Does SIA's 3.03% Bond Have Sufficient Margin of Safety?

Following up from last week's blog post on Will Temasek Bail Out SIA Bondholders In Event of Default?, here is the analysis on SIA's 5-year 3.03% bond based on Benjamin Graham's criteria as described in The Lost Art of Bond Investment. Surprisingly, the bond is not as strong as I initially thought based on a simple Debt-to-Equity ratio check. Below are the computation of the earnings coverage and stock value ratio based on SIA's latest financial statements for Financial Year 18/19 ending in Mar 2019.

Earnings Coverage

 

Profit before tax	= $868.6M
Adjusted for:
- Deduct: Share of profits from joint ventures	= $23.2M
- Add: Share of losses from associates	= $97.4M
- Add: Rental on leased aircraft	= $679.7M
- Add: Finance cost	= $116.1M
Total earnings available for covering fixed charges	= $1,738.6M
Current finance cost	= $116.1M
Adjusted for:
- Add: Rental on leased aircraft	= $679.7M
- Add: Interest for $600M @ 3.16% MTN 007 series	= 3.16% x $600M
	= $19.0M
- Add: Interest for $750M @ 3.03% MTN 001 series	= 3.03% x $750M
	= $22.7M
Total finance cost	= $837.5M
Earning Coverage	= $1,738.6M / $837.5M
	= 2.08

Several adjustments were made to compute the total earnings available for covering fixed charges and total finance cost. The more unusual adjustment in SIA's case involves adding the rental of leased aircraft to both figures. This is because SIA leases aircraft in addition to buying them. The leases range from 6 to 12 years and cannot be cancelled, although there are options for early termination for up to 2 years before the original lease expiry. The leased aircraft do not appear on the balance sheet.

On the other hand, for aircraft that SIA owns by borrowing money from the banks, the aircraft appear as a asset and the loan appears as a liability on the balance sheet. On the income statement, there is no rental required, but SIA incurs depreciation and interest on the loan.

Hence, for the leased aircraft, even though SIA does not incur a finance cost, the rental is effectively a fixed charge that SIA has to cover, as the leases cannot be cancelled and SIA needs the aircraft to continue its operations. A similar adjustment needs to be made for the balance sheet, as discussed in the section later.

The current finance cost is also adjusted for interest on a $600M 3.16% Medium Term Note (MTN) issued on 26 Oct 2018 and the $750M 3.03% bond issued on 29 Mar 2019 which is the subject of this blog post. Although both bonds already appear on the balance sheet as at 31 Mar 2019, their first interest payments will only be made in FY19/20, Hence, their interest payments need to be added to compute the actual finance cost.

Based on the above adjusted figures, the earnings coverage is computed to be 2.08 times, which is below the minimum average earnings coverage of 3 times for industrial companies.

Stock Value Ratio

No. of shares	= 1,199.9M
Share price	= $9.62
Market value of shares	= $11,542.6M
Current borrowings	= $6,654.4M
Adjusted for:
- Add: Liability for rental aircraft	= $2,200.0M
Total borrowings	= $8,854.4M
Stock value ratio	= $11,542.6M / $8,854.4M
	= 1.30

As mentioned above, adjustments need to be made to the balance sheet for the rental aircraft. The rental aircraft is effectively an asset for SIA. Correspondingly, there should be a liability to account for the loan that SIA would have borrowed to purchase the aircraft outright. In fact, International Financial Reporting Standard (IFRS) 16 on Leases came into effective starting from Jan 2019 that requires companies like SIA to account for leased assets on their balance sheets. SIA has disclosed in its Annual Report that the assets will be increased by $1.7B while liabilities will be increased by $2.2B.

Considering the $2.2B increase in total borrowings, the stock value ratio is computed to be 1.30, which is higher than the minimum stock value ratio of 1.0 for industrial companies.

Quantitative Assessment

Thus, based on the above figures, SIA's 5-year 3.03% bond does not meet the earnings coverage criterion but meets the stock value ratio criterion. Based on Benjamin Graham's criteria, the bond does not have sufficient margin of safety.

Other Considerations

As mention in my blog post on Will Temasek Bail Out SIA Bondholders In Event of Default? last week, I believe Temasek will come to the rescue of SIA bondholders in the event that SIA could not pay interest and/or redeem the bond.

P.S. I am vested in SIA's 3.03% bond.


See related blog posts:

• The Lost Art of Bond Investment
• Is Benjamin Graham's Art of Bond Investment Outdated?
• Will Temasek Bail Out SIA Bondholders In Event of Default?

Will Temasek Bail Out SIA Bondholders In Event of Default?

As regular readers would know, I stopped blogging for a year. I did not just stopped blogging; I also stopped monitoring performance of my portfolio and analysing shares and bonds in detail. So when SIA launched its retail 3.03% bond in Mar this year, I did not analyse it in detail as I would typically do using Benjamin Graham's method (see The Lost Art of Bond Investment for details) and simply bought it. I took a glance at its financial statements, carried out a simple Debt-to-Equity check and concluded that its debt obligations were not too excessive. Most importantly, I relied upon the assumption that SIA's parent, Temasek, would bail out bondholders in full in event of a default. This was not the only time that I relied on similar assumptions when buying bonds. I did the same when I bought Fraser Property's 3.65% bond (see Does FCL's 3.65% Bond Have Sufficient Margin of Safety? for more info).

Now that I am back to blogging (and thinking about financial issues), it is worth diving deeper to examine whether the assumption is rock solid and could be relied upon. Do note that this is not entirely a hypothetical question, as the airlines industry is a highly competitive one. Bankruptcies are not uncommon. Past examples include American Airlines, Delta Airways, Northwest Airlines, etc. going into Chapter 11 protection.

So, will Temasek come to the rescue of bondholders in the event SIA defaults on the bond? To answer this question, we need to first understand the background of SIA and Temasek. So, the first question is: will Temasek rescue SIA? The answer must be a resounding yes. SIA is the national airline and the pride of the nation. When our political leaders go overseas for conferences, they fly with SIA. It is difficult to imagine our political leaders flying on some other countries' national airlines. Thus, yes, Temasek will come to the rescue of SIA.

However, rescuing SIA the company is not the same as rescuing SIA bondholders. While SIA the company is a strategic national asset, SIA bondholders (and shareholders) are not. Furthermore, the ultimate shareholders of Temasek are Singaporeans. Bailing out SIA and its bondholders with Temasek's money is akin to using taxpayers' money to do so. It will be politically difficult to use taxpayers' money to bail out bondholders in full. The most likely scenario is that the settlement with bondholders will be at arm's length basis on normal commercial terms, i.e. the outcome would be similar to another company that is not owned by Temasek. In other words, bondholders will suffer some capital losses. This is not unlike the case of Hyflux preference shares and perpetual capital securities. Thus, from this perspective, SIA bondholders should not expect Temasek to bail them out in full.

