This article is an excerpt from the Shortform book guide to "The Intelligent Investor" by Benjamin Graham. Shortform has the world's best summaries and analyses of books you should be reading.
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What is a bond analysis? How do you conduct a bond analysis before buying bonds?
It’s important to do a bond analysis before deciding to buy any stocks. Bonds can be great investments as long as you do research. In The Intelligent Investor, Benjamin Graham provides advice on how to do a bond analysis.
Read more about bond market analysis and strategies and why they’re necessary
The chief risk of buying bonds is that the issuing company defaults and goes bankrupt. By studying certain criteria of safety for a bond issuer, you can avoid risky bonds that might become worthless. This is particularly important as the historical trend has been for companies to take on large loans even as they struggle to show profits.
(Shortform note: In his commentary, Zweig issues a reminder that since bonds are sold in large increments (say, $5,000), an investor buying bonds herself would need $100,000 to properly diversify. Instead, modern investors are likely better suited by bond funds, which do the hard work of bond research and diversification for you.)
Interest Coverage Ratio
One part of bond market analysis and strategies is the interest coverage ratio. The major metric for bond safety is the ratio of earnings to total interest charges, also known as the “Interest Coverage Ratio.” This is a measure of how well the company can pay the interest on its loans.
If the ratio is below 1, then the company isn’t generating enough profits to pay off its loans; this can in turn mean the company may default on its loans, which can then lead to bankruptcy and a reorganization of the company.
To be more precise, the ratio can be calculated in a few different ways:
- The earnings can be before taxes or after taxes
- The window of time can change. Graham proposes using either the average ratio of the past 7 years, or the single worst year in the past 7 years.
Different industries have different minimum coverage ratios you can use for bond market analysis and strategies. For example, Graham proposes that retail and railroad companies should have a minimum interest coverage ratio of 5 averaged over the past 7 years, while utility companies can have a lower minimum of 4 due to its relative stability.
Other Safety Factors
Beyond the interest coverage test, study other factors of the company:
- Size of business
- Asset values, particularly in real estate, utilities, and investment companies. In other industries, the value of the assets may fall while the company’s earnings power falls.
- Ratio of earnings to the total debt principal, as opposed to total interest charges. This is useful particularly in high interest rate periods, when it becomes more difficult for companies to cover multiples of their interest charges
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