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The importance of relative value

How to compare and assess investments

Sunday, September 17, 2017

With the Government of Jamaica (GOJ) USD bond redemption last Friday, investors will be assessing a wide range of options from different institutions. A common quandary: Bank A is showing me 4.5 per cent, Bank B is showing me 5.6 per cent and Bank C is showing me 8.5 per cent. How do I know which to choose? Do I go with the highest rate? What's the difference between these investment options?

A return cannot be viewed in isolation. The risk of each investment must be assessed along with the return.

Here, we introduce the concept of “risk-adjusted returns”. Everyone wants the best bang for their buck: the car that drives the most miles per gallon, the exercise that burns the most calories per minute, the highest return for the least risk, etc. The risk-adjusted return is the metric that is used to measure the latter.

An example may best illustrate the point. Bank A is showing a Government of Jamaica (GOJ) 6.75% 2028 bond which is popular among investors and is currently yielding roughly 4.5%. GOJ debt is rated B by S&P which is generally viewed as high risk. An important question to ask is: Is this the best yield I can get for this level of risk?

Bank B is showing an A-rated European bank that has a coupon of 8.125 per cent and a call date in 2025 with a yield of 5.6 per cent. This instrument carries much less credit risk than the 4.5 per cent being shown by Bank A.

Bank C is showing a Colombian private company that is rated B+ which is also categorised as high risk but rated slightly above the Jamaican sovereign. The lesson here is that investors may be able to access higher yields for the same credit risk. It's important to ask your investment advisor what similarly rated credits are yielding in the market.

The “risk-adjusted return” essentially forces the investor to focus on how much value (ie return) is being generated per unit of risk that is being assumed. It is a good way to compare investments across different risk profiles.

It is also a good tool to use when choosing between a high-yielding asset and a lower-yielding asset. What additional risks do you take to get that higher return?

A GOJ B-rated USD bond might offer a yield of 4.5 per cent while a Government of Mexico BBB+ rated USD bond of similar duration maturity may offer a yield of 3.4 per cent. Important facts belie the difference in interest rates.

The most common factor that accounts for the difference in the coupon payment or yield is the creditworthiness of the borrower. The higher the capacity of the issuer to repay the bond, the lower the risk and the lower the coupon rate. The lower the capacity of the issuer to repay the bond, the higher the coupon rate and risk.

Return and risk move in opposite directions, and credit ratings can be very useful indications of the relative risk associated with a bond.

Make sure you are getting the best bang for your buck, and consider the risk level of each security you compare. There are ways to increase return without increasing the credit risk of your portfolio.

Be sure to ask your advisor about the liquidity of each instrument, ie how easy is it to sell if you want to exit the investment.

Instruments which trade in the international capital markets and are part of large issues are likely to have more liquidity than small, locally held issues.

 

Marian Ross is an assistant vice president of Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm