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By Jeremy Glaser | 06-11-2010 12:31 PM

Mitigating Risk in Corporate Bonds

Morningstar credit analyst David Sekera outlines ways fixed-income investors can stay ahead of interest rate and credit risk.

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser.

What are the risks at investing in corporate bonds and how can you mitigate them? I am here with credit analyst, Dave Sekera to talk a little bit about this. Dave, thanks for joining me today.

David Sekera: Thank you very much.

Glaser: So, first off, maybe at a very high level, what is corporate debt and how does it differ from, say, investing in a stock or some other sort of debt instrument?

Sekera: Sure. Well, a corporate bond is a contractual obligation from the issuer to borrow money from you and then repay that at a specified time in the future, and in return the company will pay you on interest income on it, which is paid to you semiannually, as opposed to a stock, where maybe you get a dividend, maybe you don't, it's up to discretion of the board of directors. Here that interest has to get paid to you under the terms of the trust agreement every six months.

Glaser: When you think about, who would get paid first in the event of a company running into problems – where do the bondholders set in relation to other people, who invested in the company?

Sekera: Sure. Well, the bondholders, of course, have a seniority and bankruptcy to the equity holders, both the preferred equity holders as well as the common equity holders. Now, there are different classes of seniority within the bond universe, but in the investment grade world, typically most are senior unsecured notes.

Glaser: So, it seems like in front of line of all the equity holders that there's not maybe a huge risk that you would lose your principal. Is this the case, do you need to be worried about corporate credit risk when investing in bonds?

Sekera: Always need to be very worried about corporate credit risk when you invest in bonds. Now here, at Morningstar, we do have our own ratings on the bonds and we take into consideration the four different pillars that we use to rate the bonds and all of that is really just trying to get to what is the probability of default.

Now in a default situation, most likely you will be impaired, you will lose some of the principal value as it goes through the bankruptcy process, but at least at the end of the day you are more likely to at least get some of your principal back as opposed to the preferred or the common shareholders, which typically get wiped out.

Glaser: So other than the corporate level risk of a default, what other sorts of risks do you need to be worried about when you are investing?

Sekera: Sure. You always have the underlying interest rate risk, as interest rates move, the value of the bond moves inversely in the direction of interest rates. So, for example, if interest rates were to go up and you are stuck with the fixed coupon on the bond, the value of the bond would go down if you try to sell it in the secondary market.

However, note that if you do hold the bond to maturity, you will continue to keep getting that coupon every six months and you will get your full principal amount back at maturity.

Glaser: So, if you buy a bond that, say, is yielding 3%, that might seem great in this environment, but if interest rates rise and five years from now, they are at 8%, all of a sudden that bond looks a whole lot less attractive.

Sekera: Exactly.

Glaser: So, if you see these risks and still want to be a fixed income investor, what are some of the ways to mitigate them?

Sekera: Sure. First of all, it depends on the liquidity needs of the individual investor. I try and match up the duration of the bond with the investor's needs for liquidity.

So, for example, if they know they are going to need that principal amount at some point in time in the future; for example, paying for a child's college education 10 years from today, I would look to try and match that up as closely as possible with a 10-year bond.

That's going to take a lot of the interest rate risk movement out of the bond, because I am looking to hold that bond to maturity and not looking to sell that in the secondary market, when the value of the bond could be below or could be above the principal value at that point in time.

Glaser: What are some of the other things investors could consider?

Sekera: Well, I always look for individual investors' risk appetite and try and match that up with the underlying risk of the corporate credit risk of the bond. Most individual investors, if you are buying individual bonds and you don't have a natural portfolio diversification, I would always recommend to stay with more highly-rated bonds.

So, for example, here, at Morningstar, I would look for BBB or better type investment grade bonds as to below investment grade bonds, which are also commonly known as junk bonds. Junk bonds have a much higher probability of default over time than the investment grade bonds do.

Glaser: So, Morningstar is trying to differentiate between what is a junk bond and what's investment grade, how do you go about that?

Sekera: Sure. We have a very quantitative analysis that we perform and it uses our forward-looking model and we look at the four different pillars. We are looking at the business risk of the company, we are looking essentiality at the liquidity risk, the ongoing solvency risk and then we are looking at the asset volatility of the company as well.

What differentiates us, I believe, is that we are looking at what we think is going to happen in the future, we are using our forward-looking expectations, we are not looking just to the past. What we are trying to understand what's really driving the company, what's driving the cash flows and how that's going to impact their credit quality going forward?

Glaser: So it seems like some good advice to look for companies that will have solid earnings in the future and not just ones that happen to have solid earnings in the past?

Sekera: Exactly, and we've really leverage off of our equity analysts in order to perform that analysis.

Glaser: That's great. Dave, thanks so much for your insights today.

Sekera: Thank you very much.

Glaser: For Morningstar.com, I am Jeremy Glaser.

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