish the bonds. The willingness to pay depends largely on the management's integrity and is usually safeguarded by convenants in the bond agreement restricting management's rights, such as declaring excessive dividends to shareholders, or allowing bondholders to take over the company in the event of a default. Benjamin Graham's criteria measure the issuer's ability to pay and the 2 criteria of earnings coverage and stock value ratio measure the issuer's recurring earning capability and adequacy of its assets respectively. Although they were derived more than 80 years ago, the concepts are still relevant today and can be found in today's loans, including the housing mortgage loans that most people are familiar with. Interestingly, all the 4 retail bonds were issued by property developers. Let us visit each one of the criteria.

Earnings Coverage

The earnings coverage is more commonly known as interest coverage in today's age. It measures how much cushion the company's recurring earnings has to cover the total interest expense from all loans. The inverse of the earnings coverage would be equivalent to the Total Debt Servicing Ratio (TDSR) introduced by the Monetary Authority of Singapore (MAS) to determine how much of a person's salary could be used to service all the loans he has and hence how much loan he could obtain to purchase a property. Using industrial bonds as an example, Benjamin Graham recommended an earnings coverage of not less than 3 times fixed charges. This translates to a TDSR of 33%. Although this figure looks low compared to MAS' allowable TDSR of 60%, it has to be considered that individuals have mostly stable salaries, whereas companies' earnings are quite variable from year to year. The more variable the earnings are, the lower the TDSR should be. In fact, for bonds of public utilities which have more stable earnings, Benjamin Graham allowed a lower earnings coverage of 1.75 times fixed charges, which translates to a TDSR of 57%, which is quite close to MAS' allowable TSDR of 60%. Considering the variability of earnings of property companies, an earnings coverage of 3 times fixed charges is not excessively stringent. 

Stock Value Ratio

The stock value ratio measures how much cushion the company's equity could provide to the bonds in the event the company loses money. It is measured as the ratio of equity to total debt. In today's age, the related but more commonly used yardstick is the Loan-to-Value (LTV) ratio, which measures the ratio of debt to asset value. Using industrial bonds as the example, Benjamin Graham recommended a stock value ratio of not less than 1. This translates to a LTV of 50%. Again, although this figure looks low considering that individuals could borrow up to 80% of the property price, it has to be considered that individuals pay down their loans over time whereas companies mostly roll-over their loans when they mature. Thus, the LTV for individuals decline over time whereas the LTV for companies mostly stay constant. Moreover, individuals' mortgage loans are secured using the property as collateral, whereas companies' loans may either be secured or unsecured. A more appropriate benchmark would be the 45% leverage limit imposed by MAS on REITs. From this angle, the stock value ratio of 1 for property companies is not excessively stringent. For public utility bonds, Benjamin Graham allowed the stock value ratio to go up to 2 times, which translates to a LTV of 67%.

Other Considerations

Having too much debt does not necessarily means that a company will default on its bonds. It is akin to an individual with high cholesterol; while it places the individual at risk of a heart attack, it does not mean that one will definitely occur. The catalyst for a heart attack for companies would be a credit crunch or a sharp or prolonged industrial downturn in which the company is unable to find a bank willing to refinance its debts or a buyer willing to buy over its assets at reasonable prices. One of the biggest lessons REIT investors learnt from the Global Financial Crisis is that in times of crisis, having a strong parent helps. REITs with deep-pocket parents such as CapitaComm or A-REIT weathered the storm better than REITs without such parents. 

To conclude, Benjamin Graham's art of bond analysis is still as relevant today as it was formulated 80 years ago. 

Finally, you probably have heard the story that banks are famous for being fair-weather friends; they are nowhere to be found when you need the money but beg you to take the money when you do not need it. As bondholders, we should learn from the banks, i.e. lend money only to those who do not need it!

P.S. I am vested in Frasers Centrepoint's 3.65% bond (held as available-for-sale instead of held-to-maturity).

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