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Author: junkman02 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35351  
Subject: A Bond-Shopping Exercise Date: 11/8/2009 4:00 PM
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The following exercise must NOT be construed as a recommendation to buy. It is merely an exercise undertaken for the purposes of amusement.
The data is stale, but real, being the closing quotes as of Friday’s close for Ford Motor’s debt where the min purchase was one bond and YTM was at least 9%. How these prices will differ from Monday’s opening is any one’s guess. So the data is just data, and the exercise is just an exercise, meant to while away leisure time. Play along if you wish.

Issue Cpn Maturity YTM CY Price
FORD MTR CO DEL 6.500 08/01/18 9.57 7.92 82.090
FORD MTR CO DEL 9.215 09/15/21 10.62 10.17 90.625
FORD MTR CO DEL 8.875 01/15/22 10.28 9.82 90.350
FORD MTR CO DEL 7.125 11/15/25 9.88 9.12 78.090
FORD MTR CO DEL 7.500 08/01/26 10.30 9.63 77.850
FORD MTR CO DEL 6.625 02/15/28 9.67 8.94 74.125
FORD MTR CO DEL 6.375 02/01/29 9.27 8.59 74.225
FORD MTR CO DEL 7.450 07/16/31 9.04 8.77 84.997
FORD MTR CO DEL 8.900 01/15/32 10.28 10.12 87.975
FORD MTR CO DEL 7.750 06/15/43 10.64 10.52 73.689
FORD MTR CO DEL 7.400 11/01/46 9.69 9.60 77.100
FORD MTR CO DEL 9.980 02/15/47 10.94 10.93 91.350
FORD MTR CO DEL 7.700 05/15/97 10.43 10.43 73.850

Question: Which issue offers the best value?

Ford is in trouble, right? as is the whole US economy. But their prospects are improving, and to buy their debt is to make a bet on the future of the US economy. If you’re a whale in the investing world, you buy whole railroads. If you’re a minnow, you buy fractional shares of companies, or you lend them a bit of money. That’s how the purchase of corporate bonds should be viewed. Forget about prevailing interest-rates. (If you want to make bets on interest-rates, buy futures or some other appropriate vehicle.) If you want to be a lender to corporate America, pay attention first and foremost to the business to which you are lending and come to understand that business well enough to forecast its likelihood of survival. That means doing financial statement analysis, among other things.

For the purposes of this exercise, let’s assume we’ve done that part of our due diligence and we’ve concluded that Ford’s prospects are shaky, but that they might actually survive long well and well enough to pay interest and return principal. It’s far from a sure thing, but it’s possible, and to the extent that they are likely to fail is the size of the risk for which we are going to have to be paid to accept. In other words, if survival is a sure thing, we will settle for a low, but assured return. If survival is uncertain, but we want initiate a position, we need to get at a price that minimizes our risks. We might be wrong about the survival prospects of this company, but if we take a disciplined approach to our buying, and if we buy lots of companies, and if, over time, we are right more often than we are wrong, or right more often about the big things, then we will, on average, be profitable. So the strategy, as Buffet suggests, is just to not screw up too majorly. For a value investor, that means trying not to over-pay or over-buy.

Now back to Ford’s bonds: Which one offers the best value?

Your answer will likely differ from mine, and, likely, it won’t be wrong, because there’s a lot of ways to do this stuff. But here’s how I would go about trying to determine which bond to buy. Which bond is lowest in terms of price? Which bond is highest? What is the range of prices? If Ford files for Chapter 11 protection, the bondholders will likely be returned some value. It might be cash, new debt, or equity, or some combination thereof. But a haircut will be likely. To the extent that debt can be bought as close to a Chapter 11 workout price as possible (or even below that) is the extent to which one type of principal-risk can be reduced. But there is also an opposing dynamic that has to be considered. The longer the holding period, the more likely that BAD-Things-Will-Happen. However, that long-dated debt is typically the cheapest debt. So that becomes one trade-off to consider: a quicker maturity but a greater distance to a workout price versus a closer price to workout but a longer maturity.

