Sunday, October 26, 2008

Don't Neglect The Bond Market

When investors think of putting money in the market, they almost always think only of stocks. However, there's a huge bond market out there (consisting of corporate debt) that, depending on the economy, can offer value investors even more bargains than do stocks. For example, when we met with Warren Buffett a few months ago, he mentioned that while he saw some bargains in stocks, he currently saw many more inefficient pricings in debt markets.

Finding value in debt markets is nothing new for value investors. In Security Analysis, Ben Graham and David Dodd go into extensive detail for intelligent investors to help them decipher what to look for in order to find bargains in debt markets. Debt holders have certain advantages in that they have first claim on company assets (ahead of stock holders). On the other hand, debt holders don't have the possibility of receiving gains above what is promised. For this reason, Graham and Dodd suggest only purchasing a company's debt (for the purpose of gains) if the bond price is severely depressed (by 30% or more). This way, outsized gains (approximately 50%) can be made for those who can spot the inefficient pricings. (For income purposes, debt securities may still be purchased close to par.)

Unfortunately, information on debt issues is not as prevalent as it is for stocks. Nevertheless, information exists for those who seek it. Yahoo! Finance has a decent "Bond Center" devoted to corporate debt. For example, here's a look at the debt issues of The Home Depot (HD). These securities can be purchased in the same manner as are stocks, but few individual investors are aware of this market.


Paul said...

Like most I've focused my efforts the last few years on stocks, but I see how bonds can be attractive also.
A question about your Home Depot link, how do you know if a bond is undervalued?
This is a total bond newbie question, but are they all based on $100, so the Dec 16th 2036 would be 30% undervalued?
Thanks guys, I love the blog.

Saj Karsan said...

Hey Paul,

To determine if a bond is undervalued has the same complexity as determining if a stock is undervalued, so it's too much to get into here. I strongly recommend Ben Graham's Security Analysis if you're looking to get into it.

They divide bond analysis into two types, one for the investor interested in the income, and one looking for the capital gains (in which case you're looking for diamonds in the rough with prices well below par because investors have soured on the company).

To answer your question, yes at the end of the term (so in the year 2036 in your example) the company will pay out a "par" value of $100, but that doesn't translate into the bond being necessarily undervalued just because it sells for less than that.

Paul said...

Thanks Saj,
I'm trying to get through Security Analysis........I'm trying hard. lol
I figured it was different than just looking at the value on the screener, if it was that easy I guess everybody would be buying.

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