1. In fixed income investing, upside is capped. Downside is not. This can result in loss of principal. Therefore, to reduce loss of principal at a portfolio level, Graham says that one should avoid losers. I fully agree with him. In fixed income investing, errors of commission (Type 1 error) must be avoided, while errors of omission (Type 2 error) don’t represent large opportunity costs. This contrasts with venture capital investing where Type 2 error significantly hurts portfolio level returns compared to Type 1 errors.
2. Graham laid out a few general principles to ascertain safety of bonds.
a. Ability to repay is far more important than security over assets
b. Ability to repay should be considered in depression conditions
c. We should not sacrifice safety for higher yield
d. Larger companies are safer
e. More stable industries are safer
f. Track record of payment of interest and dividends over a long period of time
g. Track record of management performance over a long period of time in the past
h. Safety should be tested against well-defined standards
3. Graham recommends certain specific tests to determine the safety of high grade bonds. I’d modify these standards by making the tests even more severe. There is little penalty for this. There are many bonds. Yields are not that different. My pessimism is rooted in the fact that we have not lived through a prolonged depression condition over the last 10-15 years- hence a “laboratory-test” of earnings power under adverse conditions is unknown.
a. Earnings Coverage Over Fixed Charges: Graham’s recommends a ratio of 3x for industrials, and 1.75x for utilities over the last 7-10 years. I’d look for securities where ((EBITDA-maintenance capex-lease payments)/interest) ratio of at least 5x in each of the last 10 years for market-oriented businesses, and atleast 2x in each of the last 10 years for regulated businesses with contractual cash flow streams (gas pipelines, electricity transmission, etc). I’d also look for businesses whose (EBITDA-maintenance capex-lease payments) is atleast 80% of its previous high (in last 15 years)
b. Equity/Debt ratio: Market value of equity/total market value of debt should be atleast 1 for equities and 0.67 for utilities. I’d make this more stringent through two ways: Using the ratio (tangible book value of equity/market value of debt) if tangible book value of equity < market value of equity, and using the ratio (market value of equity/market value of debt) if tangible value of equity > market value of equity. And making this 1.5x for all kinds of securities.
c. Working Capital ratios: Current assets/current liabilities > 2. I’d modify this by making an exception for exceptional consumer businesses like Haier Smart Homes, and Nestle India which meet criteria 1 & 2, but have negative working capital since their businesses are exceptionally dominant. They can demand better terms from their customers and suppliers.
4. Graham believes that the typical preferred stocks to be permanently inferior to high grade bonds.
This is because high grade bonds have promised repayment and priority of repayment over preferred stocks and equity. In contrast, preferred stock have no promised repayment, and only has priority over equity.
However, Graham concedes that exceptional preferred stocks have similar characteristics as high grade bonds (eg: Nabisco preferred stock in the 1930s).
5a:
• Highest and lowest EBIT in the last 10 years. Compare it to the $5 interest rate.
• Sensitivity of EBIT to fuel prices
• Effects of ride hailing on EBIT of cab in industry
• What is the recourse for the bond holder if the cab is non-operational due to accident- is there insurance, how does the insurance protect the bond holder?
5b:
• Interest coverage ratio (EBIT/interest)
• Accumulated Cash + residual asset value always > principal
• Tangible book value of equity/debt amount
5c:
If maturity is 3 years, accumulated cash in the enterprise would be $71 (accumulated OCF-maintenance capex (0 in this case)- net change in WC (0 in this case). Therefore, I need to know if the cab can be liquidated after 3 years, at atleast $40+ ($10 margin of safety). If it’s a 7 year bond, then I’d worry about the liquidation value of the cab at 3 years. Accumulated cash by then would be 65 (since 100 will be spent on the new cab). I’d have to ascertain that the cab can be sold for atleast $45 ($10 margin of safety).
5d:
While his primary focus would be on the repayment ability from operating earnings and accumulated cash, he’d like to have security over the bond. I’d too.
6 a: S&P BBB or BBB- --> OXY Corp 7.5 Nov 01’96 with a yield to maturity of 6.5%.
Occidental Petroleum is a large shale producer in the Permian Basin and other oil interests. It produces ~1.4 million barrels of oil and gas/day. It has a market cap of equity of ~$40 billion, and has a net debt of $15 million.
Its debt has recently reduced by $6.5 billion since Buffett bought their subdivision OxyChem for $9.7 billion. Outstanding debt by end of year is expected to be $15 billion. Annual interest expense is likely to be $1 billion.
• At $60 oil prices, depreciation is ~$15/barrel and EBIT ~$10/barrel. If oil price goes down to $40/barrel, exploration expenses can be minimized, and the company can still produce at free cash flows of ~$5/barrel. Company produces ~450 million barrels/year. Therefore even under depression conditions, OXY has a coverage ratio over interest of 2x and in normalized conditions, the coverage ratio is 5x.
• Both tangible book value of equity/total debt and market value of equity/total debt exceeds 2x
• Current assets (including their listed midstream asset)>1.5x current liabilities
• Berkshire owns 30% of Oxy’s equity and can be a backstop in case its not able to meet its obligations (rich daddy).
6b: S&P A or above -->BNSF Corp 7.25 Aug 01’97 with a yield to maturity of 5.6%
BNSF is one of the largest North American railroads, owned by Berkshire Hathaway.
• In each of the last 10 years, (EBITDA-Maintenance capex-net change in working capital) has exceeded 6.
• Tangible value of equity/market value of debt far exceeds, and market value of equity/market value of debt far exceeds 2.
• It is a division of Berkshire Hathaway- an enterprise with an outstanding record of compounding book value, as well as management reputation of honouring its obligations. Its current assets far exceed its current liabilities (if we exclude float- which will not be called at once).
• Maturities are far lower than cash and marketable securities on the balance sheet
Both would be decent investments according to Graham, however not according to me. Bond investments are inherently investments in currencies. For a long term bond to be a satisfactory investment which would retain purchasing power, one needs to be sure that currency won't inflate too much. That requires good behaviour from governments. However, political expediency, across time immemorial, has caused ruling authorities to debase currency (even in ancient rome) at the expense of the savers. US's debt is much higher now compared to Graham's days. Moreover, the current political establishment has thus far been arbitrary with their policies. Thus, expecting these long term bonds to retain purchasing power till maturity may be foolish.
I like your point in question 3 about applying stricter standards given we haven’t experienced a prolonged recession recently. Interestingly, one of the bonds I picked was Dollar General and it seemed to have better margins during the pandemic, so think Graham’s “recession test” requires further consideration like you alluded to.
I think dollar stores tend to be somewhat counter-cyclical (i.e. people trade down to cheaper goods when their budgets are under pressure). The general point here is to not just stress test a company based on how it did in the last down cycle for the economy, but find the worst environment for that specific company and use that as the stress test.
Graham regards the choice of bonds as a negative art because the bond is a security with a limited return. In exchange for this limited return the emphasis must be on the avoidance of loss. It is a process of exclusion and rejection of as much risk as possible.
Question 2
The most important thing is the ability to pay, and I agree with this. Trying to collect debt when the debtor can’t pay is always a slow, legalistic and expensive undertaking, no matter how underwritten by guarantees the debt is.
Question 3
He has a selection of check boxes that must be met to qualify for high-grade lending to companies
1) Size – bigger is better. 0.5bn in sales (rough adjustment for inflation)
2) Earnings coverage 4x for industrials, less for more secure infrastructure
3) Poorest year of earnings must still be covered 3x
4) Leverage must be lower than 5x
5) Working capital must be greater than debts
6) Equity value must be at least 75% of debt.
I would still like to see all of these tests met for a secure high grade bond, though some of the tests are very severe by modern standards. Number 3 should be relaxed under some circumstances.
Question 4
Preferred stock, because the security does not stop poor performance in hard times, and limits the upside in good. Either way it’s a poor proposition, of the “heads I win, tails you lose” sort.
Convertible bonds at the discretion of the management of the company. This puts a further limit on upside as if interest rates fall or the market rate of return required falls, they can be redeemed and refinanced rather than rising to higher values.
Question 5
Setting the scenario against Graham’s tests:
1) Very small, so fails as there is clearly a high risk here if the cab driver falls ill, dies or is otherwise incapable of working.
2) Earnings coverage = 10/5 = 2. Not enough.
3) We only know the average so we need to ask what the worst year in the last 7-10 years are according to Graham
4) This test fails as the leverage is 100/10 = 10x. On an EBITDA basis it’s 100/30 = 3.3, but Graham does not use that metric.
5) Working capital we don’t know, so we need to ask. Should be $100, but this is very stringent as this would be all cash as the business needs no working capital according to this model.
6) Irrelevant as it’s not a listed company.
The most relevant metrics are earnings, as these support the whole enterprise. Closely followed by the consistency of earnings as the earnings coverage is not very high. If the cab driver earns more than 5% less than usual he will not be able to fund the interest out of current earnings. Finally the cushion of cash kept in the business is critical in establishing a margin of safety.
c)
If the bond maturity does not match the liability it will require a higher margin of cash in the business, and is therefore less safe. To illustrate this let’s look at the cabbies bank account, assuming he takes no money out of the business. Here are the 3 cases in a table of his bank balance. In the 5 year case his bank balance never falls below $25. In the other two cases it falls to -$25. Hence he will need to keep more working capital in the business to keep it afloat (the margin of safety is reduced)
Business Bank balance
Loan Term 3 year 5 year 7 year
Start 0 0 0
End of year 1 25 25 25
End of year 2 50 50 50
End of year 3 -25 75 75
End of year 4 100 100
End of year 5 25 25
End of year 6 50
End of year 7 -25
d) it would not matter to Graham in his analysis of large corporations, but it would to me in this case. Repossessing a car to repay a debt secured on it is easier, cheaper and much quicker than liquidating a large business, so it makes much more sense, and is therefore more important to secure the debt in this case, especially given the very high risk of this loan.
Question 6
Microsoft Class AAA financials from 06/2025. Values in $bn.
Microsoft 5.2% bond, maturing June 1, 2039
1) Size – 600 times larger than needed in sales
2) Earnings coverage 123/2.3 = 50 times
3) Poorest year of earnings 34/4/2.3 = 14.7 in 2017. NB, growth has rendered this a poor test.
4) Leverage 60/120 = 0.5
5) Working capital must be greater than debts 191 > 60
6) Equity value 3821, debt 60.
An easy pass. But neither Graham nor I would buy it because the yield at 4.88 is only 50 basis points above the nearest UST (May 15, 2039) 4.38 yield to maturity. He does not like taking risk for tiny yield advantage, and neither do I.
3) Poorest year of earnings must still be covered 3x. 2020 and 2021 losses due to covid.
4) Leverage 4.11/0.411 = 9.9
5) Working capital must be greater than debts 2.73 < 4.11
6) Equity value must be at least 75% of debt. 13.9 > 4.11*0.75
This one fails on 2, 3, 4 and 5. The current price is above par so the yield is 5.25%. Graham would not buy this one, and neither would I. Hotels are like airlines: when they have full occupancy, they make great profits, but their high fixed costs and semi-discretionary nature make them suffer greatly in recessions.
Question 7
Here is my script for Hyatt Hotels corp. Gives the same answers as me (rather to my relief), but with much more detail. Huge credit to Compound with AI posted by Gary for the basis of the script. I used the ChatGPT 5 Thinking model:
ROLE
Senior forensic bond analyst (ex–Big Four forensic accountant) in professional asset management.
OBJECTIVE
Surface and rank empirically verifiable credit vulnerabilities that could drive loss of principle in bond holding Hyatt Hotels Corp.
5.375%, 2031-12-15
Skip deep, theoretical teardown of the business model or product strategy; focus strictly on red-flag evidence.
| Core Filings | URD / Doc. de Réf. (AMF), statutory accounts, BALO notices, Banque de France liens (or local equivalents depending on listing jurisdiction) | "Hyatt Hotels Corp" "annual report" OR "rapport de gestion" |
Thought question: If we can find enough high-grade bonds without relaxing Graham's admittedly challenging standards, what is the benefit of relaxing the criteria? Phrased differently, given the narrow difference in yields within high-grade bonds, how often would you have to be wrong on the decision to lower your standards for it to be a bad one?
this is a copy of a 2023 S&P analysis of debt default. I recommend this as a read to get an understanding of how bond markets think.
To answer the question, have a look at table 4 on pp9. For BBB debt the weighted long term average default rate is 14 basis points, and the worst year in 45 was 100 basis points. Roughly the premium should be somewhere between these figures. lets add one standard deviation from the table at 25 basis points to get 38 basis points. This is allowing for the peak years of default like 2008. The premium for Hyatt is 87 basis points. So a premium of 49 basis points. Priced to perfection, but rational.
The AAA default rate is zero. The premium for Microsoft is 50 basis points. Identical 50 basis point premium.
Note that this does not include an adjustment for the recovery of debt in the case of a default: just as Graham says. However the recovery rates are significant:
There is a lot of detail in here, but the short answer is 40%. It varies from this mean a lot, but mostly in ways you would expect.
Graham also says that the time it takes to be paid after default is long. I found a reference to a paper on this which gave an estimate from Moody's 1 year as a mean, but with a large variance. The longest was 12 years!
so you can on average retrieve 40% of your capital after a year on average, which is worth approximately 14*0.4*0.95 = 5.3 basis points assuming a 5% interest loss and a year wait for the remains of your principle.
All this seems very rational. the increase in risk and volatility as you go down the scale should encourage both diversification, and a reduction in the bet size on each position. All of these should drive an increase in the price premium. For an extremely useful discussion of bet sizes, and it's proportionality to the inverse square of volatility I strongly recommend this read:
Q1: It seems to me that bond returns typically have negative skew, meaning you can lose everything (down 100%), but your returns are capped (at whatever yield you get based on the price you paid). Your goal as a bond portfolio manager is to avoid the losers – hence a ‘negative’ art. Yes, I agree. When you delve into distressed situations, the math changes.
Q2: Priority and promise is NOT assurance. It doesn’t matter what management says or believes, if the cash is not there for the debtholders (because it was wasted by the shareholders/board), then too bad.
Q3: Similar to the answer above, however in today’s environment, so many corporate assets are ‘soft’ meaning intellectual property, brands, etc, I wonder about their value in a downturn or for a different owner.
Q4: All things being equal, Graham hates things like preferred stock due to its characteristics. But really, as a value investor, he should have channeled his inner Howard Marks, and written “but everything is a good investment at a proper price” or something to that effect. Marks writes the same about high yield bonds, which were hated simply for being high yield bonds. It’s all about the return per unit of risk.
Q5: I generally agree with the other answers on Q5. Just for everyone’s FYI - There is an excellent podcast on distressed investing in NYC taxicab medallions on Invest like the Best (Aug 5 – Marble Gate Capital).
Q6: A) General Mills bond due 2031 (rated BBB): Net debt/EBITDA of 3.4x; FCF $2.1B vs. Cash interest paid of $474M (4.4x)
B) University of Virginia Bonds $600M issue due 2050 (rated AAA): Would need to dig deeper into the financials, but the issuer has ample assets, financial backing, the ability to increase tuition, and assuming the endowment assets of $10B+ also back the bond, you are very, very covered.
Q7: Benjamin Graham discusses the weakness of specialized buildings in his book “Security Analysis”. He includes examples such as hotels, garages, clubs, hospitals, churches, and factories. Some of those examples are a bit dated. I would include data centers and distribution centers as newer examples that fit his framework (pg 186). Please give me 5 examples of real estate-related companies that generally DO NOT own specialized buildings in Graham’s example. Write me 100 word investment tearsheets for each example.
It is a negative art in that the upside is limited to the coupon amounts and the downside is insolvency and loss of principal. Meaning for it to be worth your while it must be a safe/secure bet. Instead of choosing winners it is more important to say no to losers. Loss of principal is almost guaranteed in a bankruptcy situation because of the courts and how they deal with bondholders.
Question 2:
Bondholders are only entitled to fixed return, so the upside is limited, while the downside loss of principal can be severe due to the structure of bankruptcy and US courts. This asymmetry means that risk avoidance matters far more than chasing yield. I agree with this assessment. With my limited exposure to bonds, I have fallen into the trap of looking at the yields first. Bond investing requires structural discipline.
Question 3:
Graham’s bond safety framework rest on quantitative adequacy:
Safety comes from stable and ample earnings power, conservative capitalization, and sufficient asset coverage. For me I believe safety comes from quantitative and some qualitative factors. I place more importance on the level of trust I can put in the management over if they have sufficient asset coverage. Does the management have a record of meeting obligations and being truthful in disclosures about the business. Do they have a track record of safety in terms of stable and ample earnings power and are they truthful about downturns in their business.
Question 4:
Why would anyone ever invest in preferred stocks? Optional dividends with limited upside. Neither safe or return oriented. Don’t get it.
Question 5:
a) The average EBIT is $10, but how consistent is this. Are there swings in the earnings or is it relatively stable. I find it hard to imagine there aren’t fluctuations in gas prices or an accident happening and throwing off the predictable cash.
b) The interest payment is $5 per year. There is doubt the cab driver could meet his obligations in a bad year. 2x average coverage is not enough to satisfy me. The driver will not make enough to buy a new cab in cash and will need to borrow again.
c) I would prefer a shorter term as it is slightly safer. Longer term than the useful life of the cab would be nonsensical.
d) Collateral would slightly improve recovery, but does not change the fundamental safety of the investment. We should never count on recoupment of a bond based on collateral as this almost never happens as we think. A bankrupt business may sell their cab for much less than its depreciated value.
6. I looked at Crocs 4.125% Sr. Notes due 2031 (unsecured). Bonds were recently upgraded to BB-
Earnings Coverage appears strong by the results (~9x coverage). Cyclical single-product concentration (clogs) with competitors undercutting and violating IP (hard to enforce). Extra leverage introduced with acquisition of HeyDudes. Competent management looking to reduce debt.
I would include this issue in a bond portfolio as a small allocation. It’s clear the business is performing well and analysts agree with ratings increases.
AVGO. 2025 issues 5.2% due 2035. Rated A- S&P.
Earnings coverage of 7x. Massive size/scale/stability. Diversified with strong FCF. Also a deleveraging trajectory post VMWare acquisition.
AI tailwinds with a strong mix of product offerings.