On the other hand, SIA is not the only company that Temasek owns. Temasek owns a lot of companies in its portfolio. Temasek has triple-A ratings from both Moody's and S&P. Not all the companies in its portfolio has similar ratings based on their own merits. When companies with lower ratings borrow money, lenders take into consideration the fact that the company is majority owned by Temasek and offer a lower interest rate compared to a company that does not have Temasek as its backing. In the event that Temasek does not step in to bail out bondholders in full, credit markets will take note and will not offer lower interest rates to Temasek-owned companies in future. Each company has to pay an interest rate that is commensurate with its own credit rating. In other words, Temasek will have to bear higher interest payments across most of its subsidiaries. This long-term economic cost might outweigh the short-term political cost and prompt Temasek to bail out bondholders in its subsidiaries in full.

Finally, we should also note that Temasek, although it does not play an active role in day-to-day management of the subsidiaries' operations, is not a sleeping partner either. Long before trouble happens and hits the headlines, Temasek would have done something to avert it. For example, Tiger Airways, SIA's budget airline, had been losing money for 4 out of 6 years since its listing on SGX in Jan 2010. It carried out 3 rights issues over the same period. It also issued a 2% perpetual capital convertible securities (PCCS) in Apr 2013. If the trend were to continue, Tiger Airways would probably have failed and defaulted on the PCCS. In Nov 2015, SIA announced that it would take over Tiger Airways. It also redeemed all outstanding PCCS upon successful takeover of the company.

In conclusion, I had been lazy in analysing the SIA 3.03% bond when I bought it. But I guess I still can rely on the assumption that Temasek would step in and bail bondholders out in the event of default by SIA. Nevertheless, I should do my homework and analyse whether the SIA bond has sufficient margin of safety according to Benjamin Graham's method.

See related blog posts:

• The Lost Art of Bond Investment
• Does SIA's 3.03% Bond Have Sufficient Margin of Safety?
• Does FCL's 3.65% Bond Have Sufficient Margin of Safety?

Are Private Equity Bonds Better Than Corporate Bonds?

When Astrea V 3.85% bond was launched, some investors remarked that it is better than some of the recently issued corporate bonds, such as SIA 3.03% bonds. What are the differences between Private Equity (PE) bonds and corporate bonds, and are PE bonds really better than corporate bonds?

It is difficult to compare Astrea bonds with, say, SIA bonds, since their nature of business are different. To make the comparison between PE bonds and corporate bonds more meaningful, let us consider a hypothetical bond issued by Azalea Asset Management, which is the sponsor of the Astrea III/IV/V bonds. Fig. 1 below shows the corporate structure of Azalea.

Fig. 1: Azalea Corporate Structure

The assets of Azalea are the 3 Astrea companies issuing the Astrea III/IV/V bonds and owning the underlying portfolios of PE funds. Azalea probably has some other income-generating assets, such as the investment management company shown in Fig. 1 above, plus some other unlisted PE funds. Thus, the nature of business of Azalea and Astrea III/IV/V companies are similar. What would be the differences between the hypothetical Azalea corporate bond and Astrea III/IV/V PE bonds? Note that the PE bonds are not limited to the Class A-1 bonds which are open to retail investors. There are also Class A-2, B and C bonds.

The first key difference would be the security of the bonds over the assets. Astrea PE bonds are secured against the PE funds in the respective Astrea companies, whereas Azalea corporate bond would be unsecured. In the hypothetical scenario where the Astrea PE bonds default, Astrea bondholders could force the respective Astrea companies to liquidate their PE funds and return money to the bondholders. However, in the event that the liquidation proceeds are insufficient to redeem the bonds, bondholders have no recourse to Azalea, or to the other Astrea companies. For example, if Astrea III bonds were to default, Astrea III bondholders have no rights to the assets of Azalea, Astrea IV and Astrea V companies. The assets of each company are ring-fenced and could only be used to service the bonds issued by the respective company.

Similarly, in the hypothetical scenario where the Azalea corporate bond defaults, Azalea bondholders have no claims over the PE funds held in the 3 Astrea companies. Nevertheless, they could force Azalea to sell off the Astrea companies together with their portfolio of PE funds and PE bonds. However, they could not force Azalea to break up the Astrea companies, sell off their PE funds, redeem the Astrea PE bonds, and return excess cash to Azalea to pay off the corporate bondholders (Note: it might be possible to do so for other project/ asset-level bonds, but the terms of Astrea PE bonds do not allow for early liquidation of assets and redemption of bonds). In other words, regardless of what happens to Azalea, Astrea PE bondholders will not be affected. 

So does it mean that Astrea PE bonds, which are secured against the PE funds of the respective Astrea companies, are better than Azalea corporate bonds which are unsecured? Not necessarily. The key factor is the quality of the assets that are securing the bonds. If the assets are of high quality, the PE bonds have good collaterals. Conversely, if the assets are of low quality, the collaterals would be useless. Remember, Astrea PE bondholders have no recourse to Azalea and the other Astrea companies. They can only count on the assets in their respective Astrea companies to pay interest and redeem the bonds. 

Although Azalea corporate bond is unsecured, if the Astrea companies are generating good cashflows for Azalea, it does not matter whether the bond is secured or not. In a hypothetical scenario where one of the Astrea companies have poor assets whereas the other Astrea companies have good assets, it might be better to hold the unsecured Azalea corporate bond than the secured but troubled Astrea PE bond. So, quality of assets is key in determining whether secured or unsecured bonds are better.

The second difference is that Azalea could have other income-generating assets and businesses besides the 3 Astrea companies. In Fig. 1 above, it has an investment management subsidiary to manage the investments in PE funds for the Astrea companies in return for a fee. It could also have other PE funds that are outside the Astrea companies. So, for Azalea corporate bonds, there could be other sources of operating cashflows, whereas for Astrea PE bonds, the only source of cashflows is the PE funds in the respective Astrea companies.

The third difference is that besides receiving cashflows from the Astrea companies to redeem the Azalea corporate bond, Azalea could refinance the bond through bank borrowings, new corporate bonds, shareholder loans from Temasek, or even private share placements and IPO! Being a corporate bond, there are many avenues to refinance it. Astrea PE bonds do not have such avenues. To reiterate, Astrea PE bondholders can only count on the assets in the respective Astrea companies. If the assets are good, PE bondholders will get the promised returns. If the assets are poor, they will suffer some losses.

