Value in Bonds

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Market prices for fixed income securities can be volatile just like those for equities, especially for those bonds with longer maturities. As you may be aware, Benjamin Graham describes bargain issues as those stocks and bonds particularly worthy of a security analyst's investigation. In terms of bonds these bargain issues are bonds that are deemed to be safe investments but which still sell at so low a price "as to offer a chance of considerable enhancement in market value". This is why we want to find bonds of a higher quality which are trading at a discount to bonds of a lower quality. In most cases bonds would be trading cheaply because their safety is questionable but this is not always the case. As in equities, there are always a small number of cases where a security may be trading at a discount while still meeting strict investment standards. Fundamentals still reign supreme in fixed income though, so not only do you want a company that may have been battered by the market and investor sentiment (even if correlated with a higher yield on the fixed income security), but you want to be confident that your contrarian views are correct. The bonds are only valuable so long as the company is still in existence!

The concept of finding value in fixed income securities is relatively straightforward, but where do we begin to look for these bargains? If the equities of certain companies may have been negatively affected, creating value opportunities within the equity market, then perhaps the fixed income securities of these companies may be a good place to start. As there is no apparent systematic way to segment corporate bonds into value and growth categories, The Brandes Institute went back to a study they conducted on equities and then studied the bonds that the companies in the study had issued. Their main findings were as follows:

• There were more issuers with debt outstanding within the value companies.
• The bonds issued by companies within the value group delivered a better total return than the bonds issued by the growth companies over subsequent 3 year periods from 1990 to 2007.

What is interesting from the findings of the study is that one would assume the difference in total return to be merely due to the value bonds' lower average credit rating and subsequently higher average spread. As such, The Brandes Institute compared the Lehman Brothers U.S. Aggregate Corporate A Index (a proxy for bonds of the growth companies which had a credit rating of "A" on average) to the Lehman Brothers U.S. Aggregate Corporate BAA Index (a proxy for bonds of the value companies which had a credit rating of "BBB+" on average). Over the same period as the study, these indices showed a difference in total returns of 14 basis points versus the approximately 69 basis point annualized total return difference between the value and growth bonds in the Brandes Institute study. The total return advantage for bonds of value companies therefore can not be fully explained by credit quality or yield spread.

It's difficult, if not impossible, for a retail investor to build a bond portfolio with adequate diversification. Perhaps there would be demand for a fixed income ETF that invests solely in the fixed income of the low price-to-earnings universe of stocks, which is commonly used as a generalization for the universe of value stocks.