Traditionally, value investing has been identified with equity investment. Not only Graham wrote about equity valuation, but also, every well-known value investor has gain his fame by investing in this asset class. Though returns of these investors are above the average on the long term, some people are not willing to accept the high volatility associated with these investment style, or at least, they would like to complement it with some fixed income securities in their portfolios. So that, we might ask ourselves: can value investing be applied to fixed income? The answer is yes, and here is why.
Value investing consists of investing in undervalued assets, with an asset-picking strategy, and being patient until the market recognizes its value. Thus, applying this philosophy you can invest in fixed income securities of individual companies, whose market price is below its intrinsic value, with a long-term objective. Yet, although value investing can be applied to this asset class, the investment horizon depends, not only on your patience, but also on the maturity of the asset.
Having said that, how do we know if a fixed income security is undervalued? The answer is easy: a bond or a loan is undervalued if the interest rate at which is trading is above its “intrinsic” level. So that, the key point in fixed income investing is to estimate the intrinsic interest rate of a particular bond, which is given by the risk-free rate plus a risk premium.
Nevertheless, before analysing the optimal interest rate of the bond, we have to take into account that there are three different interest rates on fixed income assets, and we should choose the correct one.
First of all, we have the Coupon Yield, which is the interest rate at which the bond is issued. That is, the annual (or whatever the annuity) cash flows with respect to the par value of the financial instrument. Mathematically, it can be written as:
But the price of the bond changes, so, when an investor buys a bond in the secondary market, it can trade above or below its par value, that changes the return that he will obtain on each coupon. This yield is the so-called Current Yield, which is a more precise approximation of the return to the investor but still incomplete. Mathematically, the Current Yield is as follows:
The reason why it is incomplete is because it leaves out of the formula two important issues: time value of money and its compounding power; and the nominal value of the bond, that is supposed to be recovered at the maturity. So that, the fixed income investor must use a different interest rate, called Yield to Maturity (YTM).
It is the annualized return on a bond at current prices if it is held to maturity, considering the actual price of the bond with respect to par value, the coupons and years to maturity. So that, it is the internal rate of return (IRR) of a bond if all payments are made as scheduled. Thus, the YTM assumes that coupons are reinvested at the same rate of return. Analytically, this is the rate at which bond price equals the present value of future cash flows. Its advantage is that allows us to compare between different bonds, with different maturities. In addition, with the YTM we can obtain the value of the bond, which is derived as follows:
The Yield to Maturity is the most important concept to invest in fixed income securities. It gives the risk premium at which is trading with respect to the risk-free rate, so we can study if this risk premium is fair or not, according to the fundamentals of the company. Then, if a company has good free cash flow generation capacity, low debt ratios, high level of cash and short-term securities and the business perspectives are good; and, on the other hand, the market risk premium is very high, the bond would be undervalued, so a value investing strategy could be applied.
A practical example
Imagine we find a bond from a company trading at $900, with a nominal of $1,000 and a coupon rate of 4%. The maturity of the bond is in 5 years. The risk-free rate is 2%, and you estimate, based on the fundamentals of the business, that the intrinsic risk premium is 2.5%. Is the intrinsic value of the bond above or below the market price? And, if it is above, what is the Margin of Safety?
The estimated intrinsic YTM is 4.5% (Risk-free Rate + Risk Premium), so, using the Net Present Value approach we obtain an intrinsic value of $978.05. So that, compared with the current price of $900, we have a Margin of Safety of 7.98% on this bond. Is that enough for a fixed income security? That depends on how confident you are on the company, but if the investor is pretty sure the company will do well, it is a good number to invest.
Another important fact regarding fixed income investing is that even if the market does not recognize the value of the bond and it reaches its maturity, the investor should not feel it like a loss since he has obtained a higher return that the minimum required return, which would be the intrinsic Yield to Maturity. So that, if he has no investment alternatives, investing in fixed income assets with a buy and hold strategy, that is, until maturity, might be a good tactic to obtain low volatile returns.
– In Spain, we can find one asset management company which applies Value Investing to fixed income securities. This boutique is Buy and Hold, and you can see a video in Spanish explaining some examples here.