Having said the above, being able to borrow money is a double-edged sword. While borrowings could help to refinance the Azalea corporate bond, Azalea could also run the risk of borrowing too much money and jeopardise its ability to pay interest to and/or redeem the Azalea corporate bond if banks decide that Azalea's credit risk is too high. For the Astrea PE bonds, such risks have been mitigated. The terms of Astrea PE bonds prohibit the Astrea companies to borrow money other than to issue the different classes of bonds at inception, as well as to meet capital calls and cover bond interest payment shortfalls. The last 2 conditions are actually safeguards for the PE bondholders (see Understanding the Safeguards of Astrea IV 4.35% Bonds for more info).

In conclusion, PE bonds are not necessarily better or worse than corporate bonds. The key words are: quality of assets securing the PE bonds. This is unlike preference shares and perpetual capital securities, which are inherently inferior to stocks and bonds (see Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form for more info).

See related blog posts:

• Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form
• Understanding the Safeguards of Astrea IV 4.35% Bonds 
• Astrea V 3.85% Bonds – Understanding What You Are Buying Into

A Shrinking Balance Sheet for Bonds in Mature PE Funds

In another few more days, the Class A-1 bonds of Astrea III, the first wholesale Private Equity (PE) bond listed in Singapore, will be redeemed as scheduled. What could we learn from the 3-year existence of this bond, which could provide some useful insights on the behaviour of Astrea IV and V bonds?

Astrea III publishes annual reports, which document the cashflows received, performance of its underlying PE investments, outlook for PE investments as well as the usual income statements and balance sheets. In the 3 years of its existence, the cashflows of Astrea III from its investments in PE funds are shown in Fig. 1 below.

Fig. 1: 3-Year Cashflows of Astrea III

Over the 3 years, Astrea III has received total distributions of USD952M, capital calls of USD176M, resulting in net distributions of USD776M. At inception, the weighted average age of the PE funds which Astrea III invested into is 6 years. The cashflows are typical of investments in mature PE funds, as shown in Fig. 2 below.

Fig. 2: Typical Cashflows of PE Investments

Moving forward, Astrea III will likely see less distributions, as indicated in Fig. 2. Already, the investments made by the underlying PE funds into companies are showing signs of ageing, as shown in Fig. 3.

Fig. 3: Holding Period of Underlying PE Investments

The average holding period of the underlying PE funds' investments into companies has increased from 4.0 years in 2016, to 4.5 years in 2017 and 5.2 years in 2018. There are 2 opposing reasons why PE funds hold onto their investments for longer than usual -- it could be to extract more value from a good company, or it could be the company could not deliver as promised and the PE fund has difficulty selling it for a good price. If it is the first reason, it is a good thing for PE bond investors. But if it is the second reason, PE bond investors will have reasons to be worried.

What happened to the distributions received by Astrea III over the 3 years? Fig. 4 below shows the balance sheet for the Financial Years ending in Mar 2017, 2018 and 2019.

Fig. 4: Astrea III's Balance Sheets

The first thing to notice is the investments in PE funds (yellow bar) have been shrinking, from USD1,070M in 2017 to USD904M in 2018 and finally to USD739M in 2019. This is due to the net distributions of USD568M from the PE funds from 2017 till 2019, offset by fair value gains (i.e. capital gains) in the PE funds of USD236M over the same period.

A portion of the net distributions went to increase the cash account (grey bar), which increased from $203M in 2017 to around USD340M in both 2018 and 2019. Another portion went to pay interest of USD21M to bondholders in 2018 and 2019. The remaining distributions were used to pay the sponsor in the form of repayment of shareholder loans and dividends to shareholder. From 2017 till 2019, a total of USD385M was paid to the sponsor/ shareholder. As a result, the sponsor equity (orange bar) has been shrinking.

Because of the distributions and payments to sponsor, the asset base has been shrinking. On the other hand, there is relatively little cashflow used to pay down the bonds (blue bar), as they have not matured. If the trend continues, bond holders might end up holding onto a shrinking asset base of ageing PE funds with declining distributions while the sponsor gets all its capital back (see Where Do Astrea Bonds Stand Along PE Fund Lifecycle? for more info on PE lifecycle and its impact on cashflows). By the time the bonds mature, there might be little cashflows left to redeem the bonds. Remember, once the cash leaves Astrea III by way of repayment of shareholder loans and/or dividend to shareholder, bond holders have no recourse to the sponsor, Azalea, or Temasek.

Thus, one key risk for bond investors in mature PE funds is when the fund is in the midst of the harvesting period, the sponsor gets most of the money while bond investors get only the interest payment. When the harvesting dries up, bond investors do not get sufficient cashflows to redeem the bonds while the sponsor already gets all its capital back.

Fortunately for Class A (A-1 and A-2) bond holders of Astrea III, there are safeguards in place to ensure that the above scenario does not happen. Every 6 months, Astrea III has to set aside some cash in reserves accounts which can only be used to redeem the Class A bonds. The reserves accounts totalled USD161M, USD224M and USD258M in 2017, 2018 and 2019 respectively. These reserves accounts are sufficient to redeem the Class A-1 bonds which will mature in the next few days. The total amount of Class A-1 bonds is SGD228M (approximately USD170M).

Another safeguard that Astrea III put in place is the Loan-to-Value (LTV) ratio should not exceed certain thresholds ranging from 20% to 45%. If these thresholds were exceeded, Astrea III has to divert more cashflows to the reserves accounts. Based on Fig. 4, the LTV ratio of Astrea III is 27%, 18% and 24% in 2017, 2018 and 2019 respectively.

Had there been no such safeguards to set aside cash during the harvesting period, the balance sheet would have been worse for bondholders. Fig. 5 below shows the balance sheet had the reserves accounts been paid out to sponsor.

Fig. 5: Balance Sheet of Astrea III Excluding Reserves Accounts

The LTV ratios would have been 42%, 43% and 58% in 2017, 2018 and 2019 respectively. In particular, bond holders would end up being a larger supplier of capital than the sponsor while still not getting the bulk of the distributions from the PE investments!

In conclusion, if you are a bond investor in mature PE funds, be prepared to see a shrinking asset base while most of the distributions go to the sponsor. Make sure you have safeguards in place to ensure that a portion of the distributions are set aside for the sole purpose of redeeming the bonds!

See related blog posts:

• Where Do Astrea Bonds Stand Along PE Fund Lifecycle?
• Astrea V 3.85% Bonds – Understanding What You Are Buying Into 
• Understanding the Safeguards of Astrea IV 4.35% Bonds

Where Do Astrea Bonds Stand Along PE Fund Lifecycle?

Now that the allocation for Astrea V 3.85% bonds is released, everyone can go back to their regular activities and forget about it. However, if you, like myself, hope to get a piece of the equity portion of Private Equity (PE) investments one day, then we should continue to learn and understand more about PE. Today's discussion is on the typical lifecycle of a PE fund and where do the 3 Astrea bonds stand along the lifecycle. This has major implications on the risks of the bonds, as we shall discuss later.

