Sunday, 10 June 2012

Valuing Bond Funds (Part I)

Valuation Methods

I have put corporate and government bonds together as the methods we can use to value them are the same.

To value a bond we need to know two essential things: the yield on the bond and the risk of default. 

Investing in a bond yielding 10% a year might sound nice but if the risk of default is high then the expected returns could be much lower and in some cases even negative.

So how do we find the information we need to value a bond? Let's say we want to invest in a UK government bond fund. An example of one such fund is the ishares FTSE UK All Stocks Gilt (ticker LSE:IGLT.L). Looking at the ishares website gives information on this fund. Looking at the yield to maturity I might see a figure like 1.72%. I use the yield to maturity as it gives a clearer valuation of what the bond is worth. A bond with a high current yield might look attractive but once the bond matures capital could be lost if the bond was bought at a premium. Therefore using the yield to maturity gives a fuller and fairer picture of the bond's true value. So to find the yield is a simple case of researching it on the internet. What about the risk of default? Well the website of the fund should also give a credit rating for the bond. In the above example a Aaa credit rating has been assigned. This is the highest possible rating and the risk of default is almost zero. The table below shows the average default rates of moody's credit ratings based on data collected from 1920-2008.
Mean default rate (1920-2008)

 As you can see the default rate for Aaa rated bonds is 0.00%. In fact there hasn't been a single default on Aaa bonds between 1920 and 2008. So a Aaa bond is pretty much 100% safe. As you move down the list you see the default rates increasing pretty rapidly. Caa-C or junk bonds as they are commonly known have an average annual default rate of over 13%. If you're investing in these make sure you are getting a very high return to offset the high risk of default. 

In our model I like to add a margin of safety so I double Moody's default rates to value a bond. In the above example with the Aaa rated FTSE All Stocks Gilt bond the default would still be zero (0.00% times 2 is still 0.00%)

The expected return on a bond investment would therefore be:

R = Y - 2D - e

Where: R = Expected annual net return
Y = Gross yield to maturity
D = Default risk (See above table showing Moody's default data)
e = Expense ratio of the fund

For the ishares FTSE All Stocks Gilt fund I mentioned earlier this would give an expected return of:

= 1.52%

A return of 1.52% is not worth the effort in my opinion. Even with the low expense ratio of 0.2% on the fund the returns are far too low to make this investment worthwhile and far better investment opportunities are out there.

Let's look at a higher risk-higher return situation. ishares UK corporate bond fund (ticker LSE:SLXX.L) which as I write gives a gross yield to maturity of 4.16%. The credit rating on this bond is riskier than the government bond fund in the previous example with a rating of A. The expense ratio is again 0.2%. This gives the following estimated return:

= 3.78%

A vast improvement on the riskless government bond. The A rating means there is a small risk of default but we have double Moody's default estimates to give us some margin for safety.

Let's now look at a high yield bond. JPMorgan Emerging Markets Bond which as I write has a yield to maturity of 5.26%. The Moody's rating on this bond is Ba and the expense ratio is a fairly high 0.45%. This gives us the following expected annual net return:

= 2.69%

The initial attractive return has been reduced due to the low credit rating of the bond and the high expense ratio. In this case the UK corporate bond looks to be the safer and better investment.

Reasons Behind the Method

Clearly when valuing a bond we cannot only look at the yield. The credit rating needs to be seriously considered. There are bond funds on the market that currently have yields to maturity in excess of 7%. However, these funds are also unrated by Moody's. Why are they unrated? I don't know for sure but I would be pretty certain it's not because they have good credit ratings. The bonds at best are going to be B rated and quite possibly junk. The expected return using the above valuation technique is likely to be negative making them more of an expense than an investment.

Doubling of Moody's default rates gives us a margin of safety when investing in bonds although it can also skew our investments in bonds to only the highest credit ratings. For me this isn't a problem as my main concern is protecting my capital. More adventurous investors with an appetite for risk might want to change the formula to create more high yield opportunities.

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