I would size this as a medium position in a bond fund.
Question 7:
You are an expert in Benjamin Graham’s Security Analysis methodology, focusing on the fixed-income chapters (Part II).
1️⃣ Summarize the analytical framework Graham uses to judge bond safety, including key quantitative standards (interest coverage, debt ratios, asset coverage, size, stability, covenants).
2️⃣ Given one or more modern bonds (e.g., ticker, rating, maturity), perform a dual analysis:
• (A) Apply Graham’s original “high-grade” standards using current financials.
• (B) Apply a modernized version (cash-flow coverage, leverage, sector cyclicality, off-balance-sheet risk).
3️⃣ Score each bond 0–100 for Graham-style safety margin and provide a qualitative verdict: High-grade / Borderline / Speculative.
4️⃣ Highlight which standards remain timeless vs. outdated given today’s markets.
5️⃣ Output a table comparing:
– Earnings coverage (EBIT / Interest)
– Debt-to-capital
– Free-cash-flow coverage
– Credit rating (S&P/Moody’s/Fitch)
– Spread vs Treasury
– “Graham score”
6️⃣ Conclude with a concise summary of whether each bond would qualify as investment-grade under Graham, and whether you personally would buy it today.
Example input:
“Analyze Crocs 2029 4.25% notes (B2/B) and Broadcom 2038 4.9% notes (A-) using Graham’s criteria.”
I think the character of management is super important. We can't forget that after all this is just a scaled-up version of loaning someone money. Whether they can afford to pay is one important criteria, but the other one is whether they can be trusted to keep their word even if they could weasel out of it somehow.
Thought question: What did Graham mean by “an investment operation” in his definition above? As a corollary, can a purchase of a single security in and of itself be classified as either an investment or a speculation according to Graham? According to you?
Investment operation is a more all encompassing term for a standards-based decision making framework. Graham would say purchase of a single security could be both an investment or a speculation, and I’d agree, based on how closely the purchase of the single security aligns with a standards based framework.
Question 1: Why does Graham believe that investing in High Grade fixed income securities to be a ‘negative art’, in contrast to investing in common stocks? What does he mean by that? Do you agree?
Graham considers investing in high-grade fixed-income securities a “negative art” because the primary objective is avoiding loss, not seeking profit. He emphasizes that true analysis here lies in understanding how well a bond can withstand depression conditions — the focus is on preservation of principal and continuity of interest payments. By contrast, common stock investing involves both loss avoidance and the pursuit of profit through appreciation.
I agree with Graham to a point. When buying high-grade bonds near par, the upside is typically capped at the yield, so the real skill lies in minimizing downside risk. However, I think his phrasing “negative art” is partly rhetorical — meant to jolt readers into recognizing that even “safe” bonds can carry significant risk. As he himself notes, there are periods when deeply discounted bonds offer equity-like upside; in those cases, fixed-income investing can take on a more opportunistic, profit-oriented character.
Question 2: What is Graham’s main idea about what provides safety in a high-grade bond? Do you agree?
Graham evaluates bond safety based on a company’s ability to meet its fixed obligations under adverse economic conditions (“Depression stress test”), guided by quantitative discipline and qualitative judgment. He insists on working “upward from definite minimum standards of safety,” not downward from theoretical maximums.
Graham’s intent—tying safety standards to industry stability—remains sound. But as Howard Marks observed, his framework implicitly demands adaptability. In today’s market, coverage ratios should scale with the volatility of the business: subscription-based firms may resemble utilities, while tech or cyclical sectors require higher margins of safety.
Question 4: Which security structures does he believe to be permanently inferior in this category? Why?
Graham believes noncumulative preferred stocks are permanently inferior because they lack adequate protection for investors. If the issuer omits dividends, those missed payments are lost forever—not deferred—so the investor bears the downside of equity risk without full participation in its upside (given that it’s dividends are fixed but not predictable). Unlike bonds, they don’t have a maturity date or principal repayment obligation, and unlike common stock, they don’t share in profits if the business prospers. In Graham’s view, that combination of limited return potential and real risk of loss makes noncumulative preferreds a structurally unsound investment.
Question 5: Miniature Credit Analysis scenario:
- Cab driver has driven a cab for someone else, and now wants to buy his own for $100
- The cab will have a useful life of 5 years, and have straight-line depreciation with no residual value for accounting purposes
- For cash purposes, the cab will have no cash outlays associated with it but will need to be replaced at the end of 5 years, with another cab, which we will assume will also cost $100
- The cab driver has historically averaged EBIT of $10 on his historical revenues of $100, and expects that to continue. There are no taxes.
a) What questions would you like to ask/what would you like to know to assess whether buying a 5-year $100 bond with a 5% coupon meets Graham’s standard for investment in a high-grade bond?
Does the cab driver have a loan for a medallion or to buy the car?
How stable are earnings in the cab business especially in recession eras (2000, 2008, and 2020)? Based on this, what minimum fixed charge ratio am I willing to put on this?
What does the outlook for the cab business look like especially with competition from ride share?
Secondary importance:
Are there any guarantees? If so, what are the terms and how much earnings power does the guarantor have?
Is this secured by the vehicle? How active is the aftermarket for cabs?
b) Substantiate your answer to a) with specific credit metrics that support your analysis. What metrics are most relevant? Why?
Fixed Coverage Ratio (after taking into account any other obligations and fixed charges) so that we can determine the ability of the company to cover its fixed charges especially in a time of recession. Stock-Value Ratio so we can understand the size of its debt obligation and other commitments.
c) What would change in your analysis, if anything, if everything stayed the same but the bond had a 3-year maturity? A 7 year maturity?
I would focus my analysis on first determining the minimum fixed coverage ratio I’d be willing to accept for this enterprise. Graham was chiefly focused on this metric, and I’d want confidence in the company’s ability to meet its fixed charges under any maturity. He doesn’t place much emphasis on maturity in Part II—his analysis centers on earning power and margin of safety, not time to repayment. For example, on page 151 (6th ed.) he compared Pacific Power & Light (due 1955) with 1.53× coverage and American Gas & Electric (due 2028) with 2.52× coverage, favoring the latter despite its longer term. That shows he viewed safety as a function of earning strength, not duration. I don’t think it’s productive to speculate on when a recession might hit, since Graham himself noted their unpredictability. As a secondary consideration, a shorter-term bond could offer a bit more comfort if it were secured by the car, given its higher potential aftermarket value—but that wouldn’t be central to my analysis.
d) How much would it matter to Graham whether the bond was unsecured or if it were secured by the cab? What about you?
Graham wouldn’t put much weight on whether the bond was secured by the cab. His focus is always on the issuer’s earning power and its ability to cover fixed charges, not on collateral. However, in this specific case, the cab does have some independent economic value beyond its regulated taxi life (assuming an NYC taxi). That makes it more like the “secured equipment obligations” Graham discussed on pages 180–181 (6th ed.), which “fared well” when the underlying assets were removable and had secondary use or marketability.
So while Graham would still classify this as a secondary consideration, he’d acknowledge that having a vehicle that could be resold or repurposed provides an added margin of protection. Personally, I’d agree — the cab’s resale or replacement value wouldn’t change my credit decision, but it would give me more comfort knowing there’s a recoverable asset if earnings deteriorate.
Question 6:
a) Walmart (AA, 6.50% 2037)
2020 EBIT margin: ~4.0%
2024 Revenue: ~$648B → Adjusted EBIT ≈ $26B
2024 Fixed charges: ~$7B → Coverage ≈ 3.7×
Leverage: Conservative (Debt/Equity ≈ 0.6×)
Earnings stability: Strong even during 2020; core business defensive.
→ Graham’s View: Meets 3× minimum and shows earnings resilience under stress. Investment-grade.
→ My View: High-quality. Attractive for capital preservation.
b) Dollar General (BBB, 5.00% 2032)
2020 EBIT margin: ~11%
2024 Revenue: ~$39B → Adjusted EBIT ≈ $4.3B
2024 Fixed charges: ~$2.2B → Coverage ≈ 2.0×
Leverage: Moderate (Debt/Equity ≈ 0.9×)
Earnings stability: 2020 margins were inflated by COVID tailwinds; subsequent years saw normalization and cost pressure.
→ My View: Elevated credit risk and tightening margin of safety.
Question 7: See if you can think of an AI prompt based on Part 2 of Security analysis that would make your work easier. Suggestion: use a thinking model (e.g. Gemini 2.5 Pro or ChatGPT 5; if the latter set reasoning_effort=high; consider whether you need “Deep Research” mode enabled or not for what you are trying to do).
AI Prompt to Answer Question 6 Using Part 2 of Security Analysis:
You are a financial analyst trained in Benjamin Graham’s fixed-income evaluation methods (from Part 2 of Security Analysis, 6th ed.) with modern credit analysis expertise. Using deep reasoning and high analytical effort, analyze the following two corporate bonds:
One bond rated BBB or BBB- by S&P, maturing in 5+ years.
One bond rated A or higher by S&P, maturing in 5+ years.
For each bond, apply Graham’s investment-grade criteria, including:
Minimum fixed-charge coverage ratio by sector (e.g., 1.75× for utilities, 2× for railroads, 3× for industrials)
Maximum debt-to-equity leverage by sector (e.g., 2:1 for utilities, 1.5:1 for railroads, 1:1 for industrials)
Stress-test resilience under adverse economic conditions
Adequacy of interest coverage based on recent earnings trends (at least 5 years of data, if available)
Then incorporate modern adjustments including:
Business model risk (e.g., recurring vs. cyclical revenue)
Cash flow-based coverage (EBITDA or FCF), if more representative
Industry-specific disruption risk (e.g., AI exposure, tech disintermediation)
Output a side-by-side comparison showing whether each bond qualifies as a sound investment:
a) According to Graham’s traditional standards
b) According to a modernized, forward-looking view
Format output as a concise report with clear headers and a comparison table.
I think the term "investment operation" refers to the activity of constructing an investment portfolio over time (e.g. Graham's partnership). Meaning that it's diversification across multiple securities at a point in time and diversification over time. Put differently, I think Graham defines an *investment process* as investing vs. speculation rather than a single decision within that process.
I'm sure that's right, but he did put in some caveats. He specifically says that an "investment operation" may involve diversification: "an investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly". However he uses may and might, which implies not always. Sometimes an opportunity comes along that is both good, unique and where the size is fixed. His operation in Guggenheim Exploration is an example of this. The investors had to buy the whole concern to liquidate it. I think this meets the criteria of an investment operation, even though only one security is involved. Moreover, he is also keen to emphasise that each investment must stand on its own merits. If you set a strict set of criteria, and only one stock passes, should you buy others that are not as good just to diversify? Or would it be better to put the funds in high interest cash and wait for others of equal quality? I have found that for me, following the best ideas and ignoring the "similar but not so good" for the sake of diversity works better.
Yes, agree that each investment must stand on its own merits. Which is also why I can't really get around the idea of correlation in a portfolio - would you reject a good idea (good business, good price) because of correlation to other stocks in your portfolio, likewise would you accept one because it is negatively correlated for the sake of diversification? Could never understand that.
Thanks for bringing that up too, James. I recall too Graham mentioning single securities in the text counting so that’s why I leaned towards a “yes” in this answer.
James, I like how you flagged Graham’s choice words of “may” or “might” too. This time around reading Graham I’ve been paying closer attention to his conditional word choice.
I don't really know how it works, but I wonder if its really possible to go in deciding to buy a certain number of number of companies in order to diversify, because we are price takers and the market is a price maker. The market provides the opportunities and we decide whether to take it. But we don't know when the opportunities will appear. Also we need price discipline in order to have returns. So deciding early on to have a certain number of stocks or specific stocks - will this lead to sub optimal outcomes i.e. not buying at the right price? Is this about relative vs absolute returns? I don't know.
In a high market, we might not get the price we want for a certain stock/business so we wait, but during the wait, there will be other opportunities that come along eg acquisitions/spin offs/detestation of certain area of market etc, then we can size the position after weighing how well we know the company/ the likelihood of getting the outcomes we want/ the likelihood of failure etc. Probably more likely to be able to populate portfolio on the terms we want if we are investing in at a low/depressed period.
On a side note - apologies in advance as I will definitely be late for week 2 answers due to the complexity of the reading material -.-"
Q1 : Graham writes that “Bond investing is a commitment with limited return”. The chief emphasis on avoidance of loss reflects the reality that any failure by the issuer to meet obligations can result in total loss, making safety the primary concern. The investor may reject bonds with no penalty because passing on a bond does not mean missing out on extraordinary gains, allowing for strict selectivity without regret. Graham uses these phrases to highlight the fundamentally defensive nature of bond analysis, where the art lies in eliminating risk rather than forecasting reward. Fixed-income investing is largely about preservation of capital, while stock investing is about growth and value creation. The former demands caution and discipline; the latter invites insight and foresight.
Yes, Graham’s distinction still holds water today but there are securitisation strategies etc which alter the risk reward profile to an extend..
Q2 : Benjamin Graham’s main idea about what provides safety in a high-grade bond is adequate earning power of the issuing company. He argues that the true margin of safety lies not in the bond’s legal protections or collateral, but in the issuer’s consistent ability to generate earnings well above its fixed charges
Safety and stability are measured by the ability to repay—rooted in earnings power, the character of the industry, and the issuer’s resilience under adverse conditions. A depression-proof enterprise with stable, predictable cash flows is far better suited to bond financing than one exposed to cyclical or speculative risks. The more stable the type of enterprise, the more appropriate it is for fixed-income investment
Q3 : Benjamin Graham evaluates the safety of a high-grade bond primarily through the issuer’s financial strength, focusing on its earning power, debt coverage, and stability over time. Graham see the earnings trajectory over time. He emphasizes that the most dependable measure of safety is the company’s ability to generate consistent earnings well above its fixed charges, especially during economic downturns. This approach reflects his belief that safety is measured by the ability to repay, not by legal protections or collateral alone.
Difference now is the industry with little fixed charges but more variable charges like the new platform / internet businesses . I need to study and research more into this area if they are suitable for debt financing.
Q4 : Graham warns against bonds issued by companies in unstable industries, startups, or those with poor earnings records. Even if the bond terms appear sound, the underlying business risk undermines the security’s reliability. He emphasizes that the more stable the enterprise, the more suitable it is for bond financing.
Small-cap companies, industrial startups, and SMEs (small and medium-sized enterprises) often have an inherent lack of stability, making them poor candidates for fixed-income investment. Their earnings are volatile, their industries may be cyclical, and their financial structures are often too fragile to support long-term debt obligations.
Q5 : (A) I would ask two main questions : 1) The stability of EBIT of $10, any fluctuations there would make him unable to service interest. There is only a $5 margin of safety from the EBIT of $10 2) Can the cab owner be able to rollover debt of $100 to repay principal ?
(B) Interest Coverage Ratio (ICR) = (EBIT / Interest Expense) = 10/5 = 2.0 ; Graham would have wanted more ?
Debt / EBIT = 100/10 =10 years. He favored enterprises that could repay debt in 3–5 years from earnings.
(C) With 3 year maturity, we can make use of cabs useful life in case of default
7 year maturity seems to introduce a asset liability mismatch where asset life ends in 5 years and debt has to be serviced for 7 years .
(D) To Benjamin Graham, whether the bond was secured by the cab or unsecured would matter—but only secondarily. His primary concern was always the earning power and financial resilience of the obligor . I would concur, infact, I faced the same situation of a default by a car rental company and nothing could be salvaged from the asset sale (so far). Fingers crossed.
Q6 : Graham would likely classify BBB bond as “speculative-grade” and caution that “the chief emphasis in bond selection must be placed on avoidance of loss rather than on the promise of profit.” Graham would likely classify A or higher bond as “Sound investment, backed by “sufficient earning power,” and “suited to bond financing.”
Thought exercise: Can you find a BBB bond that you believe fails Graham's (or your more modern version) credit standards and should therefore be excluded from a high-grade portfolio?
1. As there is no participation in the upside of success, a fixed income security need only be categorized into two buckets. 1) likely to pay interest and return principal. 2) not as clear if they will be able to do both or either. Should a security not quite surely land in the first category, it warrants exclusion. It’s important to remember at Graham’s time there were a number of clearly stable companies, that weren’t treated as such. He need not determine who would “win any races” but rather those that would simply perform as their obligations demanded. — Ultimately, yes, I do agree with this approach to fixed income selection. Although, since my horizon is quite long, and there’s a relative scarcity to my investable capital, I don’t often invest in fixed income securities, except in tremendous circumstances.
2. Ultimately his focus is on the financial security of the business in a depressed earnings environment. His goal it seems is to determine how comfortably interest coverage is present for the entirety of the business during these conditions. — Ultimately I do agree, with two downstream realizations being of particular intrigue to me. 1) If a company satisfies the qualities of safety as a fixed income investment, then you should always buy the highest yielding obligation of that company. (page 148). and 2) The general sense of “safety” provided by the contract terms of senior leins is an illusion of safety. Under situations of solvency, very rarely is the full “value” of these contract terms realized. So, in combination, but the highest yielding issue of a secure company, because being holder of a “senior” issue doesn’t matter that much.
3. His general approach of combining all interest obligations into one total and then determining how many times over that number is covered seems straightforward, albeit likely quite challenging when considering issuers of multiple layers of preferred shares, public bonds, and perhaps private placements as well. A bit beyond my scope as an individual, but absolutely noteworthy that he takes issue with listing each interest obligation Individually and it’s coverage by income. Making preferreds seem generally more secure than senior, which is quite silly.— If I were to do anything differently it would be to focus exclusively on cumulative preferreds with a high coupon rate, wait patiently for some macro event to cause major price dislocations, then pounce. An example that comes to mind were the Hawaiian Electric Preferreds that were trading with yields north of 30%. Granted a lot was going on at the time, but on April 2nd-9th I wasn’t watching bonds so I have no examples to draw from.
4. I didn’t make it past page 213 (I’m a slow reader) so perhaps this isn’t the best answer. But he took a pretty strong stance against non-cumulative preferreds. Given that management has no contractual obligation to pay dividends, the security class in effect combines all the worst parts of fixed income with the worst parts of equity.
