How to Evaluate the Risk of a Company for a Bondholder
When someone loans money to a business by purchasing a bond, his most pressing concern is whether he will be able to recover his money. Because corporate bonds generally do not require repayment until a few years later, part of the issue in determining the risk in corporate debt is assessing the long-term profitability of the business. When assessing the risk of not regaining your initial investment, you need to determine the priority of your debt in comparison to the business's other debts. You also need to review the business's financial reports, determine whether the corporation has a debt rating, and look for any outstanding news reports about the business.
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Debt Priority
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The biggest fear for a corporate bond holder is that he will not recover his investment because the entity declares bankruptcy. Many times when a business goes bankrupt, its debts are either forgiven or decreased so that debt holders receive only a portion of their investment at best. When a business goes bankrupt, the debts are ranked, with the debts paid in order of priority. By establishing the priority of your bonds, you can determine the likelihood that you will get repaid in a worst-case scenario. If your bonds have the highest priority, you obviously have a better chance of repayment than if your bond is fifth in line.
Credit Ratings
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Larger companies that publicly trade their bonds are normally graded by a rating agency. These agencies assess the likelihood that corporations will repay their outstanding debts based on financial history and current economic conditions. Corporate credit ratings are sorted on a letter-based scale. AAA corporations are the ones best equipped to repay their obligations, and D Corporations are unlikely to repay.
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Financial Statements
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Audited financial reports provide the financial history of the corporation as well as disclose relevant material transactions and risks that will take place in the future. Reading through this data gives you an understanding of the business’s long-term financial potential, as well as alert you to any possible large expenses, such as lawsuits, that could jeopardize the business’s future profitability. The more likely it is that the business can make a profit, the greater the possibility of repayment, and financial statements provide a basis for determining future profitability.
Internet Search
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While financial reports provide an accurate disclosure of events regarding a business when published, it may not contain the most current information. Financial statements are only accurate as of the date published. If, for example, financial statements are published on March 15, but, in April, a significant health risk with the business’s product is discovered, that discovery will not be reflected in the statements, but it probably will have a significant effect on future profits. Using an Internet search engine can alert you to recent information that may put the long-term financial stability of the debt-issuing corporation in jeopardy.
Considerations
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For larger corporate debt investments, meet with a financial consultant so he may provide additional insight into the business’s long-term financial prospects. This article is not intended to be legal advice.
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