This chapter details the 2nd and 3rd principles of investing in fixed value assets.
These principles sound like:
II. Bonds should be bought on a depression basis
III. Unsound to sacrifice safety for yield
The first part says that it is safe and vital to invest in more proven assets against weaker companies. For the same reason, the issue of choosing bonds should be approached very carefully and opted for stable and time-tested assets.
Particular attention should be paid to the bonds of such companies that are able to withstand strong market shocks, at the same time, it should be borne in mind that there is no industry that is not prone to depression at all.
It is very important to understand the degree of resilience of the business to the vicissitudes of fate, and how firmly it can withstand the unpredictable blows of the future.
The importance of the nature of the industry was also noted, and that even the current strict division into defined sectors could change over time. A new classification may appear or the target industry may undergo significant changes in the essence of its activities, which is also an important factor for risk analysis. (Examples of public utility companies)
It is always worth remembering that one way or another, each asset is subject to its own unique correlations and risks. Thus, the choice of an asset comes down to a deep analysis of the risks, first of all, associated with this particular company from this particular industry.
Industries can evolve, split and merge, especially in the present modern time.
Another important observation can be made that the more stable the type of enterprise, the better it is for bond financing and the more of the assumed normal return can be used to pay interest.
The authors also emphasize the difference between normal and abnormal depression, the example of 1931–1933 they refer to the group of catastrophic crises.
In my opinion, March 2020 shows a similar picture to 1931, when an unexpected future for everyone caught even the most stable industries (such as airlines and natural resources) by surprise.
This chapter also discusses various examples of bond collapse situations. Among which there is a general principle that despite all the stability of some industries, in normal times, and the obvious choice of the investor in their favor, these decisions can turn into problems, since the giants also need more time to recover.
Also, in some industries, the phenomenon of unstable profitability may occur due to a series of losses that have arisen in the industrial sector. I would define this as a macro-seasonal factor.
In turn, small and medium-sized industrial enterprises have an inherent lack of stability, which makes them unsuitable for financing through bonds.
Another important point is that unavailability of sound bonds is not a reason to buy weak bonds. This in turn also stems from the principles of maximum safety and adherence to the principles of avoiding any problems, which in turn can lead to delays, which are a very significant risk factor.
The authors also note that they do not share some of the widespread ideas, leading the reader to believe that a reasonable amount of secured debt is rather an advantage for a thriving business because shareholders can profit in excess of interest charges by leveraging the capital of the bondholders.
Thus, concluding that it is preferable for both the corporation and the investor to limit the borrowed funds to the amount that can be taken care of under any conditions. Although if such bonds were issued compulsorily, then such bonds are usually attributed to the secondary quality and purchased on a straight investment basis is unwise.
The third principle says that you should not sacrifice security for the sake of profit, from here it becomes clear that investments are a constant balancing between the interest rate and the degree of risk.
The nature of returnable interest is also analyzed, it is customary to distinguish 2 components in them:
The First — “Pure interest” — the rate with no risk of loss.
The Second — representing the premium obtained to compensate for the risk assumed.
The complexity of the mathematical assessment between risk and reward is also noted, since this equation contains a lot of variables, including popularity, seasoning and marketability.
Summing up the written above I can conclude that investments are always a balance between the level of risk vs level of potential yield, where investor first of should always prefer maximum security.