The 10 key questions corporate bond investors should ask (corrected)

By Bernard Hickey Investors rushing into corporate bonds for higher returns should ask their advisor 10 key questions. (Corrected to include Tower's 8.5% (not 8%) return. Tower's BBBminus rating by AM Best is also included) What is the bond's credit rating? A BBB- or higher rating from Standard and Poor's is judged to be investment grade. Ratings from Moody's and Standard & Poor's are deemed more useful and reliable than those from Fitch and AM Best. Avoid anything without a credit rating. Some investors have been burnt by the AAA credit ratings assigned to toxic mortgage-backed bonds from the United States, but these ratings are still the best independent and expert assessment of credit risk we have. What does the company do? If the company is a monopoly or part of an oligopoly such as the power generators then that will make any revenue stream more reliable. Airports can rely on regular income streams from passengers and airlines, while councils have the power to impose rates. Who owns it? The bond is stronger if it's from a state owned enterprise such as Genesis Energy or a monopoly such as Fonterra that can rely on either the government or very wealthy shareholders to bail it out in an emergency. How will it use the money? Using the money for debt repayment is a positive, but using it for expansion or an acquisition is riskier. If the answer is "˜working capital', then do some more digging. Avoid a company using the money to fill a black hole of ongoing losses. How much debt does the company have? This is an important question to ask in an age when it is often difficult to roll over debt on wholesale markets or with nervous bankers. Every company has a different 'good' level of debt, depending on its income streams. But be wary of companies that are already heavily indebted with debt to debt plus equity ratios of more than 50%. When is the rest of the debt due? Any large chunk of debt due in the next 6-12 months is a problem in the current environment. Can it pay the interest and repay the capital on maturity? It's worth looking at how much free cash flow is regularly generated and how much "˜coverage' it has in terms of multiple of free cashflow to interest payments. Also, will the company be able to pay out on maturity. Could some business or regulatory roadblock stop that? Is the bond government guaranteed? Some financial institutions are offering government guaranteed bonds, but the guarantee expires in October 2010. Obviously government guaranteed bonds that mature before October 2010 are safer than those that don't and safer than unguaranteed bonds. How does the interest rate compare to other issues of similar risk? This is a key question. Does the return compensate for the risk. Currently even investment grade corporate debt is much riskier than government or bank debt because of the prospect of a long and damaging global recession. I would demand at least 5% more than the safest government debt at the moment for the lowest grades of investment grade bonds. Anything with a junk or sub investment grade (below BBB minus) should be returning more than 7% above the government bond yield. Given the 5 year government bonds is currently around 4%, that means I think BBB- bonds should be offering at least 9%. This means the 8% 8.5% offered by the unrated (by S&P or Moody's) Tower's is insufficient to compensate for the risks it poses. It should be closer to 11%. Tower is rated BBB minus by insurance ratings agency AM Best, but does not have a S&P or Moody's rating. Currently the iTraxx index, which measures the "˜margin' for Australian investment grade corporate debt above bond yields, is around 4%. New Zealand debt should be about 1% higher than that. What fee is the broker/advisor receiving? The advisor should be telling you up front. Where does the bond rank? If it is subordinated it ranks behind other debt holders such as banks. A senior or unsubordinated bond is first in line for cash should the company go belly up. A secured bond is directly connected to an asset owned by the company such as a mortgage, although this didn't provide much protection for finance company investors. Is it convertible into equity? Convertible bonds are riskier than pure bonds and should receive a much higher interest rate. Look at the conditions of the conversion and whether interest payments can be stopped in times of trouble. See all the current and recent bond issues here in our 'Great Corporate Bond Rush' page. * This piece was published in the Herald on Sunday. Any other questions bond investors should ask? Comments below please