5. In short - 1) too small of an enterprise. 2) Interest coverage may be enough (=2x) if we consider a cab an equivalent to a railroad. However, the ideal would be based on depression earnings, not necessarily average earnings. That’s the only graham specific points I have, but I’ll say, instinctively it seems like a lot of risk for a mere 5% coupon…
Q1. Looking for loss avoidance, not growth or appreciation. I agree.
Q2. Avoiding trouble - looking for hi-grade companies with the ability to pay when valued under conditions of depression. I agree.
Q3. Using the New York Statute Criteria - 1. The nature and location of the business or government, 2. the size of the enterprise, or the issue, 3. The terms of the issue, 4. The record of solvency and dividend payments, 5. The relation of earnings to interest requirements, 6. The relation of the value of the property to the funded debt., 7. The relation of stock capitalization to the funded debt.
Q4. Preferred Stock and convertible bonds. Each is transferrable into the other, changing their characteristics. Also fixed income securities valued on appraisals.
Q5. a. How large is the company, what do it's financials look like. Where is this bond's yield as compared to similar issues in the market. b. Debt as a % of capitalization, cash, income, free cash flow, bond covenants and security. c. Perhaps purchase at a 3 yr maturity, but not at a 7 yr due to increased risk.
Q6. Home Depot, 2.7% due 4/15/2030. Price 90.655, YTM 4.74%, Call 1/15/30 YTW 4.74%, S&P A.
Boeing 5.15% due 5/1/2030. Price 99.391, YTM 5.28%, Call 2/1/30 YTW 5.28%, S&P BBB-.
a) HD, not enough yield, Boeing perhaps depending on risk. b) I would buy either depending on the portfolio I am putting them in.
Question 1: Graham views high-grade bond investing as a "negative art" because it focuses more on avoiding losses than seeking gains. Bond analysis is about guarding against default and selecting only those issues that do not exhibit clear signs of risk. We don’t need to understand the margin of safety and the possible value/return as we know that already.
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Question 2: Graham insists that safety comes from the issuer’s ability to meet all obligations under adverse conditions, not just normal ones. This means conservative debt service coverage ratios, stable earnings, and asset protection. Agree 100%, however, if I would follow this now I might be forced to buy only low yield bonds. For these reasons, I don’t invest in bonds.
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Question 3: Graham analyzes coverage ratios (e.g. interest and principal coverage), debt structure, asset protection, and earnings history. Only bonds with sufficiently high coverage ratios and stable profits over many years are considered safe.
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Question 4: Graham regards subordinated debt, income bonds (which only pay if earnings allow), and deeply junior securities as permanently inferior due to inadequate claims on assets or unreliable coupons.
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Question 5:
a) What questions to ask?
What is the revenue volatility?
What are maintenance and insurance expenses?
Are earnings likely to persist?
Credit history?
b) Credit metrics:
EBIT/interest coverage
debt-to-asset ratio
historical cash flow stability.
c) Maturity effects:
Shorter maturity reduces credit risk (less uncertainty); longer increases it.
d) Secured/unsecured:
Graham prefers security—having the cab as collateral provides extra safety.
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Question 6:
Bond BBB-rated, Hyatt Hotels Corp. 5.375% due 2031
Size: Revenue $6.6B, Graham minimum $0.5B — passes.
Poorest Year Coverage: Losses in 2020/2021 (COVID). Fails.
Leverage: $4.11B debt/$0.411B profit = 9.9x (Graham max 5x). Fails.
Working capital vs. debts: $2.73B < $4.11B. Fails.
Equity value vs. debt: $13.9B equity > $4.11B × 0.75. Passes.
Conclusion:
Graham would reject Hyatt’s bond as a high-grade investment due to insufficient coverage, high leverage, pandemic-driven losses, and weak working capital, despite meeting size and equity cushion requirements. I would argue hotels are semi-discretionary businesses and are very cyclical. I would also reject it—credit metrics are stretched, and risk is not rewarded with high enough yield.
Poorest Year Coverage: Poorest EBIT ~$34B/interest ~$2.3B = ~15x. Passes.
Leverage: $60B debt/$120B profit = 0.5x. Passes.
Working capital vs. debt: $191B > $60B. Passes.
Equity value vs. debt: $3,821B > $60B × 0.75. Passes.
Conclusion:
Microsoft’s bond passes every Graham high-grade test with enormous margins of safety. The issue: at current pricing (yield only ~50 basis points above comparable Treasuries), Graham would consider the yield premium insufficient for the risk. I agree: it’s an extremely safe bond that nevertheless does not compensate investors for incremental credit or liquidity risk.
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Question 7:
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You are to act as a seasoned investment analyst in the tradition of Benjamin Graham. Your task is to conduct a rigorous and comprehensive evaluation of a corporate bond based exclusively on the principles and quantitative tests for fixed-income securities as detailed in Part 2 of Graham and Dodd's "Security Analysis."
Your analysis must be thorough, data-driven, and conservative, culminating in a clear judgment on whether the bond qualifies as a safe, investment-grade security suitable for a defensive investor.
Bond for Analysis: [Insert the full name of the bond]
Please structure your analysis in the following sections:
1. The Fundamental Test: Earnings Coverage
This is Graham's primary test for a bond's safety.
Calculate and present the issuer's "Times-Interest-Earned" ratio (using earnings before interest and taxes - EBIT) for each of the last seven to ten fiscal years. Display this in a clear table format.
Analyze the adequacy of the coverage. Compare the average and minimum ratios over this period to Graham's historical minimum standards (e.g., 5x for an industrial company, 3x for a public utility). State clearly whether the issuer meets these thresholds.
Evaluate the stability and trend of the issuer's earnings. Are they consistent and predictable, or volatile and cyclical? Comment on how this impacts the reliability of the coverage ratio.
2. The Secondary Test: Capital Structure and Asset Value
This section assesses the company's financial foundation and the value of its assets backing the debt.
Size of the Issuer: State the issuer's total assets and annual revenue. Comment on whether the company's size provides a buffer against adversity, as Graham suggested.
Stock-Equity Ratio (Debt-to-Capital): Calculate the ratio of total funded debt to the market value of the company's total capital (debt + market capitalization of equity). Analyze if this ratio is conservative for its industry.
Asset Coverage: Determine the value of the issuer's assets relative to its total debt.
Calculate the ratio of Total Assets to Total Debt.
Calculate the ratio of Book Value (Net Asset Value) to Total Debt.
State whether the bond has a specific lien on any property. If so, discuss the nature and likely value of that collateral.
3. Qualitative Factors and Indenture Provisions
Beyond the numbers, a qualitative assessment is crucial.
Nature of the Business: Describe the issuer's business. Is it in a stable, essential industry (like a utility) or a more competitive, cyclical one (like an automaker)? Does it have a strong, durable competitive advantage?
Protective Covenants: Analyze the key provisions in the bond's indenture. Specifically, look for and comment on:
Limitations on issuing additional debt.
Restrictions on dividend payments or share repurchases.
Collateral requirements or negative pledge clauses.
State whether these covenants provide meaningful protection for bondholders.
4. Yield and Price Considerations
The return must be satisfactory for the risk assumed.
Current Yield and Yield-to-Maturity (YTM): State the bond's current price, current yield, and YTM.
Comparison to Risk-Free Rate: Compare the bond's YTM to the yield on a U.S. Treasury bond of a similar maturity. Is the credit spread adequate compensation for the risks identified in your analysis?
Price History: Briefly comment on the bond's price stability over the last year. Has it been volatile or stable?
5. Final Synthesis and Conclusion
Synthesize all the above points into a final, decisive conclusion.
Summary of Findings: Briefly summarize the bond's strengths and weaknesses based on your Graham-style analysis.
Investment vs. Speculation: State unequivocally whether this bond meets the strict criteria for an "investment-grade" security as Benjamin Graham would define it. If it does not, classify it as "speculative" and explain precisely which of Graham's tests it fails.
Margin of Safety: Conclude by defining the margin of safety for this bond. Is it found in the robust earnings coverage, the significant asset protection, the conservative capital structure, or a combination of these? If the margin of safety is insufficient, state this clearly.
Question 1: Why does Graham believe that investing in High Grade fixed income securities to be a ‘negative art’, in contrast to investing in common stocks? What does he mean by that? Do you agree?
Investing in High Grade fixed income securities is considered negative art since the best case scenario is that the fixed income security principal and interest that it initially promised; however, where the investor adds value is analyzing the underlying business whose cash flow is likely to fund the interest coverage, predictability of that cash flow, how well it covers the interest in fixed income security and industry factors / scenarios where the cash flow may be impaired to a degree that it is unable to pay out the interest coverage and so is a process of elimination. Investing in common stocks focuses more on understanding potential upside based on economics of industry, business, competition, customer stickiness, free cash flow margins, growth potential, etc. and so is more positive in that regard. My sense is that good investments are somewhat asymmetric in that they provide low downside combined with an asymmetric high upside.
Question 2: What is Graham’s main idea about what provides safety in a high-grade bond? Do you agree?
Safety in high-grade bonds is the issuer being able to cover its interest payments with a predictable, stable, and ample free cash flow, and balance sheet strength (e.g. ratio of equity or asset to debt). I agree.
Question 3: How does Graham evaluate the safety of a high-grade bond based on the company’s financials? Is there anything you would do differently with what you know today? Why?
By evaluating the predictability, stability, and ampleness of earnings compared to interest payments and balance sheet strength. Balance sheet composition is somewhat different today as substantial value can accrue to brands, platform companies which have high marginal profit margins, and adjacent businesses that increase stickiness of customers and customers’ lifetime values. So, often, a business can have low capital intensity, high free cash flows, and low book value.
Question 4: Which security structures does he believe to be permanently inferior in this category? Why?
Hybrid security structures (e.g., preferred stock) are considered permanently inferior since they neither provide the safety of high-grade bonds nor the upside potential that comes with common equity ownership.
Question 5: Miniature Credit Analysis scenario:
- Cab driver has driven a cab for someone else, and now wants to buy his own for $100
- The cab will have a useful life of 5 years, and have straight-line depreciation with no residual value for accounting purposes
- For cash purposes, the cab will have no cash outlays associated with it but will need to be replaced at the end of 5 years, with another cab, which we will assume will also cost $100
- The cab driver has historically averaged EBIT of $10 on his historical revenues of $100, and expects that to continue. There are no taxes.
a) What questions would you like to ask/what would you like to know to assess whether buying a 5-year $100 bond with a 5% coupon meets Graham’s standard for investment in a high-grade bond?
Leaving aside the fact that averages can be misleading, the above example would imply $10 EBIT would become -$10 after the annual $20 depreciation charge and so insufficient to fund the 5% coupon.
b) Substantiate your answer to a) with specific credit metrics that support your analysis. What metrics are most relevant? Why?
While Times Interest Earned = $10 / $5 = 2.0, free cash flow = $10 - $20 -$5 = -$15 which is insufficient to support interest payment of $5
c) What would change in your analysis, if anything, if everything stayed the same but the bond had a 3-year maturity? A 7 year maturity?
d) How much would it matter to Graham whether the bond was unsecured or if it were secured by the cab? What about you?
Bond secured by cab would provide additional balance sheet strength but insufficient to neutralize the cumulative negative free cash flows for the duration.
Question 6: Find and analyze two bonds using both Graham’s process and any of your own modifications that you think are reasonable. Provide your analysis of:
a. A bond rated BBB or BBB- by S&P with a maturity at least 5 years away
AT&T bond maturing 2032: Interest payments are ~$6.8 billion per year and normalized free cash flow over last 15 years is ~17 billion providing sufficient coverage for the interest payments. AT&T has a broad set of assets and utility-like stable subscription from its customers and so seems like a decent investment.
b. A bond rated A or higher by S&P with a maturity at least 5 years away
Microsoft: Median free cash flow over the last 15 years is $32 billion and has been consistently growing. MSFT annual interest expense on debt is ~$2.4 billion providing more than adequate coverage for interest payments. It is interesting that MSFT free cash flow continues to be strong in spite of massive AI capex in recent years.
Question 7: See if you can think of an AI prompt based on Part 2 of Security analysis that would make your work easier. Suggestion: use a thinking model (e.g. Gemini 2.5 Pro or ChatGPT 5; if the latter set reasoning_effort=high; consider whether you need “Deep Research” mode enabled or not for what you are trying to do).
Suggest bonds rated A or higher that are at least five years out for companies where (median free cash flow over last 15 years) / (annual interest expense) is highest
1. He believes the operation to be a negative art because
a. The return is limited (limited upside even with negative yield) where as credit risk (or even) can wipe out all or a substantial part of the investment principal which makes loss avoidance paramount and therefore rejection is key given that “neither priority or promise [to pay] is itself an assurance of payment” (pp [143])
b. Consideration for investment operation in common stocks includes both “a desire to avoid loss and the desire to make a profit” (pp [143]). Penalty of omission (rejecting) or commission (accepting) can be great in common stocks but accepting an “unsound issue” in High Grade FI securities can be material
2. By ‘negative art’ he means placing constraints (deny out) on the selection instead of searching and finding (allow in) investments.
3. I agree. Even common stocks should be subject to negative art (inversion mental model) and then positive art because this is consistent with ancient principals (ahimsa aka ‘Do no harm’ is the first “don’t” in yoga; the “don’t” are check-listed first and the “Do’s” are check-listed next)
Q2:
1. The main idea is that only “a claim against a business” i.e. a business’ ability to pay as opposed to “a claim against property” i.e. a lien (pp [144]) provides safety. As J.P. Morgan said “the first thing is character”. Having to think of activating “recourse to indenture” is already an indication that the “investment has been unwise and unfortunate” (pp [147])
2. I agree. The reason covered on pp [145-146] (shrinkage of the collateral, possible impracticality of repo, delay in recovery of principal if at all) support the idea. After all, specialized operating assets in the absence of cash-flow are likely to have little value because of lack of possibility of re-use in a different business model.
Q3:
1. In addition to analyzing the bond as a claim on the business,
a. Analyze for possible earnings power decline in a recession and whether interest coverage (EBIT/I) has enough “surplus above the interest requirements” (pp [155]) “on a depression basis”
b. Factor in the industry (pp [156]-[157] (one Howard Marks’ eight factors in his introduction to Part II)
c. Check if there is over-extension or excessively funded debt (even a moderate decline in earning power can lead to price collapse and loss of principal) (pp [157])
d. For operations containing only an individual issue, it is ‘unsound to sacrifice safety for yield” – especially that portion of the yield above the risk-free rate compensating for credit risk.
2. If the investment operation is a portfolio of diversified bonds, then it is possible that the yield ‘reward’ compensates for credit risk at the group level (Marks refers to using the ‘law of probability’ here) given what we know in the high-yield market today. However, the caution here also is that the full extent of the probability distribution may not be known (if we did not analyze how fat is the tail) until we are in the extreme end of a crisis (like March 2009) – “the typical investment hazard is roughly similar to the conflagration [i.e. the whole group burning down] or epidemic hazard … in fire and life insurance” (pp [165])
3. Specific standards related to company’s financials
a. In addition to interest coverage discussed above, a “smaller proportion of debt to going-concern value” (pp [172]) can be used to evaluate the safety of a high-grade bond.
b. The value of “pledged assets” being “not something distinctfrom the success of the enterprise” (pp [184]). The safety therefore is directly linked to the earning power of the enterprise.
Q5:
a) Questions
a. What is minimum EBIT the cab driver has experienced in the last 10 years? I ask because already coverage is 2x (10/5) which appears to quite insufficient (ideally 3x and above is needed) (Railroads had a minimum standard of 2x (pp [190])
b. What is the prevailing interest rate at the 5 year tenor?
c. Has the cab driver defaulted on a loan in the last 10 years?
d. What is the going concern value? Assuming it is 5/0.1 in perpetuity = ($50), the debt to going-concern value appears to be 2x which appears to be too high. DSCR is 5/5 = 1 which is below minimum of 1.25
b) Calculated Ratios:
a. ICR (EBIT/I): 10/5 = 2x – relevant because the bond is a claim on the basis.
b. DSCR: NOI/I = (25-20)/5 = 1x - relevant to test the soundness of an ongoing-concern
c. Debt/Equity at maturity (100/25) = 4x – heavily leveraged – relevant to test whether the balance sheet is overextended on debt
c) A 3-year maturity is even worse because the cab driver cannot pay back the principal. A 7 year maturity would give a 2.8x debt to equity ratio (100/35) which might just be viable but the collateral would have no value after the 5th year and there is funding available to buy another cab for $100 at the end the 5th year.
d) It wouldn’t matter much to Graham because ”Safety [is] not measured by lien but by ability to pay” (pp [144]); the corollary (pp [147]) of lien being of subordinate importance is that “absence of lien is also of minor consequence”. It wouldn’t matter to me either.
- Earning power/coverage -- Can earnings cover interest payments plus contribute to future principal repayment? Can earnings cover business expenses (cab replacement)? Can earning cover these in adversity?
- Asset protection viability -- Does the cab’s resale value provide meaningful collateral for the $100 bond?
- Management -- How will earnings be allocated — will reserves be set aside for replacement? Also, he's worked for others, but now is starting his own business: how he runs his business could change his earnings.
Industry stability -- Are revenues stable in this industry across business cycles to support the fixed charges?
Q5b:
- Interest coverage: $10 EBIT/$5 interest = 2x, probably okay, but not room for adversity.
- Debt service coverage: Over 5 years, cumulative EBITDA = $150. Debt service coverage (interest + principal) = $125. Coverage ratio = 1.2×, which is very thin margin.
- Going-concern (replacement risk): At maturity, obligations = $100 bond repayment + $100 cab replacement = $200. Coverage ratio = $125 (free cash flow) ÷ $200 = 0.6x The driver is short and must refinance the new cab or default on the bond.
- Asset as protection: It's a wasting asset: from day one, there will be loss of principal if the business collapses. Asset Value/Debt = <$100/$100 principal = < 1x, no buffer.
Assuming earnings are stable and management decides to use cash reserves to pay debt, the bondholder could receive principal and interest. However, there is no room for adversity; the fundamentals of the business offer extremely thin, if any, margin of safety
Q5c:
With a 3‑year maturity, cumulative EBITDA would be $90, while total obligations (3 years of interest $15 + $100 principal) are $115. Debt service coverage = $90 ÷ $115 ≈ 0.8×. The driver cannot cover total debts, making this worse than the 5‑year case. With a 7‑year maturity, cumulative EBITDA would be $210, but the cab must be replaced at year 5, reducing available cash to $110. Obligations at maturity (7 years of interest $35 + $100 principal) total $135. Debt service coverage = $110 ÷ $135 ≈ 0.8×. This is also worse, since the wasting asset drain cash flow before the bond matures. Analysis of the safety of the bond remains unchanged as neither offers a better margin of safety.
