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Corporate bonds: Balancing risk, reward and the worst case scenario

It’s the worst possible outcome that helps establish their underlying value

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The stock market thrives on optimistic narratives about companies achieving great things that will inspire stock values to skyrocket. Properly valuating a corporate bond requires only two considerations — that the yield compensates for risk and that the company will be in good enough shape to redeem the bond at maturity. It’s all part of the art of imagining the worst case scenario in bond valuation.

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“It’s always the worst outcome that tells the relevant story for bonds we consider,” says Timothy Hicks, chief investment officer at Lysander Funds Limited. “In terms of reward, we look at bonds primarily in two ways. First is the additional interest or yield you’re getting on the bond versus a similar term Government of Canada bond, based on the risk of lending to the borrower. Second, and equally important — if the worst does happen, what is your expectation of how much you would recover?”

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Lysander is an experienced Canadian investment fund manager offering funds that specialize in corporate bonds, with Canso Investment Counsel being the funds’ portfolio manager. Among the Canso investment team’s skills is the ability to analyze the health of each borrower and assign a level of risk to the likelihood of repayment according to proprietary analysis. But it’s a sliding scale, carefully balancing risk against reward.

“Canso looks at the company issuing the debt and the nature of the business,” Hicks says. “Is it a stable business with recurring revenues, such as a grocery chain, or is it a commodities-based business where revenues are highly dependent on the price of oil, for example? We need to know that the expected revenue will be just enough to redeem the bond. We’re not interested in whether the company has the potential to do better than that, because they won’t pay us any more than the contract stipulates.”

So at best, lenders get their money back, which is what they were expecting, plus interest. At worst, the bond issuer files for bankruptcy and can’t pay the bond holder according to the contract.

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“But if you’ve done due diligence, knowing how much you’re likely to get back from an insolvent company could make that bond acceptable,” Hicks says.

Lenders must understand their order at the table to recover their debt in the case of bankruptcy. For example, secured senior debt must be repaid first and is covered by the lender’s cash flow, with the debt also collateralized by company assets. Unsecured senior debt must be settled next, and junior — or subordinated — debt is paid out only after all senior debt is settled in full.

How far will a bankrupt company’s assets stretch to repay the lender? Hicks notes that companies may hold real estate, equipment and other collateral that help to increase the security of a bond should the company become insolvent. But understanding the nature of that collateral is also critical. Airlines, for example, may not own their own aircraft, leasing many of them. Much of their collateral would be represented by the routes they own and gates they lease at various airports.

“In managing a fund, the portfolio manager might include some debt that has a lower expected recovery rate, provided the yield is attractive,” Hicks says. “They might see bonds that are trading at a discount, and the expected recovery rate they assessed now becomes acceptable, even in the event of that company’s bankruptcy.”

However, if riskier debt in the fund is weighted lower than debt with a higher likely recovery rate, it means that if the worst happens, it won’t have an undue effect on the overall health of the fund.

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Investment funds dedicated only to high-yield corporate debt may find themselves limited to choosing among bonds with potentially lower recovery rates when the economy slows. The Lysander-Canso funds are not constrained to high yield and are able to invest in senior, higher recovery debt if there is a better risk/return opportunity.

“At those times, the portfolio manager will take a look at what’s on offer in the market and perhaps decide that it’s not that attractive,” says Hicks. “The portfolio manager will stick to the two traditional criteria — additional yield in compensation for additional risk and the downside in bankruptcy.”

For more information on Lysander Funds, visit: www.lysanderfunds.com

The views and information expressed in this article are for informational purposes only. They are not intended as investment, financial, legal, accounting, tax or other advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

®Lysander Funds is a registered trademark of Lysander Funds Limited.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of Lysander Funds Limited, who is a member and content provider of this publication.

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