Another trade-off to consider is cash-flow (also known as recovery-rate) versus price-appreciation. The faster one’s cash can be recovered, the faster one’s principal-risks are reduced, as well as one’s inflation risks. Therefore, a high current-yield might trump a high yield-to-maturity. It all depends on one’s purposes and which risks one most wishes to defend against.

And I’m sure there are other trade-off that other investors use when they evaluate bonds. But for me, those two trade-off’s are the biggies. I want to minimize the distance between my entry price and a Ch 11 workout price, and I want to maximize my recovery-rate. Everything else –-call-features, etc.-- is secondary. If a low price is also a cheap price when my reward: risk ratios are considered, then I’m a happy camper. If the bonds are expensive (when my reward risk ratios are considered), I’m not happy.

So, once again: Is any of Fords’ debt cheap?

The answer to that is a resounding “NO”. To see why, pull Time & Sales (T&S) for those bonds. A couple months back, any of those bonds could have been bought for a third of their present prices. By no stretch of the imagination is this debt presently cheap. And if the economy rolls over into a double dip, prices will fall again and a buyer would feel foolish for having “bought the high”. But there is also this to asked about present prices. How much of their increase is due to buying-demand prompted by prevailing interest-rates and how much is the rise in prices due to improving prospects for Ford? To the extent that the market correctly perceives that the risks of Ford’s debt have diminished, the increased price can simply be viewed as the cost of insurance. In other words, the removal of uncertainty is expensive. If you waited to buy Ford’s debt (instead of buying it when it was truly low priced), your wait is going to cost you potential profits. But your waiting might also help ensure you will actually achieve some profits to achieve. So that’s yet another trade-off: price-risk versus information-risk. (But digging into that topic is a post for another time.)

Again, let’s re-ask our basic question: Are any of Ford’s bonds worth buying? But let’s go about answering that question by asking the reversal: Which bonds in the list above are obviously bad buys?

The easy answer would be the longest-dated bond, the 7.7’s of ’97. But that would only be true if no other bond offered a better risk-reward profile. So let’s take a look at that bond and do some comparison-shopping. The bond is priced at 73 something and offers a 7.7 coupon. The nearest priced bond is 7/3/4’s of ’43. But notice this difference. The maturity is a whopping 54 years closer and offers nearly as much current-yield and yield-to-maturity. In fact, when inflation is taken into account, the YTM of the closer bond will prove superior in terms of return of purchasing power. (I’ll leave it to you as an exercise to do the discounting.) So, scratch that bond from the list. Then repeat this process throughout the whole list until you have identified for yourself where the “sweet spot” is (if there, in fact, is one), so that you arrive at the best possible combination of the factors that matter to you. If you do find a sweet spot in an issuer’s yield-curve, and if you are inclined to buy the issuer’s debt, then all that remains is to size your position and to execute your order.

Simple, right? It’s just shopping. No different than buying broccoli or bell peppers. The key to success is not over-paying and not over-buying. The key to not over-paying is to know your prices. The key to not over-buying is to buy in prudent sizes. The key to “prudent” is to not create positions so big that the damage from mistakes of judgment and from normal market reversals can’t be sustained without seriously impairing long-term financial goals.

Note: The preceding was merely an exercise. But running these kinds of exercises for yourself when you have the time to do them in a thoughtful manner means that you are putting into place skills that you can call upon when markets are open and prices are changing and execution speed might matter. Knowing how to invest well isn't a skill we are born with. Instead, it is a skill that has to be learned, and like all skills, acquiring competence requires practice. Whether you value the competence enough to undertake the practice is your own decision, as is viewing the practice as play to be done for its own sake on a rainy, Autumn afternoon when markets are closed but it's still too early in the day to head out for a walk.

Postscript: Broker-calculated YTM’s cannot be trusted. I accepted them at face value in this exercise. But when I’m doing my own evaluation work, I check the YTMs with my own procedures. The differences are often wide enough for me to find a bond attractive, or to argue against it. Will I buy some of Ford's debt Monday morning? I don't know yet, and I won't know, until I complete the exercise. What bought earlier in the year has done well for me. Whether the buying time is past is something I won't know until I've run the needed comparisons which involves two things: an analysis of Fords' yield-curve and then benchmarking that YC against those of all other issuers. I might find something worth buying. I might not. But I won't know for sure until I shop.
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