Q5d:
It probably wouldn't matter to him. While the cab could be resold for some value in the first few years, it will never be sufficient to cover the full $100 of funded debt. It offers no protection. For me, the bond is a bad buy overall. However, if I were forced to invest I would prefer it secured. If the business failed before year 5, the cab could be liquidated for some partial recovery, reducing some my losses.
Q6a: -- Boeing's 8.625% senior unsecured bond due November 15, 2031 -- (BBB or BBB-)
Failure to demonstrate earnings power and debt coverage over the past 5 years is a major red flag. The negative book equity, eroding asset base, and heavy reliance on inventory with a substantial write-down risk do not provide adequate asset protection, as evidenced by a Net Fixed/Total Debt ratio of 0.21x. That said, this is common in this sector and may be passable according to modern standards. Liquidity is adequate at 1.32, but not robust. The trend of shareholder's deficit indicates a lack of equity buffer. I did not deeply investigate management or ability to handle adversity, but brief perusal indicated trouble. Based on these critical failures, this bond would not qualify as a high-grade investment according to Graham's criteria or my own assessment. Some arguments are more speculative, making the bond potentially suitable for high-risk-tolerant investors betting on long-term recovery. For example, given their government contracts, the issuer may fall into the "too big to fail" category.
Q6b: -- RTX Corporation 4.875% Senior Unsecured Bond Due 2040 --- (A or higher)
RTX’s fixed-charge coverage is solid, around 4x; net profits are on a rising trend. Total assets are dominated by intangibles, working capital elements and defense backlogs; not a sound base for protection but common in the sector. The post-pandemic rebuilding and unusual operating costs have gradually reduced current assets, with working capital now at 0.91. This is concerning, but not a major failure. With an Equity/Total debt ratio of 5x, they are extremely well capitalized, offering a substantial buffer to bondholders. There is no evidence of aggressive revenue recognition or off-balance sheet activities, indicating sound accounting practices. RTX has weathered tough periods—including COVID-related declines in commercial air travel and costly product recalls. Its diversified commercial and defense segments, along with management’s focus on risk control and disciplined capital allocation, have enabled sustained dividends even through crises. Graham might see this a borderline investment grade bond because while it doesn’t strictly meet asset protection or liquidity requirements, it clearly passes the other more important requirements. I see this as an investment grade bond because it does meet every other key safeguard. At the end of the day, it offers a high degree of principal safety and adequate return.
Q7: Role: You are an analyst applying Benjamin Graham’s Part II (fixed‑value investments) principles to corporate bonds. Your goal is to judge bond safety using evidence-base coverage of earnings power, stability under adversity, asset protection, management policy, interest and fixed-charge coverage, liquidity, equity cushion, and accounting integrity. Conclude with a margin-of-safety judgment.
Bond Information: INPUT NEEDED HERE
Task: For bond, first gather the required inputs via research, then apply analysis framework given. Evaluate using Graham’s Part II framework and the Analysis Framework provide below. Provide both a verdict based strictly on Grahams framework (earnings power, asset protection, margin of safety) and a verdict based on the provided framework. You may add reasonable, clearly justified modifications. Do not rely on market ratings or price momentum as primary evidence.
Step 1: Get Required Inputs for the Bond
For the bond collect:
• Financials (multi‑year, at least 3–5 years if available): EBIT, interest expense, total debt (funded debt), current assets and current liabilities, fixed assets, market value of equity.
• Qualitative context: Industry cyclicality/stability, business model resilience, capital allocation (capex, dividends, buybacks), any known adverse periods.
Step 2: Apply Analysis Framework to the Bond
1. Earnings power and fixed‑charge coverage (primary safeguard)
○ Compute: Multi‑year average and worst‑year EBIT ÷ interest and EBIT ÷ all fixed charges.
○ Assess: Stability across a cycle; trend of profits; adequacy under adversity.
2. Asset protection (secondary safeguard)
○ Compute: Fixed assets ÷ funded debt
○ Assess: Asset quality, independence, and liquidity (specialized vs. salable).
3. Liquidity and working capital
○ Compute: Current assets ÷ current liabilities; Working capital ÷ funded debt.
○ Assess: Near‑term cash sufficiency and refinancing risk.
4. Equity cushion and market (signal)
○ Compute: Market value of equity ÷ bonded debt.
○ Assess: Buffer before bondholder losses; treat market signals as secondary, not determinative.
5. Management policy and dividend record (signal)
○ Review: Dividend continuity and rationale; retention and reserve policies; leverage discipline.
○ Interpret: Skips/suspensions as potential warnings; dividends not required for bond safety.
6. Accounting integrity (signal)
○ Check: Depreciation realism; conservative coverage calculations; any signs of aggressive reporting; any red flags?
7. Adversity scenario
○ Run: Reasonable stress (e.g., EBIT down 20–30% consistent with industry history).
○ Re‑compute: Coverage, liquidity, and asset protection under stress.
○ Decide: Whether safety persists when conditions worsen.
Step 3: Output Format for bond
• Summary table:
○ Issuer/bond: Terms and structure
○ Coverage: EBIT/interest and EBIT/all fixed charges; worst‑year coverage
○ Asset protection: Fixed assets/funded debt; notes on liquidity
○ Liquidity: Current ratio; working capital/funded debt
I have not, but that’s an interesting idea as a way to test it. If I was seriously counting on it, I probably would check its sources to make sure it wasn’t hallucinating. Copilots ‘deep research’ mode has hyperlinks throughout and detailed source links at the end of the report.
I'll have to post in multiple comments (i'm getting an error)
Q1: I do agree, and this was a very interesting section. Fixed-income investments offer only limited returns through yield and modest appreciation, but poor selection can result in total loss of principal. Stocks, while also capable of 100% loss, have the potential for significant gains. Winning with bonds means avoiding losses, as their upside is capped, unlike stocks where the upside is unlimited. Bonds have downsides to avoid, while stocks have upsides to pursue. The cost of being wrong in stocks can equal the cost of missing out by avoiding risk, whereas with bonds, the cost of winning is low, but the cost of losing is high. This creates an asymmetrical risk profile for bonds versus a symmetrical one for stocks. Start with a minimum standard as a base and eliminate all options that do not meet this standard.
Q2: Graham's main idea is that a high-grade bond's degree of safety comes from its earning power and the enterprise's assumed ability to fulfill their promises of principal and interest payments, even under pressure. Earnings coverage is the primary safeguard, not assets which may or may not hold their value. Graham pays close attention to the character of the industry and the size and location of the enterprise. He acknowledges that no industry, size or location risk free, he seeks ones with the most stability and predictability. He developed minimum coverage ratios for amount of protection in various categories and used those to determine whether the company could withstand financial pressures.
Q3: When Graham analyzed the company's financial balance sheets to assess the safety of a bond, he considered several quantitative factors:
• Relation of property value to funded debt -- He looks at the worth of fixed assets relative to long-term debt. But asset value isn’t automatically protective. It depends on the type of asset, how it’s used, and whether it can be independently valued and easily liquidated.
• Ability to meet expenditures and total debt -- He emphasized the importance of a consistent record of assets of meeting expenditures and total debt.
• Dividend record -- Graham also looked at the company's history of dividend payments, not as a requirement but as a signal. If an issuer was skipping or suspending dividends, especially when the they could afford it, it could be a red flag of coming trouble needing further investigation.
• Average Earnings over time-- He analyzed average earnings over a period of time (preferably a business cycle), looking for a rising trend of profits, current good showing,
• Interest coverage -- Over given period of years, he wanted a margin of interest coverage that indicated the issuer could cover total debt, not just interest, with earnings for every year in the period being averaged.
• Stock-to-bonded debt ratio -- He used this to gain insight into market sentiment. If the ratio was high it didn't affirm the safety but indicated the market felt it was worth pursuing; if the ratio was low, it was a flag to dig deeper and see if there was a valid reason for the hesitation. He also used it to establish a buffer against loss: if equity started falling it was possibly an indication of trouble.
• Working Capital -- He desired ample cash; enough to cover current liabilities and have a surplus to fund long-term liabilities.
• Misreporting and accounting tricks --He also discussed various manners information could be misreported, such as how coverage ratios were calculated and how depreciation could be inaccurate.
Graham gives specific formulas and thresholds that probably are different today due to different industries. Despite the changes, from what I can grasp, the principles Graham outlined still seem relevant. As someone new to investing, and especially since I have a focus on stocks rather than bonds, some of these ideas are different from what I’ve been learning. It’s a bit overwhelming to figure out what items in the financials prioritize. That said, I’m intrigued by how these fundamentals help paint a picture of the company as a whole — how to use the little puzzle pieces to help answer the big question: is this business durable, profitable, and worthy of my investment.
Q4: Preferred stock is considered unattractive because its principal and income value are limited. The holder has no legal claim for principal repayment, and dividends are discretionary, meaning the issuer is not obligated to distribute them. Similarly, Graham views income bonds with skepticism; although the principal is more secure, the income remains discretionary.
1: Graham calls high-grade bond investing a “negative art” because the best you can do is get your money back with some interest. There’s no upside, only the chance to mess it up. It’s more about avoiding mistakes than finding opportunities. It reminds me of the idea of via negativa that Munger talks about, where success comes from removing errors instead of chasing brilliance. I agree with that. Bonds reward patience and discipline more than creativity. I also believe via negativa may be more beneficial in equity selection than a long checklist.
2: He says the real safety in a high-grade bond doesn’t come from collateral or the company’s name but from steady earning power that can cover interest through bad years. That still makes sense today, though I’d add that in modern markets you also have to think about liquidity and refinancing risk. A company can look fine on paper and still run into trouble if credit dries up.
3: Graham looked mostly at coverage ratios and balance sheet strength. He wanted a big enough cushion so the company could pay interest even if profits dropped. I’d still use that approach but would add cash flow analysis and access to capital markets since companies today roll debt more often than they retire it. Same logic, just updated.
4: He thought income bonds and subordinated issues were permanently inferior because they depend on good times to get paid and sit too far down in the capital stack. The investor takes equity-like risk without equity-like reward. I agree with that. The promise of extra yield usually doesn’t make up for the added risk.
5a: For the cab driver, I’d want to know how stable his $10 EBIT is. Does he own the license? What happens if he gets sick or fuel prices jump? Does he have any savings or backup income?
5b: His interest coverage would be $10 divided by $5 interest, or 2 times. That’s below Graham’s comfort zone, which was closer to 3 times or more. He’s fully leveraged with no cushion, so it wouldn’t qualify as a high-grade credit.
5c: A 3-year maturity would reduce risk because less can go wrong in that time. A 7-year would increase risk because there’s more uncertainty. Graham would probably lean toward the shorter term given the weak coverage.
5d: If the bond were secured by the cab, it might help a little but not much since the cab depreciates quickly. Graham would like the idea of collateral, but it wouldn’t change the analysis much. I’d feel the same.
6a: One example could be a Ford Motor Credit 2030 bond rated BBB-. It yields around 6 percent. That barely clears the bar for a high-grade bond. Graham would probably call it borderline because of the cyclical auto business.
6b: Another example would be a Johnson & Johnson 2030 bond rated A+. It yields about 4½ percent, has huge coverage, and low leverage. Graham would approve. Personally, I think it’s safe but not very rewarding after inflation.
7: If I were using AI to help with Part 2, I’d write something like: “Use Graham’s methods from Part 2 of Security Analysis to break down a company’s balance sheet and income statement, point out weak spots, and explain how modern accounting might hide risk.” I’d use ChatGPT 5 with reasoning set high, not deep research mode. I’d want it to think carefully, not just pull more data.
Just nipping in over the wire. But all caught up now on the reading. I have to say I had no idea that Bond investing was so complex and need to really dig into the security behind the bond. So anyway off to the questions.
Question 1: Negative art. As the quality assurance process is painful and time-consuming, you want to use your time wisely, so focus on where it is most likely to benefit. So can understand using a filter-down approach. And your filter is to only look at bonds that are likely to return your capital, even in a worst-case scenario, when the business goes insolvent. Or ideally, the business is not likely to go insolvent. And you would receive a a reasonable return for the risk Also, support the (now) traditional assumption that Bond investing protects against downside risk. So yes, some due diligence to ensure it works in practice seems sensible.
In comparison to common stocks, where any stock in theory could be worth your time, just need to see if it meets your criteria to have a look at. It seems the opposite rationale applies to Bonds. That only a few are actually worth your time, and your job is to filter out the bad ones and find the good ones.
Question 2: There are two main ideas of safety. The business itself is of a decent quality and unlikely to go insolvent. Secondly, the Business can easily cover the debt repayments of the bond. (Graham doesn't seem to set much store on contingent assets...might not be worth the paper there written on.)
Question 3: It looks like Graham recommends two-time coverage of the coupon payment. I would also be interested in understanding why business wanted the bond, and the maturity length. and the interest rate. To understand if worth investing in, while a bond might be safe, it may not offer sufficient return.
Question 4: Security structures...I don't think he really had much time for many security structures. All would need to be considered in a business insolvency scenario, and consider what a fire sale price could be. He was particularly sniffy at hotels etc, as it would be difficult to use for an alternative use.
Question 5: I would be keen to understand how he would expect to pay for the bond (e.g would he do more hours, hire the taxi out on his off-hours. As I believe he would need more income to service the bond.) I would also be keen in understanding if he could set-prices and what the local competition was like. For instance, in London there a lot, and there Uber. While at home in Scotland, there is much less competition, where he would have more pricing power. Also, be keen to understand what protections I would have if he doesn't pay the coupon.
B. Credit metrics, previous history of paying back credit. As it's an individual, I would check CCJ etc. And maybe his credit score on Experian. (If he was a business I would do something similar.) I would also look at cashflow, and see if the business could currently pay the coupon at twice coverage. And then take into account of any additional plans he had for earning if he owned a taxi and see if that made a difference.
C. The most obvious change would be time-period to pay back the loan. while for a seven year period, I would have to assume he would either need to buy-a new taxi at year 5 ($100) or he would look for a new bond as well at year 5 and be paying off two loans in years 6 and 7. And whether the business could afford that.
D. I would want the bond secured to the taxi....downside of course, if he defaults in year 4 or 5 I get a worthless asset. But I would get good protection in year 1 and 2. I would secure the loan, But I can see Graham not being that fussed by it.
Question 6: Not had time do. (will have a dig about how I can find info about a corporate bond as a retail investor.)
AI prompt: Could you be a great Bond analyst to help me analyse a bond to understand it's creditworthiness, whether the business will still be solvent for the length of the bond, and whether understand any contigent assets and the risks. And also help me understand if the bond is of a good quality would offer a reasonable return for the risk. I would then do series of follow-ups. (Ie is it a growing industry, is bond coupon rate have two time coverage.) What the business cashflow like? What do S&P and Moody's think of the bond etc. Has the company defaulted on previous bonds. (I'm personally not a fan of a really large initial prompt as I prefer chatting more.) I would also prediocally ask, whether the answer was correct. If I really wanted to ensure accuarracy, I would ask I needed the correct answer or else my boss would be very unhappy and fire me. (For some reason that improves the quality of the answer.)
1. Investing in High Grade fixed income securities is an investment of limited returns – i.e. in exchange for limiting participation in profits, the bondholder obtains prior claim and a definite promise of payment. But neither priority nor promise is itself an assurance of payment. Since the chief emphasis must be placed on the avoidance of loss, bond selection is a negative art. It is the process of exclusion and rejection rather than search and acceptance. Therefore, to avoid loss, there are no penalties for rejecting a good bond, but penalties for accepting a bad bond.
In general I agree, in most times all these hold, however during depressive periods or crisis or intense pessimism of an industry, it may be possible to have more equity like returns when the bond price drifts far below the principal. Assuming interest and free cash flow coverage is adequate.
2. Graham believes that safety is provided by the ability of the issuer to meet all its obligations measured under conditions of depression rather than prosperity. Lack of safety cannot be compensated for by abnormally high coupon rates. In order to test for safety, the selection of all bonds should be subject to rules of exclusion and to specific quantitative tests.
Yes I agree with this. When a bond is not able to meet its obligations and goes into default, specific remedies may not result in the protection of coupon and principle. Asset sales to pay down debt may not be sufficient as there is shrinkage of property values when the business fails i.e. fire sales to raise cash may not get best prices, asset values currently on the balance sheet may be more optimistic than realistic as it’s the job of management to get the lowest interest rates. Voting control to direct cashflows to payment of coupon and principal depends on cash availability. Receivership may lead to delays and a debt payment structure that is not to the benefit of the bondholder but rather to the capability of the company i.e. the coupon may be lowered to what the company can realistically shoulder, and the maturity date dragged out.
3. Graham has previously used earnings before interest and tax to measure the fixed charge coverage.
I would prefer to use free cash flows after capex as a measure for coverage instead, as income statement figures can be subject to much more “creativity” and it’s really cash that pays down debt and interest.
Given how managements are compensated by stock options/equity today, I would be wary of how managements manage their capital structures i.e. what is the purpose of maintaining debt – are they paying huge dividend payments instead of paying down principal? What is the purpose of raising debt - would proceeds be used for dividend payment? These may not be inherently destabilizing as high grade bonds would imply a company with sound financials and adequate cover, but it does give some insight into how managements view stakeholders.
4. Overextended pyramided capital structures which absorb almost all earnings with hardly any margin available to withstand moderate setbacks and shrinkage in profits. These were inferior as it was not due to the weakness inherent in the businesses but rather the recklessness of financing methods. The business i.e. utilities can be stable through cycles but unsound financing methods can cause collapse.
5ab. Currently, is there any debt? Are there plans to take on more debt? How will this additional debt be ranked? Is the debt backed by the cab as collateral?
Assuming that there is no other debt, and this is a more similar business to railroads, compared to public utilities or industrials – transportation sector, where the cab, similar to the railroad car, can be sold off without much issue. Graham recommended a 2x fixed charge for investment bonds. (Pg 190, 6th edition).
