Adding Fixed Income to Your Value Investing Toolbox

It is important to remember that in the early days of value investing Benjamin Graham and his crew would only invest in fixed income. In fact, back then, placing your money into the debt market of high quality firms was the safest option. Common stock, with a few exceptions, was considered a vehicle of speculation. It’s interesting how things have changed. Value investing literature for the current day focuses heavily on equity. However, we mustn’t forget that fixed income is still a great value investment.

The term “fixed income” in the investment world can refer to a variety of different vehicles; bonds, CDOs, ABSs, etc. But generally fixed income is any type of investment where a borrower/issuer is to make a payment to the counterparty on a fixed schedule. To simplify this post I’ll be writing about bonds when talking about fixed income. A bond is basically a loan. It is the other way that a company can raise money outside of issuing equity. When equity is issued a company sells shares to buyers in exchange for cash. With bonds the firm basically takes a loan from investors and commits to pay back the loan at the end of the term as well as periodic interest payments (called coupons) throughout the duration of the term. (Note: there are various types of bonds; ones with no coupons, ones that pay quarterly versus annually, ones that are taken by governmental bodies versus companies. This is beyond the scope of this post.)

Just like investing in equity, many paradigms hold true for fixed income investing. Looking into a company’s balance sheet to see if they have the capability to pay off their loans, finding a firm that has an economic moat and therefore a competitive advantage that will ensure going concern and repayment, and even the durability of its business and revenue sources should be looked at. But fixed income investing has additional metrics that should be analyzed as well; interest coverage ratios now hold more weight and debt covenants are valuable metrics for seeing how flexible a company will be going forward. Also, we can’t forget about interest rate risk, credit risk, tax implications, and income stability, amongst other things.

Bond holders are paid back before equity holders receive any payment and this often gives bonds the reputation of being safe investments. Graham makes it explicitly clear that this, by no means, implies that bonds are safe and stable. They can fluctuate just as wildly as equity. However, you can take steps to limit the possibility of this happening. By investing in large and established companies an investor can have some additional confidence in the repayment. This assurance can even be further extended by purchasing bonds issued by governments. Governments are typically considered the safest entities on the planet for repayment of loans (although this has recently been called into question with the Eurozone crisis). And so, a value investor will find these good and durable entities and wait for them to be underpriced in the bond market, similar to the way this happens in the equity market.

Critics of the value philosophy of investing take a jab at this. They will say “how can a bond be undervalued? Does this not mean that the safety of the company and the investment is questionable?” Frequently this is correct, but not always. And this is the job of a trained analyst: to find these companies. Graham speaks about two main sources of this discrepancy in market value and intrinsic value and those are: disappointing results, and company neglect/unpopularity. If those can be the causes of inefficiencies in the equity market, they surely can do the same thing in the fixed income market.

Finally, keep in mind that simply adding fixed income securities to a portfolio can be considered a value investment move of its own. Assuming that the underlying company in a fixed income security is stable and relatively guaranteed (like most governments are considered), an investor can rely on periodic coupon payments. These coupon payments will help balance out losses in the rest of the portfolio, reducing volatility and normalizing portfolio results. They act as a safety net for times of trouble in the rest of the market. This same fixed income investment will also have a full loan repayment at the end of the term. Knowing the exact amount of money that will be paid back and when it is paid back prior to purchasing the loan is a great advantage to have that doesn’t exist in the equity market. As value investors, this allows us to diagnose the return that our investment will provide and contrast it against the risk required to take it.

The lesson here is that fixed income can’t be ignored as a value investment vehicle as well as an important part of any value investors portfolio.