A PE fund usually has a lifecycle of around 10 years and comprises 4 phases. These 4 phases usually overlap. See Fig. 1 below (source: The Ultimate Guide to Private Equity).

Fig. 1: Lifecycle of PE Fund

In the first phase, the General Partner (GP) who runs the PE fund, will source for new investors and get their commitment to provide capital as and when needed to invest into promising companies. When capital commitments reach the target fund size, the fund will close. 

In the second phase, the GP will source for promising companies to invest into. This is usually called the Investment Period, as the fund is busy investing into companies. During this phase, the fund can invest in any new companies so long as they satisfy the criteria in the investment mandate.

After buying into the companies, the fund will work with the companies' management to enhance their operations such that they can achieve a higher valuation than what the fund paid for. The typical duration that a fund holds onto a company is about 5 years, but could exceed 10 years for an under-performing company.

When the time is ripe, the fund will seek to exit the company, either by IPO, sale to another company, or even sale to another PE fund. This is known as the Harvesting phase. During this period, the PE fund is not allowed to invest in new companies, but is allowed to invest additional money into existing companies, known as follow-on investments.

Finally, before the stated lifespan of the fund is up, the GP has to exit all remaining companies, return all proceeds to investors and dissolve the fund. The 10-year lifespan is not a fixed timeline, as GPs can request for extensions of 1-2 years so that they do not need to carry out a fire sale of the remaining companies.

Based on the above lifecycle of a PE fund, investors of the PE fund (known as Limited Partners) will contribute capital in the early years of the fund before receiving distributions in the later years when the PE fund exits its investments. The cumulative cash inflow over the lifecycle of the PE fund resembles a J-Curve. See Fig. 2 below.

Fig. 2: PE J-Curve

For an investor in a PE fund, where the fund is along its lifespan matters. In the early years, there is significant capital outlay as the PE fund invests into new companies. There are also significant risks in streamlining the company for greater efficiency. In addition, the company might struggle under the usually significant debt load placed upon it by the PE fund. Not all of the companies will prosper and make money for the PE fund. 

In the closing years of the PE fund, although there is no further capital outlay, the cash distribution from the PE fund is declining as it exits more and more companies. Also, whatever companies remaining in the PE fund might be under-performing and might not be worth much. If a company is attractive to other buyers, it probably would have been sold before the 10-year lifespan of the PE fund is up and not get left behind in the fund.

Thus, if the PE J-Curve shown in Fig. 2 is accurate, the sweet spot is around the 5th year of the PE fund. In addition, exits should be timed before the 10-year lifespan is up.

In Jun 2016, Azalea first introduced PE bonds to the market with Astrea III bonds. 2 years later, it launched Astrea IV bonds and just last week, it launched Astrea V bonds. The weighted average age of funds at the time of launch and scheduled call date of the 3 Astrea Class A-1 bonds are as follow.

Bond	Wt Age of Fund	Scheduled Call (Yrs)
Astrea III	6	3
Astrea IV	7	5
Astrea V	5.4	5

Their lifespans superimposed onto the PE J-Curve are shown in Fig. 3 below.

Fig. 3: Lifespan of Astrea Bonds Relative to PE Fund Lifecycle

Astrea III bonds (blue line) will last from the 6th to 9th year of the underlying PE funds that Astrea III invested into. This is the sweet spot that we discussed earlier -- enter around the 5th year and exit before the 10th year. It is probably the safest of the 3 Astrea bonds. In fact, it has just been announced that this bond would be redeemed as scheduled in 2 weeks' time.

Astrea IV bonds (purple line) will last from the 7th to 12th year of the underlying PE funds. The PE funds are generating a lot of cash currently, with total net distributions (after deducting capital calls) of USD243M in Astrea IV's first year of existence. This is equivalent to 22% of its portfolio value at the time of IPO. However, as shown in Fig. 3, the amount of distributions is expected to decline moving forward.

Astrea V bonds (brown line) will last from the 5th to 10th year of the underlying PE funds. Compared to Astrea IV bonds, there is a little more risks initially, as the companies in the PE funds are less mature and less ready to be exited. Furthermore, there are higher capital calls expected. But if these risks in the initial years can be overcome, Astrea V bonds will have less risks towards the end compared to Astrea IV bonds, as cashflows towards the tail-end would not have declined as much.

When you look at the risks of Astrea IV and Astrea V bonds, some of the safeguards that Azalea put in place for the bonds start to make a lot of sense. Let's talk about Astrea V bonds first, as it is simpler. As mentioned, one of the key risks for it is higher capital calls. This is mitigated by the capital call facility that allows Astrea V to borrow money from the banks to meet the capital calls.

For Astrea IV bonds, the key risk is not receiving sufficient distributions towards the tail-end to redeem the bonds in full. Although there is liquidity facility to meet interest payments in the event of shortfalls in distributions, there is no equivalent liquidity facility that Astrea IV can borrow from to redeem the bonds. Money to redeem the bonds can only come from the distributions from the underlying PE funds. However, towards the tail-end, such distributions are declining and might not be sufficient to redeem the SGD242M bonds in full.

In fact, it would be unfair to bondholders if it were to happen, considering that in the initial years of the bond, the underlying PE funds are generating a lot of cash, most of which are passed through to the sponsor. For the first year of Astrea IV, out of total net distributions of USD243M, all classes of bondholders (Class A-1, A-2 and B) were paid only USD26M in interest. Other expenses during the same period totalled USD7M. If there were no safeguards in place, the remaining USD210M (equivalent to 86% of net distribution of USD243M) and another USD15M in existing cash would flow to the sponsor. This money can leave Astrea IV as dividends to shareholder and repayment of shareholder loans instead of being retained within Astrea IV. Once the money leaves Astrea IV, bondholders have no recourse to Azalea as the shareholder/ sponsor to redeem the bonds in full. Recall that the bond is not guaranteed by either Azalea, or its parent, Temasek?

To prevent this scenario from happening, Azalea has put in place a safeguard that part of the distributions have to be set aside in reserves accounts for the sole purpose of redeeming the bonds. For the first year of Astrea IV, a total of USD80M has been set aside. Hence, the distributions flowing to the sponsor is reduced from USD225M to USD145M. This ensures that there will be sufficient cash to redeem the bonds when they mature, even though distributions from the underlying PE funds are declining.

In conclusion, PE bonds are not a simple matter of buy-and-forget. Investors need to understand where they stand along the lifecycle of PE funds and also what investor protection they have. Azalea has done a good job protecting investors from losses, but investors still need to protect themselves by learning more about PE investments.