Interest charges on the bond would be – $5
Fixed charges earned – 2x $(10/5)
Straight line depreciation would imply a depreciation charge of $20 a year. Assuming the depreciation is a non-cash expense, there is no actual cash outflow, and the principal can be paid back in 5 years - $20*5. Assuming that the cab driver has history of paying back debts.
5c. If he is able to sell the car at residual value with no issues:
3 year maturity – At year 3 he has cash flows from total depreciation charge of $60 ($20*3)and $40 residual value $(100-60) from sale of cab. At worst, the driver cannot sell the cab below $25 ($(40-15) - he has $5 of cashflows yearly after paying interest. So after 3 years, if earnings are retained he would have $15.)
7 year maturity – he would have rolled the $100 from 5 year cash flows from depreciation into a new cab at year 5. At year 7, he would have $40 of cashflows from 2 years of depreciation charges, and $60 of residual value from the sale of cab. The minimum sale value of the cab is $50, per explanation above.
I don’t think my assessment would change.
5d. I think most important for Graham would be the interest charge cover in the ordinary course of the business, and if any additional debt is added. To the degree of additional debt added, security might matter. I agree with Graham.
6. I am not able to search for specific bonds.
All of the bonds above are considered investment grade. The ‘-‘ sign denotes a negative outlook and an increased probability of a downgrade. While these are investment grade bonds, they all require regular monitoring for deterioration, as, under stressed conditions, the deterioration of the underlying businesses can cause these bond ratings to slide below investment grade. (https://www.spglobal.com/ratings/en/regulatory/article/-/view/sourceId/504352 table 42- credit stability as a limiting factor on ratings.
7. I will need to get back to this – I am not sure exactly what a thinking model is or how I can feed that into AI. I am only able to do basic questioning.
1. In fixed income investing, upside is capped. Downside is not. This can result in loss of principal. Therefore, to reduce loss of principal at a portfolio level, Graham says that one should avoid losers. I fully agree with him. In fixed income investing, errors of commission (Type 1 error) must be avoided, while errors of omission (Type 2 error) don’t represent large opportunity costs. This contrasts with venture capital investing where Type 2 error significantly hurts portfolio level returns compared to Type 1 errors.
2. Graham laid out a few general principles to ascertain safety of bonds.
a. Ability to repay is far more important than security over assets
b. Ability to repay should be considered in depression conditions
c. We should not sacrifice safety for higher yield
d. Larger companies are safer
e. More stable industries are safer
f. Track record of payment of interest and dividends over a long period of time
g. Track record of management performance over a long period of time in the past
h. Safety should be tested against well-defined standards
3. Graham recommends certain specific tests to determine the safety of high grade bonds. I’d modify these standards by making the tests even more severe. There is little penalty for this. There are many bonds. Yields are not that different. My pessimism is rooted in the fact that we have not lived through a prolonged depression condition over the last 10-15 years- hence a “laboratory-test” of earnings power under adverse conditions is unknown.
a. Earnings Coverage Over Fixed Charges: Graham’s recommends a ratio of 3x for industrials, and 1.75x for utilities over the last 7-10 years. I’d look for securities where ((EBITDA-maintenance capex-lease payments)/interest) ratio of at least 5x in each of the last 10 years for market-oriented businesses, and atleast 2x in each of the last 10 years for regulated businesses with contractual cash flow streams (gas pipelines, electricity transmission, etc). I’d also look for businesses whose (EBITDA-maintenance capex-lease payments) is atleast 80% of its previous high (in last 15 years)
b. Equity/Debt ratio: Market value of equity/total market value of debt should be atleast 1 for equities and 0.67 for utilities. I’d make this more stringent through two ways: Using the ratio (tangible book value of equity/market value of debt) if tangible book value of equity < market value of equity, and using the ratio (market value of equity/market value of debt) if tangible value of equity > market value of equity. And making this 1.5x for all kinds of securities.
c. Working Capital ratios: Current assets/current liabilities > 2. I’d modify this by making an exception for exceptional consumer businesses like Haier Smart Homes, and Nestle India which meet criteria 1 & 2, but have negative working capital since their businesses are exceptionally dominant. They can demand better terms from their customers and suppliers.
4. Graham believes that the typical preferred stocks to be permanently inferior to high grade bonds.
This is because high grade bonds have promised repayment and priority of repayment over preferred stocks and equity. In contrast, preferred stock have no promised repayment, and only has priority over equity.
However, Graham concedes that exceptional preferred stocks have similar characteristics as high grade bonds (eg: Nabisco preferred stock in the 1930s).
5a:
• Highest and lowest EBIT in the last 10 years. Compare it to the $5 interest rate.
• Sensitivity of EBIT to fuel prices
• Effects of ride hailing on EBIT of cab in industry
• What is the recourse for the bond holder if the cab is non-operational due to accident- is there insurance, how does the insurance protect the bond holder?
5b:
• Interest coverage ratio (EBIT/interest)
• Accumulated Cash + residual asset value always > principal
• Tangible book value of equity/debt amount
5c:
If maturity is 3 years, accumulated cash in the enterprise would be $71 (accumulated OCF-maintenance capex (0 in this case)- net change in WC (0 in this case). Therefore, I need to know if the cab can be liquidated after 3 years, at atleast $40+ ($10 margin of safety). If it’s a 7 year bond, then I’d worry about the liquidation value of the cab at 3 years. Accumulated cash by then would be 65 (since 100 will be spent on the new cab). I’d have to ascertain that the cab can be sold for atleast $45 ($10 margin of safety).
5d:
While his primary focus would be on the repayment ability from operating earnings and accumulated cash, he’d like to have security over the bond. I’d too.
6 a: S&P BBB or BBB- --> OXY Corp 7.5 Nov 01’96 with a yield to maturity of 6.5%.
Occidental Petroleum is a large shale producer in the Permian Basin and other oil interests. It produces ~1.4 million barrels of oil and gas/day. It has a market cap of equity of ~$40 billion, and has a net debt of $15 million.
Its debt has recently reduced by $6.5 billion since Buffett bought their subdivision OxyChem for $9.7 billion. Outstanding debt by end of year is expected to be $15 billion. Annual interest expense is likely to be $1 billion.
• At $60 oil prices, depreciation is ~$15/barrel and EBIT ~$10/barrel. If oil price goes down to $40/barrel, exploration expenses can be minimized, and the company can still produce at free cash flows of ~$5/barrel. Company produces ~450 million barrels/year. Therefore even under depression conditions, OXY has a coverage ratio over interest of 2x and in normalized conditions, the coverage ratio is 5x.
• Both tangible book value of equity/total debt and market value of equity/total debt exceeds 2x
• Current assets (including their listed midstream asset)>1.5x current liabilities
• Berkshire owns 30% of Oxy’s equity and can be a backstop in case its not able to meet its obligations (rich daddy).
6b: S&P A or above -->BNSF Corp 7.25 Aug 01’97 with a yield to maturity of 5.6%
BNSF is one of the largest North American railroads, owned by Berkshire Hathaway.
• In each of the last 10 years, (EBITDA-Maintenance capex-net change in working capital) has exceeded 6.
• Tangible value of equity/market value of debt far exceeds, and market value of equity/market value of debt far exceeds 2.
• It is a division of Berkshire Hathaway- an enterprise with an outstanding record of compounding book value, as well as management reputation of honouring its obligations. Its current assets far exceed its current liabilities (if we exclude float- which will not be called at once).
• Maturities are far lower than cash and marketable securities on the balance sheet
Both would be decent investments according to Graham, however not according to me. Bond investments are inherently investments in currencies. For a long term bond to be a satisfactory investment which would retain purchasing power, one needs to be sure that currency won't inflate too much. That requires good behaviour from governments. However, political expediency, across time immemorial, has caused ruling authorities to debase currency (even in ancient rome) at the expense of the savers. US's debt is much higher now compared to Graham's days. Moreover, the current political establishment has thus far been arbitrary with their policies. Thus, expecting these long term bonds to retain purchasing power till maturity may be foolish.
7. I couldn't think of an appropriate AI prompt.
I like your point in question 3 about applying stricter standards given we haven’t experienced a prolonged recession recently. Interestingly, one of the bonds I picked was Dollar General and it seemed to have better margins during the pandemic, so think Graham’s “recession test” requires further consideration like you alluded to.
I think dollar stores tend to be somewhat counter-cyclical (i.e. people trade down to cheaper goods when their budgets are under pressure). The general point here is to not just stress test a company based on how it did in the last down cycle for the economy, but find the worst environment for that specific company and use that as the stress test.
Question 1
Graham regards the choice of bonds as a negative art because the bond is a security with a limited return. In exchange for this limited return the emphasis must be on the avoidance of loss. It is a process of exclusion and rejection of as much risk as possible.
Question 2
The most important thing is the ability to pay, and I agree with this. Trying to collect debt when the debtor can’t pay is always a slow, legalistic and expensive undertaking, no matter how underwritten by guarantees the debt is.
Question 3
He has a selection of check boxes that must be met to qualify for high-grade lending to companies
1) Size – bigger is better. 0.5bn in sales (rough adjustment for inflation)
2) Earnings coverage 4x for industrials, less for more secure infrastructure
3) Poorest year of earnings must still be covered 3x
4) Leverage must be lower than 5x
5) Working capital must be greater than debts
6) Equity value must be at least 75% of debt.
I would still like to see all of these tests met for a secure high grade bond, though some of the tests are very severe by modern standards. Number 3 should be relaxed under some circumstances.
Question 4
Preferred stock, because the security does not stop poor performance in hard times, and limits the upside in good. Either way it’s a poor proposition, of the “heads I win, tails you lose” sort.
Convertible bonds at the discretion of the management of the company. This puts a further limit on upside as if interest rates fall or the market rate of return required falls, they can be redeemed and refinanced rather than rising to higher values.
Question 5
Setting the scenario against Graham’s tests:
1) Very small, so fails as there is clearly a high risk here if the cab driver falls ill, dies or is otherwise incapable of working.
2) Earnings coverage = 10/5 = 2. Not enough.
3) We only know the average so we need to ask what the worst year in the last 7-10 years are according to Graham
4) This test fails as the leverage is 100/10 = 10x. On an EBITDA basis it’s 100/30 = 3.3, but Graham does not use that metric.
5) Working capital we don’t know, so we need to ask. Should be $100, but this is very stringent as this would be all cash as the business needs no working capital according to this model.
6) Irrelevant as it’s not a listed company.
The most relevant metrics are earnings, as these support the whole enterprise. Closely followed by the consistency of earnings as the earnings coverage is not very high. If the cab driver earns more than 5% less than usual he will not be able to fund the interest out of current earnings. Finally the cushion of cash kept in the business is critical in establishing a margin of safety.
c)
If the bond maturity does not match the liability it will require a higher margin of cash in the business, and is therefore less safe. To illustrate this let’s look at the cabbies bank account, assuming he takes no money out of the business. Here are the 3 cases in a table of his bank balance. In the 5 year case his bank balance never falls below $25. In the other two cases it falls to -$25. Hence he will need to keep more working capital in the business to keep it afloat (the margin of safety is reduced)
Business Bank balance
Loan Term 3 year 5 year 7 year
Start 0 0 0
End of year 1 25 25 25
End of year 2 50 50 50
End of year 3 -25 75 75
End of year 4 100 100
End of year 5 25 25
End of year 6 50
End of year 7 -25
d) it would not matter to Graham in his analysis of large corporations, but it would to me in this case. Repossessing a car to repay a debt secured on it is easier, cheaper and much quicker than liquidating a large business, so it makes much more sense, and is therefore more important to secure the debt in this case, especially given the very high risk of this loan.
Question 6
Microsoft Class AAA financials from 06/2025. Values in $bn.
Microsoft 5.2% bond, maturing June 1, 2039
1) Size – 600 times larger than needed in sales
2) Earnings coverage 123/2.3 = 50 times
3) Poorest year of earnings 34/4/2.3 = 14.7 in 2017. NB, growth has rendered this a poor test.
4) Leverage 60/120 = 0.5
5) Working capital must be greater than debts 191 > 60
6) Equity value 3821, debt 60.
An easy pass. But neither Graham nor I would buy it because the yield at 4.88 is only 50 basis points above the nearest UST (May 15, 2039) 4.38 yield to maturity. He does not like taking risk for tiny yield advantage, and neither do I.
Hyatt Hotels Corp.
5.375%, 2031-12-15 S&P: BBB- (stable)
1) Size –6.6/.5 = 13.2
2) Earnings coverage interest/normalised pretax profit 0.411/.18 = 2.3
3) Poorest year of earnings must still be covered 3x. 2020 and 2021 losses due to covid.
4) Leverage 4.11/0.411 = 9.9
5) Working capital must be greater than debts 2.73 < 4.11
6) Equity value must be at least 75% of debt. 13.9 > 4.11*0.75
This one fails on 2, 3, 4 and 5. The current price is above par so the yield is 5.25%. Graham would not buy this one, and neither would I. Hotels are like airlines: when they have full occupancy, they make great profits, but their high fixed costs and semi-discretionary nature make them suffer greatly in recessions.
Question 7
Here is my script for Hyatt Hotels corp. Gives the same answers as me (rather to my relief), but with much more detail. Huge credit to Compound with AI posted by Gary for the basis of the script. I used the ChatGPT 5 Thinking model:
ROLE
Senior forensic bond analyst (ex–Big Four forensic accountant) in professional asset management.
OBJECTIVE
Surface and rank empirically verifiable credit vulnerabilities that could drive loss of principle in bond holding Hyatt Hotels Corp.
5.375%, 2031-12-15
Skip deep, theoretical teardown of the business model or product strategy; focus strictly on red-flag evidence.
DATA-GATHERING
| Bucket | Must-pull docs (last 10 yrs) | Quick query hints |
|--------|-----------------------------|-------------------|
| Core Filings | URD / Doc. de Réf. (AMF), statutory accounts, BALO notices, Banque de France liens (or local equivalents depending on listing jurisdiction) | "Hyatt Hotels Corp" "annual report" OR "rapport de gestion" |
| Transcripts | Earnings calls, broker conferences, investor days | "Hyatt Hotels Corp" "Q&A" |
| Alt-Data | Glassdoor & LinkedIn attrition, trademark/IP disputes, customs/trade data, SimilarWeb traffic, app-store ratings, insider trades, short-interest registers | "Hyatt Hotels Corp" "turnover" OR "employee departures" |
| Opinions | Broker downgrades, ESG notes, activist posts | "Hyatt Hotels Corp" "sell" OR "short thesis" |
Save full URL / file path + page or line # for every excerpt.
---
ANALYSIS Tests (score each finding ratio, Pass, fail)
1) Size – bigger is better. 0.5bn in sales minimum
2) normalised pretax profits/interest costs coverage 4x minimum
3) Poorest year of normalised pretax profits in previous 10 years must still be covered 3x
4) total borrowing/normalised pretax profits must be lower than 5x
5) Working capital must be greater than total borrowing
6) Equity value must be at least 75% of total borrowing.
(No extended business-model section—only include if a fact-based weakness surfaces in the above buckets.)
---
REPORT FRAME (flex length)
1. Executive Summary ≤ 1 page
Give pass/fail conclusion with reasons
2. Ranked Analysis Table (1-6)
| Rank | Test | ratio | difference from minimum | certainty | Pass fail|
3. Detailed Findings
One sub-section per bucket; numbered footnotes link to sources.
4. Falsifiability Checks
What could disprove each core point.
5. Missing-Data Flags
Critical gaps + follow-up query strings.
---
STYLE RULES
• Cite exact file + page for every claim.
• No adjectives without numbers.
• Bullets > prose; zero filler.
• Tables first, narrative second.
---
DELIVERY
Single .docx or PDF dossier. No CSVs, slides, or appendices unless requested.
Thought question: If we can find enough high-grade bonds without relaxing Graham's admittedly challenging standards, what is the benefit of relaxing the criteria? Phrased differently, given the narrow difference in yields within high-grade bonds, how often would you have to be wrong on the decision to lower your standards for it to be a bad one?
Looking at this question, I think there is benefit in relaxing the standards.
Quantifying this as best I can:
https://www.maalot.co.il/Publications/TS20240709142640.PDF
this is a copy of a 2023 S&P analysis of debt default. I recommend this as a read to get an understanding of how bond markets think.
To answer the question, have a look at table 4 on pp9. For BBB debt the weighted long term average default rate is 14 basis points, and the worst year in 45 was 100 basis points. Roughly the premium should be somewhere between these figures. lets add one standard deviation from the table at 25 basis points to get 38 basis points. This is allowing for the peak years of default like 2008. The premium for Hyatt is 87 basis points. So a premium of 49 basis points. Priced to perfection, but rational.
The AAA default rate is zero. The premium for Microsoft is 50 basis points. Identical 50 basis point premium.
Note that this does not include an adjustment for the recovery of debt in the case of a default: just as Graham says. However the recovery rates are significant:
https://www.moodys.com/sites/products/defaultresearch/2002300000424883.pdf
There is a lot of detail in here, but the short answer is 40%. It varies from this mean a lot, but mostly in ways you would expect.
Graham also says that the time it takes to be paid after default is long. I found a reference to a paper on this which gave an estimate from Moody's 1 year as a mean, but with a large variance. The longest was 12 years!
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4738268
so you can on average retrieve 40% of your capital after a year on average, which is worth approximately 14*0.4*0.95 = 5.3 basis points assuming a 5% interest loss and a year wait for the remains of your principle.
All this seems very rational. the increase in risk and volatility as you go down the scale should encourage both diversification, and a reduction in the bet size on each position. All of these should drive an increase in the price premium. For an extremely useful discussion of bet sizes, and it's proportionality to the inverse square of volatility I strongly recommend this read:
https://en.wikipedia.org/wiki/The_Missing_Billionaires
Q1: It seems to me that bond returns typically have negative skew, meaning you can lose everything (down 100%), but your returns are capped (at whatever yield you get based on the price you paid). Your goal as a bond portfolio manager is to avoid the losers – hence a ‘negative’ art. Yes, I agree. When you delve into distressed situations, the math changes.
Q2: Priority and promise is NOT assurance. It doesn’t matter what management says or believes, if the cash is not there for the debtholders (because it was wasted by the shareholders/board), then too bad.
