Bond value investors look for undervalued securities to achieve a yield advantage for themselves compared with other investors.
Government bonds in countries with important economies such as the USA or Germany or particularly stable economies such as Switzerland are generally considered to be the safest investments with regard to the default risk. Therefore, other fixed-interest securities generally carry a higher yield than they do.
The yield difference is called the risk premium because its scope reflects the magnitude of the risk an investor takes if he chooses this investment instead of a safe government bond.
If this risk premium is much higher, however, than the actual default risk implies, this opens up an opportunity for value investors. They examine and evaluate the default risk of a bond with financial analysis methods. If the yield reflected in the market price is clearly higher than the analytically determined ”fair risk premium“, a purchase opportunity arises.
Value investors in bonds have one advantage compared with value investors in shares: shares need a market mechanism to align them to their fair value. Success is dependent on the shares being discovered by the market. Nobody can forecast when this will happen or whether it will happen at all. However, bonds generally have a fixed maturity. The actual value of a bond is realigned with its fair value when it is repaid at the latest.
There are three different approaches to search for undervalued bonds:
1) Government bonds without excellent credit rating
Government bonds enjoy a yield premium if they are issued by countries that do not yet have the level of development of the leading industrial nations or that are deemed to be economically or politically instable. In order to estimate their suitability as an investment, it is necessary to assess whether - and to what extent - these nations are able and willing to pay back their debts. Furthermore, it is necessary to evaluate whether the political or economic risks are already reflected in the interest rate premium.
In particular, investments in the government bonds of emerging markets have increased strongly during recent years. According to our assessment, many investors underestimate the political risks connected with an investment in countries with questionable stability.
2) Corporate bonds with high solvency (investment grade)
Enterprises with investment grades are highly solvent with only a low default risk. Nevertheless, they show a yield premium compared with government bonds. To assess whether these securities are suitable as an investment, the circumstances that could lead to the deterioration of their solvency have to be analysed and evaluated.
The magnitude of the risk premium in comparison to safe government bonds depends very much on the state of the capital markets. While in uneventful times the risk premium for relatively safe corporate bonds can melt down to a few basis points, it expands significantly in phases of worsening market sentiment.
3) High-yield bonds (junk bonds)
High-yield bonds (junk bonds) are fixed-interest securities with a significant default risk, which offer a very high yield premium compared with government bonds. They are the most aggressive form of investing in bonds. A detailed financial analysis of the default risk and tight risk management are decisive for the success of this method.
In addition, the chances of success for this strategy are dependent on the business cycle. In the late phase of an economic boom, investors tend to be careless. Therefore, the risk premiums are generally relatively low. At the same time, however, the default risks increase. In the early phase of an economic boom, however, investors tend to be very cautious. Therefore the risk premiums are relatively high even if the at the same time the default risks decrease.