How to calculate EV of this proposed investment?

[Bill C]

As part of my retirement portfolio, an advisor has suggested I purchase a "high yield" bond in a company that has some chance of going under during the 3 year term of the bond. Obviously he feels it is unlikely that it WILL fail, but admits there is perhaps a 10% chance the company will fail. The bond is yielding approximately 10%.

How do I calculate EV here, and how can I best understand the risks involved in terms of mathmatics?

Any help would be greatly appreciated.

bill c

[icetonez]

I think it is definately +EV and that's assuming you would get nothing from liquidation which I think is unlikey. I'm not sure, but I think you could just take for example a $100,000 investment and do this:

-100,000 * .10 v. $133,100 * .90

[DesertCat]

[ QUOTE ]
As part of my retirement portfolio, an advisor has suggested I purchase a "high yield" bond in a company that has some chance of going under during the 3 year term of the bond. Obviously he feels it is unlikely that it WILL fail, but admits there is perhaps a 10% chance the company will fail. The bond is yielding approximately 10%.

How do I calculate EV here, and how can I best understand the risks involved in terms of mathmatics?

Any help would be greatly appreciated.

bill c

[/ QUOTE ]

Your best EV may be to fire the advisor. If he's putting you into a risky investment that you don't seem to understand, that's a big -EV right there. It makes me wonder how much he is charging you, and how fair that is, and how safe the rest of your investments are.

If this is your retirement fund, and you are not a skilled investor, I can't see putting even a tiny portion of your portfolio into this bond. What's the benefit? The greater yield is miniscule if it's a tiny investment, and the risk is too high if it's a significant investment.

You can get a risk free yield of 4% or so right now from the federal government. Which means 100% of the time you get 4%. Your bond pays 10% 90% of the time, and if you believe your advisor, -100% the remainder. EV by that calculation is -1%, or about 5% less than a risk free deal.

Of course I'm simplfiying. you are getting 10% for a three year term, you probably have to take much less than 4% on a three year treasury (don't know, I'm equities only right now). And as the other poster said, if the company fails you still have a chance of getting some or all of your money back.

But you can't understand your risks in terms of raw mathematics. You need to review the companies SEC filings in detail to understand the amounts and nature of the assets that you are counting on to repay your bond. You need to understand your bonds position, i.e. is it getting paid first, or is it subordinate to a bunch of other bonds that get paid before it. This is very tricky stuff, which is why I am so dismissive of your advisor.

A key rule of gambling and investing is to stick to what you understand. When your advisor puts you in things you don't understand, then you will never be able to truly estimate your risks.

[DesertCat]

[ QUOTE ]
I'm not sure, but I think you could just take for example a $100,000 investment and do this:

-100,000 * .10 v. $133,100 * .90

[/ QUOTE ]

Both of our math was wrong . In your case bonds don't compound, and you won't have a 100k gain, that's just your basis. Where you were ahead of me is placing the default risk is over 3 years, not one year as I did it, which I believe is what the author meant. Teh formula should be like this

-100k*.1 + 30k*.9 = +17k, or 5.67% risk adjusted yield.

But I'm wondering if a 3.3% annual default rate isn't rather low for a junk bond. Once again, the only way to make a reasonable estimate of the bond's security is to review the company and the bond in detail.

[Bill C]

The bonds are GMAC; the company that "may fail" is General Motors.

I appreciate the helpful thoughts, and if anybody has more insights, bring them on!
FWIW I think this advisor is pretty good and has brought me to early retirement on his picks. Still, I wonder about this one...

Best to all...
bill c

[adios]

You need to provide a lot more info on the specifics of the bond.

[crazy canuck]

FWIW I think this advisor is pretty good and has brought me to early retirement on his picks. Still, I wonder about this one...

Or more likely that he is pretty lucky.

[Bill C]

Thanks Adios,
I'm not very knowledgable about bonds (surprise!). What information do you need? I'll see if I can get it.

bill c

[player24]

General Motors is not technically a "high yield" bond because it is still not rated below investment grade by any of the major credit rating agencies. But it is one notch from "high yield" and the market is expecting a downgrade to below investment grade.

Because of the company's enormous cash balance, there is materially less risk in short maturity GM debt than long maturity debt. Default risk in a three year window is low/moderate. Longer term, risk rises considerably.

GM 6.125% notes due 2008 are offered at 94.62 which translates to a yield of 8.34%. You will not get a 10% yield without moving further out the curve (i.e. longer maturities, much more default risk).

GM represents about 2% of the entire outstanding principal of investment grade bonds. If/when the next ratings downgrade occurs, some institutional investors will be forced to sell the bonds. The buyers will be high yield investors, including mutual funds, pension funds, insurance companies, hedge funds, etc... There is great concern in the market that selling pressure will continue to push the bonds lower in price. The bonds have been trading off steadily for the past few weeks and the selling has accelerated in recent days.

GM's cost structure is way out of line with current market share and the company's new vehicle lineup will probably result in even greater loss of market share. Labor costs are extremely high because of UAW contracts which grossly overpay workers and do not expire until 2007. GM is simply not competitive and the situation is likely to get worse before it gets better.

Never ever ever ever concentrate your financial assets in a single corporate bond, regardless of credit quality. Diversification is the only free lunch in investing, especially in corporate bond investing.

Long term historical default rates in the high yield market are about 5% and the range is 1% to 14% (default rate was only 1% in 2004). Keep in mind that default usually results in bankruptcy, but this does not mean you lose your entire investment. On average, defaulted corporate bonds recover about 40 cents on the dollar. The results are better for secured debt.

Probably more info than you need/want. I believe the risk and return on GM bonds are fairly well balanced at current prices, but I would never consider this investment except in the context of a well diversified portfolio.

[adios]

The "seniority" of the debt, if the bonds are "callable", agency ratings (I'm fairly certain the bond market is anticipating the rating agencies to downgrade a lot of the automakers debt so you probably need to do some research into what the ratings are anticipated to be ), Yield-to-maturity to name a few things. Once you have a good idea as to what the rating of the bonds will finally be, you might want to compare them to other bonds that have the same rating both in the corporate sector and the mortgage backed security (MBS) sector. I'd definitely study up on bonds a little bit before taking the plunge. You also might want to think about a bond fund that is appropriate to the risk level you're willing to take with this bond. You might sacrifice some yield but the level of risk you undertake would probably go down a lot since you've diversified individual company risk away. I wouldn't ignore the MBS market with equivalent ratings. Ford bonds tanked and I know some are yielding 10% or so. At least compare the GMAC and Ford bonds. I would think that your advisor would be able to answer a lot, if not all of these questions if they know what they're doing.