Q3: Similar to the answer above, however in today’s environment, so many corporate assets are ‘soft’ meaning intellectual property, brands, etc, I wonder about their value in a downturn or for a different owner.
Q4: All things being equal, Graham hates things like preferred stock due to its characteristics. But really, as a value investor, he should have channeled his inner Howard Marks, and written “but everything is a good investment at a proper price” or something to that effect. Marks writes the same about high yield bonds, which were hated simply for being high yield bonds. It’s all about the return per unit of risk.
Q5: I generally agree with the other answers on Q5. Just for everyone’s FYI - There is an excellent podcast on distressed investing in NYC taxicab medallions on Invest like the Best (Aug 5 – Marble Gate Capital).
Q6: A) General Mills bond due 2031 (rated BBB): Net debt/EBITDA of 3.4x; FCF $2.1B vs. Cash interest paid of $474M (4.4x)
B) University of Virginia Bonds $600M issue due 2050 (rated AAA): Would need to dig deeper into the financials, but the issuer has ample assets, financial backing, the ability to increase tuition, and assuming the endowment assets of $10B+ also back the bond, you are very, very covered.
Q7: Benjamin Graham discusses the weakness of specialized buildings in his book “Security Analysis”. He includes examples such as hotels, garages, clubs, hospitals, churches, and factories. Some of those examples are a bit dated. I would include data centers and distribution centers as newer examples that fit his framework (pg 186). Please give me 5 examples of real estate-related companies that generally DO NOT own specialized buildings in Graham’s example. Write me 100 word investment tearsheets for each example.
Thanks you for the podcast suggestions, I am looking forward to checking it out. Medallions, eh?
Question 1:
It is a negative art in that the upside is limited to the coupon amounts and the downside is insolvency and loss of principal. Meaning for it to be worth your while it must be a safe/secure bet. Instead of choosing winners it is more important to say no to losers. Loss of principal is almost guaranteed in a bankruptcy situation because of the courts and how they deal with bondholders.
Question 2:
Bondholders are only entitled to fixed return, so the upside is limited, while the downside loss of principal can be severe due to the structure of bankruptcy and US courts. This asymmetry means that risk avoidance matters far more than chasing yield. I agree with this assessment. With my limited exposure to bonds, I have fallen into the trap of looking at the yields first. Bond investing requires structural discipline.
Question 3:
Graham’s bond safety framework rest on quantitative adequacy:
Safety comes from stable and ample earnings power, conservative capitalization, and sufficient asset coverage. For me I believe safety comes from quantitative and some qualitative factors. I place more importance on the level of trust I can put in the management over if they have sufficient asset coverage. Does the management have a record of meeting obligations and being truthful in disclosures about the business. Do they have a track record of safety in terms of stable and ample earnings power and are they truthful about downturns in their business.
Question 4:
Why would anyone ever invest in preferred stocks? Optional dividends with limited upside. Neither safe or return oriented. Don’t get it.
Question 5:
a) The average EBIT is $10, but how consistent is this. Are there swings in the earnings or is it relatively stable. I find it hard to imagine there aren’t fluctuations in gas prices or an accident happening and throwing off the predictable cash.
b) The interest payment is $5 per year. There is doubt the cab driver could meet his obligations in a bad year. 2x average coverage is not enough to satisfy me. The driver will not make enough to buy a new cab in cash and will need to borrow again.
c) I would prefer a shorter term as it is slightly safer. Longer term than the useful life of the cab would be nonsensical.
d) Collateral would slightly improve recovery, but does not change the fundamental safety of the investment. We should never count on recoupment of a bond based on collateral as this almost never happens as we think. A bankrupt business may sell their cab for much less than its depreciated value.
6. I looked at Crocs 4.125% Sr. Notes due 2031 (unsecured). Bonds were recently upgraded to BB-
Earnings Coverage appears strong by the results (~9x coverage). Cyclical single-product concentration (clogs) with competitors undercutting and violating IP (hard to enforce). Extra leverage introduced with acquisition of HeyDudes. Competent management looking to reduce debt.
I would include this issue in a bond portfolio as a small allocation. It’s clear the business is performing well and analysts agree with ratings increases.
AVGO. 2025 issues 5.2% due 2035. Rated A- S&P.
Earnings coverage of 7x. Massive size/scale/stability. Diversified with strong FCF. Also a deleveraging trajectory post VMWare acquisition.
AI tailwinds with a strong mix of product offerings.
I would size this as a medium position in a bond fund.
Question 7:
You are an expert in Benjamin Graham’s Security Analysis methodology, focusing on the fixed-income chapters (Part II).
1️⃣ Summarize the analytical framework Graham uses to judge bond safety, including key quantitative standards (interest coverage, debt ratios, asset coverage, size, stability, covenants).
2️⃣ Given one or more modern bonds (e.g., ticker, rating, maturity), perform a dual analysis:
• (A) Apply Graham’s original “high-grade” standards using current financials.
• (B) Apply a modernized version (cash-flow coverage, leverage, sector cyclicality, off-balance-sheet risk).
3️⃣ Score each bond 0–100 for Graham-style safety margin and provide a qualitative verdict: High-grade / Borderline / Speculative.
4️⃣ Highlight which standards remain timeless vs. outdated given today’s markets.
5️⃣ Output a table comparing:
– Earnings coverage (EBIT / Interest)
– Debt-to-capital
– Free-cash-flow coverage
– Credit rating (S&P/Moody’s/Fitch)
– Spread vs Treasury
– “Graham score”
6️⃣ Conclude with a concise summary of whether each bond would qualify as investment-grade under Graham, and whether you personally would buy it today.
Example input:
“Analyze Crocs 2029 4.25% notes (B2/B) and Broadcom 2038 4.9% notes (A-) using Graham’s criteria.”
I think the character of management is super important. We can't forget that after all this is just a scaled-up version of loaning someone money. Whether they can afford to pay is one important criteria, but the other one is whether they can be trusted to keep their word even if they could weasel out of it somehow.
Thought question: What did Graham mean by “an investment operation” in his definition above? As a corollary, can a purchase of a single security in and of itself be classified as either an investment or a speculation according to Graham? According to you?
Investment operation is a more all encompassing term for a standards-based decision making framework. Graham would say purchase of a single security could be both an investment or a speculation, and I’d agree, based on how closely the purchase of the single security aligns with a standards based framework.
Question 1: Why does Graham believe that investing in High Grade fixed income securities to be a ‘negative art’, in contrast to investing in common stocks? What does he mean by that? Do you agree?
Graham considers investing in high-grade fixed-income securities a “negative art” because the primary objective is avoiding loss, not seeking profit. He emphasizes that true analysis here lies in understanding how well a bond can withstand depression conditions — the focus is on preservation of principal and continuity of interest payments. By contrast, common stock investing involves both loss avoidance and the pursuit of profit through appreciation.
I agree with Graham to a point. When buying high-grade bonds near par, the upside is typically capped at the yield, so the real skill lies in minimizing downside risk. However, I think his phrasing “negative art” is partly rhetorical — meant to jolt readers into recognizing that even “safe” bonds can carry significant risk. As he himself notes, there are periods when deeply discounted bonds offer equity-like upside; in those cases, fixed-income investing can take on a more opportunistic, profit-oriented character.
Question 2: What is Graham’s main idea about what provides safety in a high-grade bond? Do you agree?
Graham evaluates bond safety based on a company’s ability to meet its fixed obligations under adverse economic conditions (“Depression stress test”), guided by quantitative discipline and qualitative judgment. He insists on working “upward from definite minimum standards of safety,” not downward from theoretical maximums.
Graham’s intent—tying safety standards to industry stability—remains sound. But as Howard Marks observed, his framework implicitly demands adaptability. In today’s market, coverage ratios should scale with the volatility of the business: subscription-based firms may resemble utilities, while tech or cyclical sectors require higher margins of safety.
Question 4: Which security structures does he believe to be permanently inferior in this category? Why?
Graham believes noncumulative preferred stocks are permanently inferior because they lack adequate protection for investors. If the issuer omits dividends, those missed payments are lost forever—not deferred—so the investor bears the downside of equity risk without full participation in its upside (given that it’s dividends are fixed but not predictable). Unlike bonds, they don’t have a maturity date or principal repayment obligation, and unlike common stock, they don’t share in profits if the business prospers. In Graham’s view, that combination of limited return potential and real risk of loss makes noncumulative preferreds a structurally unsound investment.
Question 5: Miniature Credit Analysis scenario:
- Cab driver has driven a cab for someone else, and now wants to buy his own for $100
- The cab will have a useful life of 5 years, and have straight-line depreciation with no residual value for accounting purposes
- For cash purposes, the cab will have no cash outlays associated with it but will need to be replaced at the end of 5 years, with another cab, which we will assume will also cost $100
- The cab driver has historically averaged EBIT of $10 on his historical revenues of $100, and expects that to continue. There are no taxes.
a) What questions would you like to ask/what would you like to know to assess whether buying a 5-year $100 bond with a 5% coupon meets Graham’s standard for investment in a high-grade bond?
Does the cab driver have a loan for a medallion or to buy the car?
How stable are earnings in the cab business especially in recession eras (2000, 2008, and 2020)? Based on this, what minimum fixed charge ratio am I willing to put on this?
What does the outlook for the cab business look like especially with competition from ride share?
Secondary importance:
Are there any guarantees? If so, what are the terms and how much earnings power does the guarantor have?
Is this secured by the vehicle? How active is the aftermarket for cabs?
b) Substantiate your answer to a) with specific credit metrics that support your analysis. What metrics are most relevant? Why?
Fixed Coverage Ratio (after taking into account any other obligations and fixed charges) so that we can determine the ability of the company to cover its fixed charges especially in a time of recession. Stock-Value Ratio so we can understand the size of its debt obligation and other commitments.
c) What would change in your analysis, if anything, if everything stayed the same but the bond had a 3-year maturity? A 7 year maturity?
I would focus my analysis on first determining the minimum fixed coverage ratio I’d be willing to accept for this enterprise. Graham was chiefly focused on this metric, and I’d want confidence in the company’s ability to meet its fixed charges under any maturity. He doesn’t place much emphasis on maturity in Part II—his analysis centers on earning power and margin of safety, not time to repayment. For example, on page 151 (6th ed.) he compared Pacific Power & Light (due 1955) with 1.53× coverage and American Gas & Electric (due 2028) with 2.52× coverage, favoring the latter despite its longer term. That shows he viewed safety as a function of earning strength, not duration. I don’t think it’s productive to speculate on when a recession might hit, since Graham himself noted their unpredictability. As a secondary consideration, a shorter-term bond could offer a bit more comfort if it were secured by the car, given its higher potential aftermarket value—but that wouldn’t be central to my analysis.
d) How much would it matter to Graham whether the bond was unsecured or if it were secured by the cab? What about you?
Graham wouldn’t put much weight on whether the bond was secured by the cab. His focus is always on the issuer’s earning power and its ability to cover fixed charges, not on collateral. However, in this specific case, the cab does have some independent economic value beyond its regulated taxi life (assuming an NYC taxi). That makes it more like the “secured equipment obligations” Graham discussed on pages 180–181 (6th ed.), which “fared well” when the underlying assets were removable and had secondary use or marketability.
So while Graham would still classify this as a secondary consideration, he’d acknowledge that having a vehicle that could be resold or repurposed provides an added margin of protection. Personally, I’d agree — the cab’s resale or replacement value wouldn’t change my credit decision, but it would give me more comfort knowing there’s a recoverable asset if earnings deteriorate.
Question 6:
a) Walmart (AA, 6.50% 2037)
2020 EBIT margin: ~4.0%
2024 Revenue: ~$648B → Adjusted EBIT ≈ $26B
2024 Fixed charges: ~$7B → Coverage ≈ 3.7×
Leverage: Conservative (Debt/Equity ≈ 0.6×)
Earnings stability: Strong even during 2020; core business defensive.
→ Graham’s View: Meets 3× minimum and shows earnings resilience under stress. Investment-grade.
→ My View: High-quality. Attractive for capital preservation.
b) Dollar General (BBB, 5.00% 2032)
2020 EBIT margin: ~11%
2024 Revenue: ~$39B → Adjusted EBIT ≈ $4.3B
2024 Fixed charges: ~$2.2B → Coverage ≈ 2.0×
Leverage: Moderate (Debt/Equity ≈ 0.9×)
Earnings stability: 2020 margins were inflated by COVID tailwinds; subsequent years saw normalization and cost pressure.
→ Graham’s View: Fails 3× coverage threshold, implying lower quality.
→ My View: Elevated credit risk and tightening margin of safety.
Question 7: See if you can think of an AI prompt based on Part 2 of Security analysis that would make your work easier. Suggestion: use a thinking model (e.g. Gemini 2.5 Pro or ChatGPT 5; if the latter set reasoning_effort=high; consider whether you need “Deep Research” mode enabled or not for what you are trying to do).
AI Prompt to Answer Question 6 Using Part 2 of Security Analysis:
You are a financial analyst trained in Benjamin Graham’s fixed-income evaluation methods (from Part 2 of Security Analysis, 6th ed.) with modern credit analysis expertise. Using deep reasoning and high analytical effort, analyze the following two corporate bonds:
One bond rated BBB or BBB- by S&P, maturing in 5+ years.
One bond rated A or higher by S&P, maturing in 5+ years.
For each bond, apply Graham’s investment-grade criteria, including:
Minimum fixed-charge coverage ratio by sector (e.g., 1.75× for utilities, 2× for railroads, 3× for industrials)
Maximum debt-to-equity leverage by sector (e.g., 2:1 for utilities, 1.5:1 for railroads, 1:1 for industrials)
Stress-test resilience under adverse economic conditions
Adequacy of interest coverage based on recent earnings trends (at least 5 years of data, if available)
Then incorporate modern adjustments including:
Business model risk (e.g., recurring vs. cyclical revenue)
Cash flow-based coverage (EBITDA or FCF), if more representative
Industry-specific disruption risk (e.g., AI exposure, tech disintermediation)
Output a side-by-side comparison showing whether each bond qualifies as a sound investment:
a) According to Graham’s traditional standards
b) According to a modernized, forward-looking view
Format output as a concise report with clear headers and a comparison table.
I think the term "investment operation" refers to the activity of constructing an investment portfolio over time (e.g. Graham's partnership). Meaning that it's diversification across multiple securities at a point in time and diversification over time. Put differently, I think Graham defines an *investment process* as investing vs. speculation rather than a single decision within that process.
I'm sure that's right, but he did put in some caveats. He specifically says that an "investment operation" may involve diversification: "an investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly". However he uses may and might, which implies not always. Sometimes an opportunity comes along that is both good, unique and where the size is fixed. His operation in Guggenheim Exploration is an example of this. The investors had to buy the whole concern to liquidate it. I think this meets the criteria of an investment operation, even though only one security is involved. Moreover, he is also keen to emphasise that each investment must stand on its own merits. If you set a strict set of criteria, and only one stock passes, should you buy others that are not as good just to diversify? Or would it be better to put the funds in high interest cash and wait for others of equal quality? I have found that for me, following the best ideas and ignoring the "similar but not so good" for the sake of diversity works better.
Yes, agree that each investment must stand on its own merits. Which is also why I can't really get around the idea of correlation in a portfolio - would you reject a good idea (good business, good price) because of correlation to other stocks in your portfolio, likewise would you accept one because it is negatively correlated for the sake of diversification? Could never understand that.
Thanks for bringing that up too, James. I recall too Graham mentioning single securities in the text counting so that’s why I leaned towards a “yes” in this answer.
James, I like how you flagged Graham’s choice words of “may” or “might” too. This time around reading Graham I’ve been paying closer attention to his conditional word choice.
I don't really know how it works, but I wonder if its really possible to go in deciding to buy a certain number of number of companies in order to diversify, because we are price takers and the market is a price maker. The market provides the opportunities and we decide whether to take it. But we don't know when the opportunities will appear. Also we need price discipline in order to have returns. So deciding early on to have a certain number of stocks or specific stocks - will this lead to sub optimal outcomes i.e. not buying at the right price? Is this about relative vs absolute returns? I don't know.
In a high market, we might not get the price we want for a certain stock/business so we wait, but during the wait, there will be other opportunities that come along eg acquisitions/spin offs/detestation of certain area of market etc, then we can size the position after weighing how well we know the company/ the likelihood of getting the outcomes we want/ the likelihood of failure etc. Probably more likely to be able to populate portfolio on the terms we want if we are investing in at a low/depressed period.
On a side note - apologies in advance as I will definitely be late for week 2 answers due to the complexity of the reading material -.-"
Thanks for your time and perspective! I’ll keep that in mind as I continue reading Graham!
Q1 : Graham writes that “Bond investing is a commitment with limited return”. The chief emphasis on avoidance of loss reflects the reality that any failure by the issuer to meet obligations can result in total loss, making safety the primary concern. The investor may reject bonds with no penalty because passing on a bond does not mean missing out on extraordinary gains, allowing for strict selectivity without regret. Graham uses these phrases to highlight the fundamentally defensive nature of bond analysis, where the art lies in eliminating risk rather than forecasting reward. Fixed-income investing is largely about preservation of capital, while stock investing is about growth and value creation. The former demands caution and discipline; the latter invites insight and foresight.
Yes, Graham’s distinction still holds water today but there are securitisation strategies etc which alter the risk reward profile to an extend..
Q2 : Benjamin Graham’s main idea about what provides safety in a high-grade bond is adequate earning power of the issuing company. He argues that the true margin of safety lies not in the bond’s legal protections or collateral, but in the issuer’s consistent ability to generate earnings well above its fixed charges
Safety and stability are measured by the ability to repay—rooted in earnings power, the character of the industry, and the issuer’s resilience under adverse conditions. A depression-proof enterprise with stable, predictable cash flows is far better suited to bond financing than one exposed to cyclical or speculative risks. The more stable the type of enterprise, the more appropriate it is for fixed-income investment
Q3 : Benjamin Graham evaluates the safety of a high-grade bond primarily through the issuer’s financial strength, focusing on its earning power, debt coverage, and stability over time. Graham see the earnings trajectory over time. He emphasizes that the most dependable measure of safety is the company’s ability to generate consistent earnings well above its fixed charges, especially during economic downturns. This approach reflects his belief that safety is measured by the ability to repay, not by legal protections or collateral alone.