See related blog posts:

• A Shrinking Balance Sheet for Bonds in Mature PE Funds
• Astrea V 3.85% Bonds – Understanding What You Are Buying Into 
• Understanding the Safeguards of Astrea IV 4.35% Bonds

Astrea V 3.85% Bonds – Understanding What You Are Buying Into

It has been exactly a year since I last blogged. My last blog post was on Astrea IV 4.35% bonds. Coincidentally, Astrea's management, Azalea, has recently launched the IPO for Astrea V 3.85% bonds. One year has passed. What do I think about Astrea bonds?

If you read last year's blog post on Would I Invest in Astrea IV 4.35% Bonds?, you would know that I was not too keen on Astrea IV 4.35% bonds. A large part of the reasons had to do with Private Equity (PE) bonds being a new asset class and there was too little time to properly analyse whether it would be a good investment. Given the time constraint, I relied on whatever understanding I had about fund of funds and leveraged buyout funds and concluded that I would not be applying for the IPO.

A week later, after the IPO had closed, I had more time to look at the structure of the Astrea IV bond and acknowledged that it could be a safe one, but only because of all the credit enhancement safeguards put in place. See Understanding the Safeguards of Astrea IV 4.35% Bonds for more info.

Thus, when the IPO for Astrea V 3.85% bonds was launched this week, the first thing I checked was whether it has similar safeguards as Astrea IV 4.35% bonds. It has. Still, it is necessary to re-iterate that being PE bonds, Astrea bonds are not traditional bonds and it is important to understand the risks of the underlying assets. Below is a summary of the risks that I am aware of.

Understated Loan-to-Value Ratio in Fund of Funds

Astrea V bonds invest in 38 PE funds run by independent PE fund managers. Its stated Loan-to-Value (LTV) ratio for the Class A bonds (comprising Class A-1 and Class A-2 bonds which have equal seniority) is 34.8%. This means that for Class A bonds to start losing money, the value of the underlying investments has to drop by 65.2%. However, the underlying PE funds have their own debts and these debts are not considered when computing the LTV ratio of 34.8% for Astrea V bonds. The true LTV ratio after considering the debts in the underlying PE funds (i.e. look-though basis) is likely to be much higher. This ratio matters. See Would I Invest in Astrea IV 4.35% Bonds? for an example.

High Leverage Used by Buyout Funds

80% of the Astrea V investments are in buyout funds. As discussed in Would I Invest in Astrea IV 4.35% Bonds?, buyout funds use a lot of debts when acquiring companies. Typical debts is in the region of 6-7 times Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). High debts at the underlying PE funds, couple with a Fund of Fund structure, underestimates the true, look-through LTV ratio of the Astrea bonds.

Assurance of Net Asset Value

Astrea V has a portfolio value of USD1,342M. This is an important figure that is used to compute the LTV ratio. After the debacle of the Hyflux preference shares and perpetual securities, it became clear that asset values should not be taken at face value. Hyflux's main asset, Tuaspring Integrated Water and Power Project, which has a stated Net Asset Value (NAV) of $902M as at end of Financial Year 2017, could not be sold at close to book value. Given that PE investments are illiquid assets, what is the assurance that the portfolio value of Astrea V is really as stated?

This question was posted during the Astrea Investor Day in Jan 2019 and during the public roadshow on Astrea V bonds conducted with SGX Academy on Saturday. Azalea's management replied that the NAV of PE funds is checked by reputable auditors. In addition, there are secondary markets where PE funds are traded. The value at which they are traded is close to the NAV reported by the PE fund managers. Furthermore, when the PE investments are disposed of, Azalea cross-checks the sale value against the reported NAV. In most cases, the sale value exceeds the reported NAV.

PE in a Potential Bubble

PE investments have generated better returns than public equities in the last 20 years. This has resulted in a lot of funds flowing into PE investments, and increased competition between PE fund managers to find good deals. This has led to assets being purchased at higher prices. At the same time, the debts used by buyout funds to acquire companies has been on the rise. At some point in time, the PE boom will probably end, potentially leading to falls in NAV. See Bain & Company's report on Private Equity: Still Booming, but Is the Cycle Near Its End? for more info.

At Saturday's roadshow, Azalea replied that this is also a good time for selling assets in the PE funds that Astrea V has already invested in, which will result in cashflows coming back to the Astrea bonds. Furthermore, as most of the PE fund managers have a lot of experience running PE funds, they believe that the PE fund managers will be able to navigate the environment.

While I agree that this is a good time for selling assets in PE funds, this also means that the high asset prices are reflected in the portfolio value of Astrea's investments. In the event that asset prices correct, Astrea's portfolio value will also decline. This will lead to a rise in the LTV ratio, but there is a safeguard in place if the LTV ratio exceeds 50%.

Conclusion

Although I believe Astrea IV and V bonds to be fairly safe for retail investors, I cannot emphasize enough that the reason this is so is because of the credit enhancement safeguards that Azalea painstakingly put in place. Also, for investors interested to buy Astrea bonds, please understand what you are buying into.


See related blog posts:

• Would I Invest in Astrea IV 4.35% Bonds?
• Understanding the Safeguards of Astrea IV 4.35% Bonds
• A Shrinking Balance Sheet for Bonds in Mature PE Funds

Understanding the Safeguards of Astrea IV 4.35% Bonds

Astrea IV 4.35% bonds are unusual retail bonds as they are backed by Private Equity (PE). There are 5 safeguards put in place by the issuer to ensure that cashflows from PE investments are adequate to meet the obligations of the bond. These are:

• Reserves Accounts
• Sponsor Sharing
• Maximum Loan-to-Value (LTV) Ratio
• Liquidity Facilities
• Capital Call Facilities

To understand why these safeguards are important and necessary, let us consider a hypothetical scenario in which I wish to issue Boring Investor bonds to retail investors to raise capital to invest in public equities listed on the SGX. Cashflows for the bonds would come from sale of equity investments and dividends from investee companies. 

Generally, the Straits Times Index (STI) generates annualised returns of 7% in capital appreciation and 3% in dividends on average. To entice investors to my Boring Investor bonds, I would probably have to pay interest rate of 5% on the bonds. The first question that comes to mind is how do I ensure that I could meet the 5% interest obligations on the Boring Investor bonds on a sustainable basis when I could only receive 3% dividends from the equity investments? There are several things I can do, as described below. 

Maximum Loan-to-Value (LTV) Ratio

Supposed I intend to invest $1M in the SGX equities. At a dividend rate of 3%, the maximum dividends I could get from the equities annually is only $30K. Based on the bond interest rate of 5%, the maximum amount of Boring Investor bonds I could issue is $30K / 5%, or $600K. The maximum Loan-to-Value (LTV) ratio that can be supported by dividends on a sustainable basis is only 60%. Thus, by setting a maximum cap on the LTV ratio, I can better ensure that bond holders are paid on time.

