Bond Fundamental Analysis - The Risk And The Numbers

Bonds are one of the safest investment instruments in the market today for many reasons. The main reason is that bonds have the least risks for loss of capital because of their low price volatility coupled with fixed principal amounts and interest rates in most bond types. Still, it is necessary to perform bond fundamental analysis to determine which of the debt securities on offer will provide the highest yield for a certain period of time.

In many ways, bond analysis is similar to stock analysis in that both internal and external factors must be considered. The past, present and future performance of the issuing entity must be weighed against the general market and economic conditions to arrive at a decision to invest or not to invest in the bonds. In this article, a few of the most important factors in bond fundamental analysis will be briefly discussed.

Credit Risk

Even the bonds secured by the US federal government have a certain amount of credit risk. In recent memory, this was underlined when Standard & Poor's downgraded the US federal government's previously sterling credit rating of AAA to AA+. In 1995, too, the US Treasury was close to default.

The first step in bond fundamental analysis is to know the bond issuer's credit rating from the credit rating agencies. The best known credit rating agencies are Moody's, Standard and Poor's, and Fitch's with the most common rating system from AAA (prime grade) to D (default), the latter one known as junk bonds.

If the bond issuer has an AAA credit rating, it means that the bonds will most likely be paid on time complete with the interests due. Conversely, if the bond issuer has a credit rating from B+ to D, the bonds are highly speculative and, thus, present high risks for default.

How Financial Statements Help In Bond Fundamental Analysis

Like stock analysis, bond fundamental analysis also requires analyzing the past and present financial indicators of the issuing entity as well as making forecasts for its future financial performance. The tools and techniques available for stock analysis can be used for bond analysis, too, even for bond issuers like federal, state and local governments.

Thus, you should compute for the issuer's fundamentals like earnings per share, price/earnings to growth ratio, and cash flows, among other quantitative factors. You should learn to understand the financial statements including the balance sheet, income statement and cash flows statement from which these figures are gleaned from.

Inflation and Interest Rates

Bond fundamental analysis also involves looking at the factors beyond your control, namely, the inflation and interest rates in the market. Let's take a closer look at each one.

On one hand, inflation lessens the amount of real return on investment for the bond. Common sense reveals that a bond with a yield of 8% on paper will be worth less than its coupon value when the inflation rate is at 4% even when the bond is tax-exempt itself.

On the other hand, interest rates affect un-matured bonds in many ways. A rise in interest rate lessens the price for the prospective sellers who want to sell their bonds before the maturity period.

When you have considered all of the three abovementioned factors in bond fundamental analysis, you are more likely to make a better investment decision. Add in good technical analysis and your opportunity to make a profit rises even higher.