Difference now is the industry with little fixed charges but more variable charges like the new platform / internet businesses . I need to study and research more into this area if they are suitable for debt financing.
Q4 : Graham warns against bonds issued by companies in unstable industries, startups, or those with poor earnings records. Even if the bond terms appear sound, the underlying business risk undermines the security’s reliability. He emphasizes that the more stable the enterprise, the more suitable it is for bond financing.
Small-cap companies, industrial startups, and SMEs (small and medium-sized enterprises) often have an inherent lack of stability, making them poor candidates for fixed-income investment. Their earnings are volatile, their industries may be cyclical, and their financial structures are often too fragile to support long-term debt obligations.
Q5 : (A) I would ask two main questions : 1) The stability of EBIT of $10, any fluctuations there would make him unable to service interest. There is only a $5 margin of safety from the EBIT of $10 2) Can the cab owner be able to rollover debt of $100 to repay principal ?
(B) Interest Coverage Ratio (ICR) = (EBIT / Interest Expense) = 10/5 = 2.0 ; Graham would have wanted more ?
Debt / EBIT = 100/10 =10 years. He favored enterprises that could repay debt in 3–5 years from earnings.
(C) With 3 year maturity, we can make use of cabs useful life in case of default
7 year maturity seems to introduce a asset liability mismatch where asset life ends in 5 years and debt has to be serviced for 7 years .
(D) To Benjamin Graham, whether the bond was secured by the cab or unsecured would matter—but only secondarily. His primary concern was always the earning power and financial resilience of the obligor . I would concur, infact, I faced the same situation of a default by a car rental company and nothing could be salvaged from the asset sale (so far). Fingers crossed.
Q6 : Graham would likely classify BBB bond as “speculative-grade” and caution that “the chief emphasis in bond selection must be placed on avoidance of loss rather than on the promise of profit.” Graham would likely classify A or higher bond as “Sound investment, backed by “sufficient earning power,” and “suited to bond financing.”
Thought exercise: Can you find a BBB bond that you believe fails Graham's (or your more modern version) credit standards and should therefore be excluded from a high-grade portfolio?
1. As there is no participation in the upside of success, a fixed income security need only be categorized into two buckets. 1) likely to pay interest and return principal. 2) not as clear if they will be able to do both or either. Should a security not quite surely land in the first category, it warrants exclusion. It’s important to remember at Graham’s time there were a number of clearly stable companies, that weren’t treated as such. He need not determine who would “win any races” but rather those that would simply perform as their obligations demanded. — Ultimately, yes, I do agree with this approach to fixed income selection. Although, since my horizon is quite long, and there’s a relative scarcity to my investable capital, I don’t often invest in fixed income securities, except in tremendous circumstances.
2. Ultimately his focus is on the financial security of the business in a depressed earnings environment. His goal it seems is to determine how comfortably interest coverage is present for the entirety of the business during these conditions. — Ultimately I do agree, with two downstream realizations being of particular intrigue to me. 1) If a company satisfies the qualities of safety as a fixed income investment, then you should always buy the highest yielding obligation of that company. (page 148). and 2) The general sense of “safety” provided by the contract terms of senior leins is an illusion of safety. Under situations of solvency, very rarely is the full “value” of these contract terms realized. So, in combination, but the highest yielding issue of a secure company, because being holder of a “senior” issue doesn’t matter that much.
3. His general approach of combining all interest obligations into one total and then determining how many times over that number is covered seems straightforward, albeit likely quite challenging when considering issuers of multiple layers of preferred shares, public bonds, and perhaps private placements as well. A bit beyond my scope as an individual, but absolutely noteworthy that he takes issue with listing each interest obligation Individually and it’s coverage by income. Making preferreds seem generally more secure than senior, which is quite silly.— If I were to do anything differently it would be to focus exclusively on cumulative preferreds with a high coupon rate, wait patiently for some macro event to cause major price dislocations, then pounce. An example that comes to mind were the Hawaiian Electric Preferreds that were trading with yields north of 30%. Granted a lot was going on at the time, but on April 2nd-9th I wasn’t watching bonds so I have no examples to draw from.
4. I didn’t make it past page 213 (I’m a slow reader) so perhaps this isn’t the best answer. But he took a pretty strong stance against non-cumulative preferreds. Given that management has no contractual obligation to pay dividends, the security class in effect combines all the worst parts of fixed income with the worst parts of equity.
5. In short - 1) too small of an enterprise. 2) Interest coverage may be enough (=2x) if we consider a cab an equivalent to a railroad. However, the ideal would be based on depression earnings, not necessarily average earnings. That’s the only graham specific points I have, but I’ll say, instinctively it seems like a lot of risk for a mere 5% coupon…
Q1. Looking for loss avoidance, not growth or appreciation. I agree.
Q2. Avoiding trouble - looking for hi-grade companies with the ability to pay when valued under conditions of depression. I agree.
Q3. Using the New York Statute Criteria - 1. The nature and location of the business or government, 2. the size of the enterprise, or the issue, 3. The terms of the issue, 4. The record of solvency and dividend payments, 5. The relation of earnings to interest requirements, 6. The relation of the value of the property to the funded debt., 7. The relation of stock capitalization to the funded debt.
Q4. Preferred Stock and convertible bonds. Each is transferrable into the other, changing their characteristics. Also fixed income securities valued on appraisals.
Q5. a. How large is the company, what do it's financials look like. Where is this bond's yield as compared to similar issues in the market. b. Debt as a % of capitalization, cash, income, free cash flow, bond covenants and security. c. Perhaps purchase at a 3 yr maturity, but not at a 7 yr due to increased risk.
Q6. Home Depot, 2.7% due 4/15/2030. Price 90.655, YTM 4.74%, Call 1/15/30 YTW 4.74%, S&P A.
Boeing 5.15% due 5/1/2030. Price 99.391, YTM 5.28%, Call 2/1/30 YTW 5.28%, S&P BBB-.
a) HD, not enough yield, Boeing perhaps depending on risk. b) I would buy either depending on the portfolio I am putting them in.
Q7. N/A
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Question 1: Graham views high-grade bond investing as a "negative art" because it focuses more on avoiding losses than seeking gains. Bond analysis is about guarding against default and selecting only those issues that do not exhibit clear signs of risk. We don’t need to understand the margin of safety and the possible value/return as we know that already.
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Question 2: Graham insists that safety comes from the issuer’s ability to meet all obligations under adverse conditions, not just normal ones. This means conservative debt service coverage ratios, stable earnings, and asset protection. Agree 100%, however, if I would follow this now I might be forced to buy only low yield bonds. For these reasons, I don’t invest in bonds.
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Question 3: Graham analyzes coverage ratios (e.g. interest and principal coverage), debt structure, asset protection, and earnings history. Only bonds with sufficiently high coverage ratios and stable profits over many years are considered safe.
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Question 4: Graham regards subordinated debt, income bonds (which only pay if earnings allow), and deeply junior securities as permanently inferior due to inadequate claims on assets or unreliable coupons.
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Question 5:
a) What questions to ask?
What is the revenue volatility?
What are maintenance and insurance expenses?
Are earnings likely to persist?
Credit history?
b) Credit metrics:
EBIT/interest coverage
debt-to-asset ratio
historical cash flow stability.
c) Maturity effects:
Shorter maturity reduces credit risk (less uncertainty); longer increases it.
d) Secured/unsecured:
Graham prefers security—having the cab as collateral provides extra safety.
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Question 6:
Bond BBB-rated, Hyatt Hotels Corp. 5.375% due 2031
Size: Revenue $6.6B, Graham minimum $0.5B — passes.
Earnings coverage: Normalized pretax profit/interest cost, 0.411/0.18 = 2.3x (Graham minimum 4x). Fails.
Poorest Year Coverage: Losses in 2020/2021 (COVID). Fails.
Leverage: $4.11B debt/$0.411B profit = 9.9x (Graham max 5x). Fails.
Working capital vs. debts: $2.73B < $4.11B. Fails.
Equity value vs. debt: $13.9B equity > $4.11B × 0.75. Passes.
Conclusion:
Graham would reject Hyatt’s bond as a high-grade investment due to insufficient coverage, high leverage, pandemic-driven losses, and weak working capital, despite meeting size and equity cushion requirements. I would argue hotels are semi-discretionary businesses and are very cyclical. I would also reject it—credit metrics are stretched, and risk is not rewarded with high enough yield.
***
Bond 2: A/AAA-rated, Microsoft 5.2% due 2039
Size: Revenue ~$600B, far above minimum. Passes.
Earnings coverage: $123B EBIT/$2.3B interest = 53x. Passes.
Poorest Year Coverage: Poorest EBIT ~$34B/interest ~$2.3B = ~15x. Passes.
Leverage: $60B debt/$120B profit = 0.5x. Passes.
Working capital vs. debt: $191B > $60B. Passes.
Equity value vs. debt: $3,821B > $60B × 0.75. Passes.
Conclusion:
Microsoft’s bond passes every Graham high-grade test with enormous margins of safety. The issue: at current pricing (yield only ~50 basis points above comparable Treasuries), Graham would consider the yield premium insufficient for the risk. I agree: it’s an extremely safe bond that nevertheless does not compensate investors for incremental credit or liquidity risk.
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Question 7:
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You are to act as a seasoned investment analyst in the tradition of Benjamin Graham. Your task is to conduct a rigorous and comprehensive evaluation of a corporate bond based exclusively on the principles and quantitative tests for fixed-income securities as detailed in Part 2 of Graham and Dodd's "Security Analysis."
Your analysis must be thorough, data-driven, and conservative, culminating in a clear judgment on whether the bond qualifies as a safe, investment-grade security suitable for a defensive investor.
Bond for Analysis: [Insert the full name of the bond]
Please structure your analysis in the following sections:
1. The Fundamental Test: Earnings Coverage
This is Graham's primary test for a bond's safety.
Calculate and present the issuer's "Times-Interest-Earned" ratio (using earnings before interest and taxes - EBIT) for each of the last seven to ten fiscal years. Display this in a clear table format.
Analyze the adequacy of the coverage. Compare the average and minimum ratios over this period to Graham's historical minimum standards (e.g., 5x for an industrial company, 3x for a public utility). State clearly whether the issuer meets these thresholds.
Evaluate the stability and trend of the issuer's earnings. Are they consistent and predictable, or volatile and cyclical? Comment on how this impacts the reliability of the coverage ratio.
2. The Secondary Test: Capital Structure and Asset Value
This section assesses the company's financial foundation and the value of its assets backing the debt.
Size of the Issuer: State the issuer's total assets and annual revenue. Comment on whether the company's size provides a buffer against adversity, as Graham suggested.
Stock-Equity Ratio (Debt-to-Capital): Calculate the ratio of total funded debt to the market value of the company's total capital (debt + market capitalization of equity). Analyze if this ratio is conservative for its industry.
Asset Coverage: Determine the value of the issuer's assets relative to its total debt.
Calculate the ratio of Total Assets to Total Debt.
Calculate the ratio of Book Value (Net Asset Value) to Total Debt.
State whether the bond has a specific lien on any property. If so, discuss the nature and likely value of that collateral.
3. Qualitative Factors and Indenture Provisions
Beyond the numbers, a qualitative assessment is crucial.
Nature of the Business: Describe the issuer's business. Is it in a stable, essential industry (like a utility) or a more competitive, cyclical one (like an automaker)? Does it have a strong, durable competitive advantage?
Protective Covenants: Analyze the key provisions in the bond's indenture. Specifically, look for and comment on:
Limitations on issuing additional debt.
Restrictions on dividend payments or share repurchases.
Collateral requirements or negative pledge clauses.
State whether these covenants provide meaningful protection for bondholders.
4. Yield and Price Considerations
The return must be satisfactory for the risk assumed.
Current Yield and Yield-to-Maturity (YTM): State the bond's current price, current yield, and YTM.
Comparison to Risk-Free Rate: Compare the bond's YTM to the yield on a U.S. Treasury bond of a similar maturity. Is the credit spread adequate compensation for the risks identified in your analysis?
Price History: Briefly comment on the bond's price stability over the last year. Has it been volatile or stable?
5. Final Synthesis and Conclusion
Synthesize all the above points into a final, decisive conclusion.
Summary of Findings: Briefly summarize the bond's strengths and weaknesses based on your Graham-style analysis.
Investment vs. Speculation: State unequivocally whether this bond meets the strict criteria for an "investment-grade" security as Benjamin Graham would define it. If it does not, classify it as "speculative" and explain precisely which of Graham's tests it fails.
Margin of Safety: Conclude by defining the margin of safety for this bond. Is it found in the robust earnings coverage, the significant asset protection, the conservative capital structure, or a combination of these? If the margin of safety is insufficient, state this clearly.
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Question 1: Why does Graham believe that investing in High Grade fixed income securities to be a ‘negative art’, in contrast to investing in common stocks? What does he mean by that? Do you agree?
Investing in High Grade fixed income securities is considered negative art since the best case scenario is that the fixed income security principal and interest that it initially promised; however, where the investor adds value is analyzing the underlying business whose cash flow is likely to fund the interest coverage, predictability of that cash flow, how well it covers the interest in fixed income security and industry factors / scenarios where the cash flow may be impaired to a degree that it is unable to pay out the interest coverage and so is a process of elimination. Investing in common stocks focuses more on understanding potential upside based on economics of industry, business, competition, customer stickiness, free cash flow margins, growth potential, etc. and so is more positive in that regard. My sense is that good investments are somewhat asymmetric in that they provide low downside combined with an asymmetric high upside.
Question 2: What is Graham’s main idea about what provides safety in a high-grade bond? Do you agree?
Safety in high-grade bonds is the issuer being able to cover its interest payments with a predictable, stable, and ample free cash flow, and balance sheet strength (e.g. ratio of equity or asset to debt). I agree.
Question 3: How does Graham evaluate the safety of a high-grade bond based on the company’s financials? Is there anything you would do differently with what you know today? Why?
By evaluating the predictability, stability, and ampleness of earnings compared to interest payments and balance sheet strength. Balance sheet composition is somewhat different today as substantial value can accrue to brands, platform companies which have high marginal profit margins, and adjacent businesses that increase stickiness of customers and customers’ lifetime values. So, often, a business can have low capital intensity, high free cash flows, and low book value.
Question 4: Which security structures does he believe to be permanently inferior in this category? Why?
Hybrid security structures (e.g., preferred stock) are considered permanently inferior since they neither provide the safety of high-grade bonds nor the upside potential that comes with common equity ownership.
Question 5: Miniature Credit Analysis scenario:
- Cab driver has driven a cab for someone else, and now wants to buy his own for $100
- The cab will have a useful life of 5 years, and have straight-line depreciation with no residual value for accounting purposes
- For cash purposes, the cab will have no cash outlays associated with it but will need to be replaced at the end of 5 years, with another cab, which we will assume will also cost $100
- The cab driver has historically averaged EBIT of $10 on his historical revenues of $100, and expects that to continue. There are no taxes.
a) What questions would you like to ask/what would you like to know to assess whether buying a 5-year $100 bond with a 5% coupon meets Graham’s standard for investment in a high-grade bond?
Leaving aside the fact that averages can be misleading, the above example would imply $10 EBIT would become -$10 after the annual $20 depreciation charge and so insufficient to fund the 5% coupon.
b) Substantiate your answer to a) with specific credit metrics that support your analysis. What metrics are most relevant? Why?
While Times Interest Earned = $10 / $5 = 2.0, free cash flow = $10 - $20 -$5 = -$15 which is insufficient to support interest payment of $5
c) What would change in your analysis, if anything, if everything stayed the same but the bond had a 3-year maturity? A 7 year maturity?
3-year maturity: Free cash flow = $10 - $33 -$5 = -$28
7-year maturity: Free cash flow = $10 - $15 - $5 = -$30
d) How much would it matter to Graham whether the bond was unsecured or if it were secured by the cab? What about you?
Bond secured by cab would provide additional balance sheet strength but insufficient to neutralize the cumulative negative free cash flows for the duration.
Question 6: Find and analyze two bonds using both Graham’s process and any of your own modifications that you think are reasonable. Provide your analysis of:
a. A bond rated BBB or BBB- by S&P with a maturity at least 5 years away
AT&T bond maturing 2032: Interest payments are ~$6.8 billion per year and normalized free cash flow over last 15 years is ~17 billion providing sufficient coverage for the interest payments. AT&T has a broad set of assets and utility-like stable subscription from its customers and so seems like a decent investment.
b. A bond rated A or higher by S&P with a maturity at least 5 years away
Microsoft: Median free cash flow over the last 15 years is $32 billion and has been consistently growing. MSFT annual interest expense on debt is ~$2.4 billion providing more than adequate coverage for interest payments. It is interesting that MSFT free cash flow continues to be strong in spite of massive AI capex in recent years.
Question 7: See if you can think of an AI prompt based on Part 2 of Security analysis that would make your work easier. Suggestion: use a thinking model (e.g. Gemini 2.5 Pro or ChatGPT 5; if the latter set reasoning_effort=high; consider whether you need “Deep Research” mode enabled or not for what you are trying to do).
Suggest bonds rated A or higher that are at least five years out for companies where (median free cash flow over last 15 years) / (annual interest expense) is highest
"the above example would imply $10 EBIT would become -$10 after the annual $20 depreciation charge "
Anurag - Isn't EBIT after depreciation has been accounted for ? This is not EBITDA !
You're correct.
Q1:
1. He believes the operation to be a negative art because
a. The return is limited (limited upside even with negative yield) where as credit risk (or even) can wipe out all or a substantial part of the investment principal which makes loss avoidance paramount and therefore rejection is key given that “neither priority or promise [to pay] is itself an assurance of payment” (pp [143])
b. Consideration for investment operation in common stocks includes both “a desire to avoid loss and the desire to make a profit” (pp [143]). Penalty of omission (rejecting) or commission (accepting) can be great in common stocks but accepting an “unsound issue” in High Grade FI securities can be material
2. By ‘negative art’ he means placing constraints (deny out) on the selection instead of searching and finding (allow in) investments.