Liquidity Facilities

There will be times when the economy is not doing well and the investee companies have to cut dividends. When this happens, I might not get sufficient dividends from the equity investments to pay interest to bond holders. I will need to borrow money temporarily from the banks to pay the bond interest.

Capital Call Facilities

There will also be times when some companies need to issue rights issues to raise money. Given that most the funds raised from the Boring Investor bonds have been invested in the SGX equities, I might not have sufficient funds to subscribe to the rights issues and buy additional shares in the companies at a bargain. To guard against this, I can set up a credit line with the banks to temporarily borrow money to subscribe to the rights issues.

Reserves Accounts

Given the unpredictable nature of the cashflows from dividends and sale of equity investments, it is prudent to set up a sinking fund to save some excess cashflows after paying the bond interest and other necessary expenses. The amount to be set aside for the sinking fund each year is a pre-determined amount, but it is only set aside if excess cashflows are available. The sinking fund will be topped up until there are sufficient funds to redeem the Boring Investor bonds in full. This would increase the likelihood that the bonds could be redeemed in full when they mature.

Sponsor Sharing

Generally, after meeting all the obligations mentioned above, any remaining cashflows would belong to the sponsor shareholder. However, as an additional gesture of goodwill, I can share the remaining cashflows 50:50 with bond holders if certain performance threshold is met by a certain date. The cashflows shared with bond holders would be used to top up the sinking fund mentioned above, if it is not full yet. 

Conclusion

As you can see above, cashflows from equity investments (more so for PE investments and PE funds) are unpredictable, irregular and discretionary whereas interest and principal repayment obligations of bonds are fixed and mandatory. There is a need for some of the above-mentioned safeguards (known as credit enhancements) to ensure that bond obligations can be met when they fall due. If there were no credit enhancements, and the fixed and mandatory bond obligations were solely funded by the irregular and discretionary cashflows from equity investments, defaults on the bonds would likely happen at some point in time. 

Thus, the Astrea IV 4.35% bonds are safe mainly because of the safeguards put in place. It is not a bond, but a structured bond. The credit ratings for Astrea IV 4.35% bonds are expected to be "A(sf)", with "sf" denoting structured finance. To avoid confusion with traditional bonds, it is best to refer to the Astrea IV 4.35% bonds as structured bonds, just like we differentiate structured deposits from fixed deposits. 

Did I invest in Astrea IV 4.35% bonds? No, I did not. I prefer to invest in traditional bonds in which the underlying cashflows are sufficient to meet the bond obligations without any credit enhancements. 

See related blog posts:

• Would I Invest in Astrea IV 4.35% Bonds?
• Astrea V 3.85% Bonds – Understanding What You Are Buying Into 
• A Shrinking Balance Sheet for Bonds in Mature PE Funds

Would I Invest in Astrea IV 4.35% Bonds?

Recently, Temasek launched a Private Equity (PE) bond for retail investors known as Astrea IV 4.35% bond. It is the first PE bond open to retail investors. Would I invest my money in this bond?

First of all, let us understand what this bond is all about. This bond is issued by Astrea IV Pte Ltd, an indirect wholly owned subsidiary of Temasek, to hold a portfolio of PE investments. The investments are managed by 27 General Partners in 36 PE funds and invested in 596 companies. 86.1% of these funds are invested in buyouts, with 12.3% in growth equity and 1.6% in private debt. 

Buyout funds are funds that privatise publicly listed companies, cut the excesses in the companies and streamline their operations to make them more efficient, and seek to exit the companies by selling them or listing them again. An example is Amtek Engineering, which was delisted from SGX in 2007 after being bought out by a PE fund, and was relisted as Interplex Holdings in 2010. And the story did not end there. Interplex Holdings itself was delisted in 2016 after being bought out by another PE fund.

The issuer, Astrea IV, has 3 classes of bonds, as follow:

• Class A-1 - SGD242M 4.35% senior bonds that are open to retail investors and which are the subject of this post.
• Class A-2 - USD210M senior bonds open only to Institutional and/or Accredited Investors. Class A-2 bonds have the same seniority as Class A-1 bonds.
• Class B - USD110M bonds junior bonds open only to Institutional and/or Accredited Investors. 

The structure of the bonds is such that Class A bonds have priority to interest payments and bond redemption. In addition, it can borrow money from banks to make interest payments in the event that there are insufficient cashflows to do so. Moreover, its Loan-to-Value (LTV) ratio is capped at 50% of the portfolio value. If this threshold is crossed, it will have to cut debt levels. Furthermore, Class A bonds are senior to Class B bonds and shareholder equity. For Class A bonds to lose money, the portfolio that Astrea IV invests in must lose at least 64.4% of its value. So, it is quite safe, isn't it? 

First of all, you need to recognise that Astrea IV, the company that you are investing into by buying the retail bond, is essentially a fund of funds. Although its LTV is capped at 50%, this is only at the Astrea IV level. The funds that Astrea IV invests into could have their own borrowings and these are not counted in the 50% LTV cap. After accounting for these borrowings at the lower levels (i.e. look-through basis), the leverage could be much higher. As a hypothetical example, Company A could have shareholder equity of $50M and bonds of $50M. Using this $100M, Company A invests into Company B. Company B borrows another $100M. Company B invests the $200M into a property. How much of the investment in the property is funded by equity and borrowings? The answer is $50M in equity and $150M in borrowings. Thus, even though the LTV at Company A's level is only 50%, on a look-through basis, the LTV is 75%! Does LTV on a look-through basis matter? For Company A's equity to be wiped out completely and its bonds to start losing money, the property's value only need to fall by 25% ($50M equity out of $200M asset value). So, LTV on a look-through basis does matter!

Secondly, most of the money are invested in buyout funds. Buyouts are usually highly leveraged operations. In the process of buying out companies, they take on large debts and usually pay a premium to acquire a 100% stake in the companies. After successfully acquiring the companies (which are usually cashflow-rich companies), they extract most of the cash from the companies to pay down their own debts. They also streamline the operations of the companies and load them with debts, such that the companies become more conscious about cutting costs and direct most of their cashflows to paring down the debts loaded onto them. Thus, the high returns of buyout funds are partly due to making the companies more efficient and partly due to the leverage employed. As an example, when 3G Capital teamed up with Berkshire Hathaway to buy Heinz for USD23.3B in 2013, they only forked out USD4.4B in capital each. The remaining was borrowed. (Note: Berkshire Hathaway also bought USD8B of preferred stocks paying 9% interest. I will leave it to readers to decide whether to classify this USD8B as equity or debt.)

Thus, in conclusion, Astrea IV is essentially a fund of leveraged buyout funds. I will not be investing in these bonds, even if its 4.35% coupon looks attractive.

See related blog posts:

• Are Private Equity Bonds Better Than Corporate Bonds?
• Understanding the Safeguards of Astrea IV 4.35% Bonds
• Astrea V 3.85% Bonds – Understanding What You Are Buying Into 

Singapore Savings Bonds – 2 Years On

It has been 2 years since the launch of the Singapore Savings Bonds (SSB) in Oct 2015. How have the SSB interest rates changed in the past 1 year and how have SSB performed compared to the more traditional Singapore government bonds, i.e. Singapore Government Securities (SGS)? The comparison for the 1st year (Oct 2015 to Sep 2016) is discussed in Singapore Savings Bonds – A Year On. This post continues the discussion for the 2nd year (Oct 2016 to Sep 2017).

The most important factor for both SGS and SSB is interest rates. In the 1st year, interest rates went down. However, in the 2nd year, interest rates went up, especially during the Nov to Dec 2016 period which saw US Federal Reserve raising interest rates again in Dec 2016 after a 1-year hiatus. Figs. 1 and 2 below show the 10-year interest rates for the 1st and 2nd year.

Fig. 1: 10-Year Interest Rate for Year 1

Fig. 2: 10-Year Interest Rate for Year 2

For the 2nd year, the highest 10-Year SSB interest rate achieved is 2.44%, for the tranche issued in Feb 2017. This is still lower than the all-time high of 2.78%, for the tranche issued in Nov 2015. The all-time low is 1.75%, for the tranche issued in Sep 2016. The current SSB interest rate is 2.07%.

If you have bought the 1st tranche of SSB in Oct 2015, the interest rate for the 2nd year would have stepped up from 0.96% to 1.09% in Oct 2016. The market price of SSB is a constant $100, as it is capital protected by the government. In comparison, the coupon (i.e. interest rate) for SGS is constant while the market price of SGS varies with prevailing interest rates, rising when interest rates fall, and falling when interest rates rise.

How does this 1st tranche of SSB compare with the corresponding 10-year SGS bond? Figs. 3 and 4 show the price performance of the SSB and 10Y SGS for the 1st and 2nd year.

Fig. 3: Price Performance of 10-Year SGS and SSB for Year 1

Fig. 4: Price Performance of 10-Year SGS and SSB for Year 2

In the 1st year, the 10Y SGS went up in price due to the fall in interest rates, resulting in a capital gain of 6.57%. On top of that, investors in 10Y SGS would have pocketed a coupon of 2.375%, which, based on the purchase price of $98.61 in end Sep 2015, is equivalent to a yield of 2.41%. The total gain for the SGS is 8.98%, compared to 0.96% for the SSB. The table below shows the comparison between SSB and SGS for the 1st year.

	SSB	SGS
Capital appreciation	-	6.57%
Yield	0.96%	2.41%
Total	0.96%	8.98%

However, in the 2nd year, interest rates went up, especially during the Nov to Dec 2016 period, resulting in a capital loss of -2.53% for the SGS. The yield for the 2nd year, based on the price of $105.09 in end Sep 2016, is 2.26%. Thus, investors who hold the 10Y SGS for the 2nd year would have a net loss of -0.27%, compared to 1.09% for the SSB. The table below shows the comparison between SSB and SGS for the 2nd year.

	SSB	SGS
Capital appreciation	-	-2.53%
Yield	1.09%	2.26%
Total	1.09%	-0.27%

Thus, when interest rates go up, it is better to hold SSB, as they are capital protected. However, when interest rates go down, it is better to hold SGS, as they can generate capital gains. By juggling between SGS and SSB, you can get the best of both worlds. The contrasting performance of SGS and SSB for the past 2 years shows that the discussion in Getting the Best of Both SSB & SGS is correct.

See related blog posts:

• Getting the Best of Both SSB & SGS
• Singapore Savings Bonds – A Year On
• SSB Interest Rate Estimates

If You Invest In Fixed Income, Read the Fine Print

After the exertion to read the Offer Information Statement (OIS) of Hyflux's preference shares and perpetual capital securities (perps) in the past few weekends, this week's post will be a lighter one. 

In my post last week, I extracted the relevant portions of the OIS of Hyflux's preference shares and perps to discuss the conditions upon which Hyflux could omit the preference dividend and perps distribution respectively. For me, the most surprising discovery is that the preference shares are ranked pari passu (or have the same seniority) with the perps! See the figure below, which is extracted from the perps' OIS.

Fig. 1: Relative Ranking of Hyflux's Preference Shares and Perps

All along, I had thought that the preference shares would rank lower than the perps, mainly because the preference shares are a type of shares and perps have characteristics of a bond. Conventional wisdom suggests that a bond must rank higher in seniority than a share. It was only until I read the above from the perps' OIS that I realised that I was wrong!

The relative ranking of the preference shares and perps have important implications for their respective holders. If the preference shares were ranked below the perps, the preference shares would serve as a cushion for the perps. Any losses would be absorbed first by the ordinary shareholders, followed by the preference shareholders before the perp holders suffer a loss. As at Jun 2017, the total debt of Hyflux is $1,308.7M. The equity attributable to ordinary shareholders is about $226.9M (corresponding to net asset value per share of $0.289 for 785.3M shares, which is down from $0.451 in Dec 2016). The debt-to-ordinary-equity ratio works out to be 5.77, which is very high. If the preference shares were ranked below the perps, there is another $392.6M of preference equity between the ordinary equity and the perps. The debt-to-(ordinary + preference)-equity would be 2.11, which is a lot less than the original ratio of 5.77.

Unfortunately, that is not the case. Both preference shares and perps are ranked pari passu with each other. This means that both preference shareholders and perp holders share in the loss together if losses exceed the $226.9M equity attributable to ordinary shareholders. 

The key takeaway for me from reading the Hyflux's OIS is never to assume the relative ranking of different instruments based on their names. And if you invest in fixed income instruments, better read the fine print too.

See related blog posts:

• Watch Out for Hyflux's Omission of Ordinary Dividends
• Do Hyflux's 6% Perps Have Sufficient Margin of Safety?
• Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form

Watch Out for Hyflux's Omission of Ordinary Dividends

Hyflux announced its half year financial results last month. For holders of Hyflux preference shares and perpetual capital securities (perps), perhaps the most noteworthy point is that it did not declare an interim dividend on its ordinary shares. Why is this important? It is because the payment of a preference dividend or perps distribution is discretionary. If certain conditions are met, the company can choose not to pay or only pay partially any preference dividend or perps distribution. One of these conditions is that a dividend on the ordinary shares is not paid out. The conditions for preference shares and perps are different, so let's discuss these separately.

Preference Shares

There are 2 conditions upon which Hyflux can choose not to pay or only pay partially its preference dividends. The 2 conditions are:

1. If it does not have sufficient Distributable Reserves; or
2. If it does not pay its next dividend on its ordinary shares.

See Figs. 1 and 2 below for extracts of the Offer Information Statement (OIS) for the preference shares.

Fig. 1: Conditions for No/Partial Preference Dividend (Extract)

Fig. 2: Definition of Distributable Reserves

For Condition 1, if Hyflux does not have sufficient Distributable Reserves, it will not be able to pay its preference dividends in full. The definition of Distributable Reserves is shown in Fig. 2 above. I interpret it to mean that Hyflux must have sufficient retained earnings to pay dividends, regardless of whether they are ordinary dividends or preference dividends. As at Jun 2017, the retained earnings are $146.9M. The retained earnings have been dropping recently. In Dec 2015 and Dec 2016, the corresponding figures are $284.2M and $210.3M. See Did Hyflux Make Money for its Ordinary Shareholders? for more information.

For Condition 2, if Hyflux does not pay its next dividend on ordinary shares, then it can choose not to pay or only pay partially the preference dividend. Nevertheless, this does not mean that Hyflux will definitely not pay its next preference dividend in full. It only means that Hyflux can choose not to if it wishes.

In addition, the preference dividends are cumulative. If a preference dividend is skipped, it will continue to accumulate until it is fully paid out or the preference shares are redeemed.

Perpetual Capital Securities

For perps, the condition upon which Hyflux can choose not to pay or only pay partially its perps distribution is if it does not pay a dividend on, redeem or buy back any of its Junior Obligations in the preceding 6 months. The ordinary shares are considered as Junior Obligations. In addition, Hyflux can defer part of the perps distribution if it pays a dividend on, redeem or buy back its Parity Obligations on a pro-rata basis with the perps in the preceding 6 months. The preference shares are considered as Parity Obligations. See Figs. 3 and 4 below for extracts of the OIS for the perps.

Fig. 3: Conditions for No/Partial Payment of Perps Distribution (Extracts)

Fig. 4: Ranking of Hyflux Preference Shares and Perps

The last ordinary dividend was paid on 25 May 2017 and the last preference dividend was paid on 25 Apr 2017. As Hyflux did not declare an interim dividend on its ordinary shares in its latest financial results, if Hyflux chooses not to pay the next preference dividend scheduled on 25 Oct 2017 in full, Hyflux can defer part of the next perps distribution scheduled on 27 Nov 2017.

And like the preference dividends, the perps distributions are cumulative. If a distribution is skipped, it will continue to accumulate until it is fully paid out or the perps are redeemed.

Just a disclaimer, this post is not a recommendation for anyone to buy or sell Hyflux's preference shares or perps. It is also based on my interpretation of the terms in the OIS. You can find a copy of the OIS/ prospectus in Bondsupermart. Please read the OIS and do your own due diligence.

See related blog posts:

• Did Hyflux Make Money for its Ordinary Shareholders?
• If You Invest In Fixed Income, Read the Fine Print
• Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form

Fundamentals of Stock and Bond Picking

You have probably heard of the study in which monkeys throwing darts on a dartboard with stock names on it could produce portfolios that outperform those picked by professional investors. A few reasons were given for the outperformance, such as size of the companies, Price-to-Book valuation of the stocks, etc. I wonder if the same study were to be repeated for bond picking, would monkeys still outperform professional investors?

There is no study on the above, but my answer to it is probably not. When you pick a stock to buy, you are expecting it to change in the future, whether it is the earnings or dividends increasing or the Price-to-Earnings valuation improving. In essence, you are forecasting the future. This can be seen from the various models for valuing stocks. The Dividend Discount Model, for example, estimates the intrinsic value of a stock as the summation of all future dividends discounted to the present. The Discounted Cash Flow Model does so similarly, using free cashflows instead of dividends. The present matters less in stock valuation, and yardsticks based on present assets such as Price-to-Book ratio do not feature much in investors' minds. There are good reasons for this, because if the assets cannot produce good future earnings, the assets have to be discounted from book value. 

The corollary is that, if things are not expected to change in the future, you should not pick the stock (except for dividend stocks, which have similarities with bonds). Also, since nobody can predict the future accurately, it is not surprising that monkeys can beat professional investors in stock picking. Likewise, professional investors underperform their respective stock benchmarks when they carry out tactical allocations according to their outlook for the future.

Bond investment is quite the mirror opposite of stock investment. When you pick a bond (or dividend-paying stock) to buy, you are expecting it to continue paying the same amount of coupons or dividends until they mature. In other words, you are expecting it not to change in the future. Hence, bond valuation starts with present assets and earnings and computes a margin of safety to cater for unexpected changes in the future. While the future is still important, the present plays a bigger role in bond valuation. Thus, bond valuation deals with yardsticks such as the debt-to-equity ratio, interest coverage ratio, etc. which are found in the present income statements and balance sheets.

Hence, when you compare stock and bond valuation methods, stock valuations are more of an art, because it is based on forecasts for the future, which everybody will have different opinions of. Whereas bond valuations are more of a science, because that they are based on figures in the income statements and balance sheets, which people rarely dispute. 

Hence, on the above question on whether monkeys will outperform professional investors on bond picking, my answer is probably not, since monkeys cannot analyse income statements and balance sheets. Also, based on the above argument, more professional bond investors should outperform their benchmarks compared to their stock counterparts. This is true. S&P publishes annual SPIVA (S&P Indices Versus Active) reports on whether active fund managers outperform their benchmarks. In all equities categories, active fund managers underperform their respective benchmarks. In bonds, active fund managers outperform their benchmarks in the investment-grade short and intermediate, global income and general municipal categories on a 5-year basis (see SPIVA report for US Year-End 2016).

Thus, on the question whether you should buy the stocks or bonds of a particular company, it depends on your outlook for the company in the future, summarised as follows.

Company Outlook	Bonds	Stocks	Conclusion
Changes for the Better	Good	Best	Best for Stock Investment
No Change	Good	No Good	Best for Bond Investment
Changes for the Worse	Bad	Worst	Both Investments are Bad

When things do not change in the future, bonds are better investments than stocks. When things change for the better in the future, bonds are good investments, but you can perform better by buying the stock. When things change for the worse, both are bad investments, but stocks are worse than bonds.

The above also has implications on the types of stocks we should buy. If there are no catalysts for changes such as improved earnings or dividends, asset sales or a bull market in the future, an undervalued stock will continue to remain undervalued. A growth stock will be a good investment, but only until the day its growth starts to slow down, from which it becomes a bad investment. A dividend stock is good provided things do not change or change for the better.


See related blog posts:

• What Can We Learn About Stocks From Bonds
• The Lost Art of Bond Investment
• The Investigative Approach to Stock Investments