3. I agree. Even common stocks should be subject to negative art (inversion mental model) and then positive art because this is consistent with ancient principals (ahimsa aka ‘Do no harm’ is the first “don’t” in yoga; the “don’t” are check-listed first and the “Do’s” are check-listed next)
Q2:
1. The main idea is that only “a claim against a business” i.e. a business’ ability to pay as opposed to “a claim against property” i.e. a lien (pp [144]) provides safety. As J.P. Morgan said “the first thing is character”. Having to think of activating “recourse to indenture” is already an indication that the “investment has been unwise and unfortunate” (pp [147])
2. I agree. The reason covered on pp [145-146] (shrinkage of the collateral, possible impracticality of repo, delay in recovery of principal if at all) support the idea. After all, specialized operating assets in the absence of cash-flow are likely to have little value because of lack of possibility of re-use in a different business model.
Q3:
1. In addition to analyzing the bond as a claim on the business,
a. Analyze for possible earnings power decline in a recession and whether interest coverage (EBIT/I) has enough “surplus above the interest requirements” (pp [155]) “on a depression basis”
b. Factor in the industry (pp [156]-[157] (one Howard Marks’ eight factors in his introduction to Part II)
c. Check if there is over-extension or excessively funded debt (even a moderate decline in earning power can lead to price collapse and loss of principal) (pp [157])
d. For operations containing only an individual issue, it is ‘unsound to sacrifice safety for yield” – especially that portion of the yield above the risk-free rate compensating for credit risk.
2. If the investment operation is a portfolio of diversified bonds, then it is possible that the yield ‘reward’ compensates for credit risk at the group level (Marks refers to using the ‘law of probability’ here) given what we know in the high-yield market today. However, the caution here also is that the full extent of the probability distribution may not be known (if we did not analyze how fat is the tail) until we are in the extreme end of a crisis (like March 2009) – “the typical investment hazard is roughly similar to the conflagration [i.e. the whole group burning down] or epidemic hazard … in fire and life insurance” (pp [165])
3. Specific standards related to company’s financials
a. In addition to interest coverage discussed above, a “smaller proportion of debt to going-concern value” (pp [172]) can be used to evaluate the safety of a high-grade bond.
b. The value of “pledged assets” being “not something distinctfrom the success of the enterprise” (pp [184]). The safety therefore is directly linked to the earning power of the enterprise.
Q5:
a) Questions
a. What is minimum EBIT the cab driver has experienced in the last 10 years? I ask because already coverage is 2x (10/5) which appears to quite insufficient (ideally 3x and above is needed) (Railroads had a minimum standard of 2x (pp [190])
b. What is the prevailing interest rate at the 5 year tenor?
c. Has the cab driver defaulted on a loan in the last 10 years?
d. What is the going concern value? Assuming it is 5/0.1 in perpetuity = ($50), the debt to going-concern value appears to be 2x which appears to be too high. DSCR is 5/5 = 1 which is below minimum of 1.25
b) Calculated Ratios:
a. ICR (EBIT/I): 10/5 = 2x – relevant because the bond is a claim on the basis.
b. DSCR: NOI/I = (25-20)/5 = 1x - relevant to test the soundness of an ongoing-concern
c. Debt/Equity at maturity (100/25) = 4x – heavily leveraged – relevant to test whether the balance sheet is overextended on debt
c) A 3-year maturity is even worse because the cab driver cannot pay back the principal. A 7 year maturity would give a 2.8x debt to equity ratio (100/35) which might just be viable but the collateral would have no value after the 5th year and there is funding available to buy another cab for $100 at the end the 5th year.
d) It wouldn’t matter much to Graham because ”Safety [is] not measured by lien but by ability to pay” (pp [144]); the corollary (pp [147]) of lien being of subordinate importance is that “absence of lien is also of minor consequence”. It wouldn’t matter to me either.
Q6: N/A
Q7: N/A
(part 2 of post)
Q5a:
- Earning power/coverage -- Can earnings cover interest payments plus contribute to future principal repayment? Can earnings cover business expenses (cab replacement)? Can earning cover these in adversity?
- Asset protection viability -- Does the cab’s resale value provide meaningful collateral for the $100 bond?
- Management -- How will earnings be allocated — will reserves be set aside for replacement? Also, he's worked for others, but now is starting his own business: how he runs his business could change his earnings.
Industry stability -- Are revenues stable in this industry across business cycles to support the fixed charges?
Q5b:
- Interest coverage: $10 EBIT/$5 interest = 2x, probably okay, but not room for adversity.
- Debt service coverage: Over 5 years, cumulative EBITDA = $150. Debt service coverage (interest + principal) = $125. Coverage ratio = 1.2×, which is very thin margin.
- Going-concern (replacement risk): At maturity, obligations = $100 bond repayment + $100 cab replacement = $200. Coverage ratio = $125 (free cash flow) ÷ $200 = 0.6x The driver is short and must refinance the new cab or default on the bond.
- Asset as protection: It's a wasting asset: from day one, there will be loss of principal if the business collapses. Asset Value/Debt = <$100/$100 principal = < 1x, no buffer.
Assuming earnings are stable and management decides to use cash reserves to pay debt, the bondholder could receive principal and interest. However, there is no room for adversity; the fundamentals of the business offer extremely thin, if any, margin of safety
Q5c:
With a 3‑year maturity, cumulative EBITDA would be $90, while total obligations (3 years of interest $15 + $100 principal) are $115. Debt service coverage = $90 ÷ $115 ≈ 0.8×. The driver cannot cover total debts, making this worse than the 5‑year case. With a 7‑year maturity, cumulative EBITDA would be $210, but the cab must be replaced at year 5, reducing available cash to $110. Obligations at maturity (7 years of interest $35 + $100 principal) total $135. Debt service coverage = $110 ÷ $135 ≈ 0.8×. This is also worse, since the wasting asset drain cash flow before the bond matures. Analysis of the safety of the bond remains unchanged as neither offers a better margin of safety.
Q5d:
It probably wouldn't matter to him. While the cab could be resold for some value in the first few years, it will never be sufficient to cover the full $100 of funded debt. It offers no protection. For me, the bond is a bad buy overall. However, if I were forced to invest I would prefer it secured. If the business failed before year 5, the cab could be liquidated for some partial recovery, reducing some my losses.
Q6a: -- Boeing's 8.625% senior unsecured bond due November 15, 2031 -- (BBB or BBB-)
Failure to demonstrate earnings power and debt coverage over the past 5 years is a major red flag. The negative book equity, eroding asset base, and heavy reliance on inventory with a substantial write-down risk do not provide adequate asset protection, as evidenced by a Net Fixed/Total Debt ratio of 0.21x. That said, this is common in this sector and may be passable according to modern standards. Liquidity is adequate at 1.32, but not robust. The trend of shareholder's deficit indicates a lack of equity buffer. I did not deeply investigate management or ability to handle adversity, but brief perusal indicated trouble. Based on these critical failures, this bond would not qualify as a high-grade investment according to Graham's criteria or my own assessment. Some arguments are more speculative, making the bond potentially suitable for high-risk-tolerant investors betting on long-term recovery. For example, given their government contracts, the issuer may fall into the "too big to fail" category.
Q6b: -- RTX Corporation 4.875% Senior Unsecured Bond Due 2040 --- (A or higher)
RTX’s fixed-charge coverage is solid, around 4x; net profits are on a rising trend. Total assets are dominated by intangibles, working capital elements and defense backlogs; not a sound base for protection but common in the sector. The post-pandemic rebuilding and unusual operating costs have gradually reduced current assets, with working capital now at 0.91. This is concerning, but not a major failure. With an Equity/Total debt ratio of 5x, they are extremely well capitalized, offering a substantial buffer to bondholders. There is no evidence of aggressive revenue recognition or off-balance sheet activities, indicating sound accounting practices. RTX has weathered tough periods—including COVID-related declines in commercial air travel and costly product recalls. Its diversified commercial and defense segments, along with management’s focus on risk control and disciplined capital allocation, have enabled sustained dividends even through crises. Graham might see this a borderline investment grade bond because while it doesn’t strictly meet asset protection or liquidity requirements, it clearly passes the other more important requirements. I see this as an investment grade bond because it does meet every other key safeguard. At the end of the day, it offers a high degree of principal safety and adequate return.
Q7: Role: You are an analyst applying Benjamin Graham’s Part II (fixed‑value investments) principles to corporate bonds. Your goal is to judge bond safety using evidence-base coverage of earnings power, stability under adversity, asset protection, management policy, interest and fixed-charge coverage, liquidity, equity cushion, and accounting integrity. Conclude with a margin-of-safety judgment.
Bond Information: INPUT NEEDED HERE
Task: For bond, first gather the required inputs via research, then apply analysis framework given. Evaluate using Graham’s Part II framework and the Analysis Framework provide below. Provide both a verdict based strictly on Grahams framework (earnings power, asset protection, margin of safety) and a verdict based on the provided framework. You may add reasonable, clearly justified modifications. Do not rely on market ratings or price momentum as primary evidence.
Step 1: Get Required Inputs for the Bond
For the bond collect:
• Financials (multi‑year, at least 3–5 years if available): EBIT, interest expense, total debt (funded debt), current assets and current liabilities, fixed assets, market value of equity.
• Qualitative context: Industry cyclicality/stability, business model resilience, capital allocation (capex, dividends, buybacks), any known adverse periods.
Step 2: Apply Analysis Framework to the Bond
1. Earnings power and fixed‑charge coverage (primary safeguard)
○ Compute: Multi‑year average and worst‑year EBIT ÷ interest and EBIT ÷ all fixed charges.
○ Assess: Stability across a cycle; trend of profits; adequacy under adversity.
2. Asset protection (secondary safeguard)
○ Compute: Fixed assets ÷ funded debt
○ Assess: Asset quality, independence, and liquidity (specialized vs. salable).
3. Liquidity and working capital
○ Compute: Current assets ÷ current liabilities; Working capital ÷ funded debt.
○ Assess: Near‑term cash sufficiency and refinancing risk.
4. Equity cushion and market (signal)
○ Compute: Market value of equity ÷ bonded debt.
○ Assess: Buffer before bondholder losses; treat market signals as secondary, not determinative.
5. Management policy and dividend record (signal)
○ Review: Dividend continuity and rationale; retention and reserve policies; leverage discipline.
○ Interpret: Skips/suspensions as potential warnings; dividends not required for bond safety.
6. Accounting integrity (signal)
○ Check: Depreciation realism; conservative coverage calculations; any signs of aggressive reporting; any red flags?
7. Adversity scenario
○ Run: Reasonable stress (e.g., EBIT down 20–30% consistent with industry history).
○ Re‑compute: Coverage, liquidity, and asset protection under stress.
○ Decide: Whether safety persists when conditions worsen.
Step 3: Output Format for bond
• Summary table:
○ Issuer/bond: Terms and structure
○ Coverage: EBIT/interest and EBIT/all fixed charges; worst‑year coverage
○ Asset protection: Fixed assets/funded debt; notes on liquidity
○ Liquidity: Current ratio; working capital/funded debt
○ Equity cushion: Market cap/bonded debt (signal)
○ Management & dividends: Policy notes; reserve discipline (signal )
○ Accounting: Depreciation realism; reporting red flags
○ Adversity test: Stress assumptions; stressed coverage
○ Verdicts: Graham pass/fail; my modified view with rationale
• Narrative judgment (concise):
○ Graham’s view: Does the bond strictly meet Part II’s high‑grade standard? Why?
My modified view: Does the bond meet my custom analysis? Why?
Very thorough prompt, thank you for sharing. Have you run it on any bonds of companies you know to see how good/useful the output is?
I have not, but that’s an interesting idea as a way to test it. If I was seriously counting on it, I probably would check its sources to make sure it wasn’t hallucinating. Copilots ‘deep research’ mode has hyperlinks throughout and detailed source links at the end of the report.
I'll have to post in multiple comments (i'm getting an error)
Q1: I do agree, and this was a very interesting section. Fixed-income investments offer only limited returns through yield and modest appreciation, but poor selection can result in total loss of principal. Stocks, while also capable of 100% loss, have the potential for significant gains. Winning with bonds means avoiding losses, as their upside is capped, unlike stocks where the upside is unlimited. Bonds have downsides to avoid, while stocks have upsides to pursue. The cost of being wrong in stocks can equal the cost of missing out by avoiding risk, whereas with bonds, the cost of winning is low, but the cost of losing is high. This creates an asymmetrical risk profile for bonds versus a symmetrical one for stocks. Start with a minimum standard as a base and eliminate all options that do not meet this standard.
Q2: Graham's main idea is that a high-grade bond's degree of safety comes from its earning power and the enterprise's assumed ability to fulfill their promises of principal and interest payments, even under pressure. Earnings coverage is the primary safeguard, not assets which may or may not hold their value. Graham pays close attention to the character of the industry and the size and location of the enterprise. He acknowledges that no industry, size or location risk free, he seeks ones with the most stability and predictability. He developed minimum coverage ratios for amount of protection in various categories and used those to determine whether the company could withstand financial pressures.
Q3: When Graham analyzed the company's financial balance sheets to assess the safety of a bond, he considered several quantitative factors:
• Relation of property value to funded debt -- He looks at the worth of fixed assets relative to long-term debt. But asset value isn’t automatically protective. It depends on the type of asset, how it’s used, and whether it can be independently valued and easily liquidated.
• Ability to meet expenditures and total debt -- He emphasized the importance of a consistent record of assets of meeting expenditures and total debt.
• Dividend record -- Graham also looked at the company's history of dividend payments, not as a requirement but as a signal. If an issuer was skipping or suspending dividends, especially when the they could afford it, it could be a red flag of coming trouble needing further investigation.
• Average Earnings over time-- He analyzed average earnings over a period of time (preferably a business cycle), looking for a rising trend of profits, current good showing,
• Interest coverage -- Over given period of years, he wanted a margin of interest coverage that indicated the issuer could cover total debt, not just interest, with earnings for every year in the period being averaged.
• Stock-to-bonded debt ratio -- He used this to gain insight into market sentiment. If the ratio was high it didn't affirm the safety but indicated the market felt it was worth pursuing; if the ratio was low, it was a flag to dig deeper and see if there was a valid reason for the hesitation. He also used it to establish a buffer against loss: if equity started falling it was possibly an indication of trouble.
• Working Capital -- He desired ample cash; enough to cover current liabilities and have a surplus to fund long-term liabilities.
• Misreporting and accounting tricks --He also discussed various manners information could be misreported, such as how coverage ratios were calculated and how depreciation could be inaccurate.
Graham gives specific formulas and thresholds that probably are different today due to different industries. Despite the changes, from what I can grasp, the principles Graham outlined still seem relevant. As someone new to investing, and especially since I have a focus on stocks rather than bonds, some of these ideas are different from what I’ve been learning. It’s a bit overwhelming to figure out what items in the financials prioritize. That said, I’m intrigued by how these fundamentals help paint a picture of the company as a whole — how to use the little puzzle pieces to help answer the big question: is this business durable, profitable, and worthy of my investment.
Q4: Preferred stock is considered unattractive because its principal and income value are limited. The holder has no legal claim for principal repayment, and dividends are discretionary, meaning the issuer is not obligated to distribute them. Similarly, Graham views income bonds with skepticism; although the principal is more secure, the income remains discretionary.
1: Graham calls high-grade bond investing a “negative art” because the best you can do is get your money back with some interest. There’s no upside, only the chance to mess it up. It’s more about avoiding mistakes than finding opportunities. It reminds me of the idea of via negativa that Munger talks about, where success comes from removing errors instead of chasing brilliance. I agree with that. Bonds reward patience and discipline more than creativity. I also believe via negativa may be more beneficial in equity selection than a long checklist.
2: He says the real safety in a high-grade bond doesn’t come from collateral or the company’s name but from steady earning power that can cover interest through bad years. That still makes sense today, though I’d add that in modern markets you also have to think about liquidity and refinancing risk. A company can look fine on paper and still run into trouble if credit dries up.
3: Graham looked mostly at coverage ratios and balance sheet strength. He wanted a big enough cushion so the company could pay interest even if profits dropped. I’d still use that approach but would add cash flow analysis and access to capital markets since companies today roll debt more often than they retire it. Same logic, just updated.
4: He thought income bonds and subordinated issues were permanently inferior because they depend on good times to get paid and sit too far down in the capital stack. The investor takes equity-like risk without equity-like reward. I agree with that. The promise of extra yield usually doesn’t make up for the added risk.
5a: For the cab driver, I’d want to know how stable his $10 EBIT is. Does he own the license? What happens if he gets sick or fuel prices jump? Does he have any savings or backup income?
5b: His interest coverage would be $10 divided by $5 interest, or 2 times. That’s below Graham’s comfort zone, which was closer to 3 times or more. He’s fully leveraged with no cushion, so it wouldn’t qualify as a high-grade credit.
5c: A 3-year maturity would reduce risk because less can go wrong in that time. A 7-year would increase risk because there’s more uncertainty. Graham would probably lean toward the shorter term given the weak coverage.
5d: If the bond were secured by the cab, it might help a little but not much since the cab depreciates quickly. Graham would like the idea of collateral, but it wouldn’t change the analysis much. I’d feel the same.
6a: One example could be a Ford Motor Credit 2030 bond rated BBB-. It yields around 6 percent. That barely clears the bar for a high-grade bond. Graham would probably call it borderline because of the cyclical auto business.
6b: Another example would be a Johnson & Johnson 2030 bond rated A+. It yields about 4½ percent, has huge coverage, and low leverage. Graham would approve. Personally, I think it’s safe but not very rewarding after inflation.
7: If I were using AI to help with Part 2, I’d write something like: “Use Graham’s methods from Part 2 of Security Analysis to break down a company’s balance sheet and income statement, point out weak spots, and explain how modern accounting might hide risk.” I’d use ChatGPT 5 with reasoning set high, not deep research mode. I’d want it to think carefully, not just pull more data.
Just nipping in over the wire. But all caught up now on the reading. I have to say I had no idea that Bond investing was so complex and need to really dig into the security behind the bond. So anyway off to the questions.
Question 1: Negative art. As the quality assurance process is painful and time-consuming, you want to use your time wisely, so focus on where it is most likely to benefit. So can understand using a filter-down approach. And your filter is to only look at bonds that are likely to return your capital, even in a worst-case scenario, when the business goes insolvent. Or ideally, the business is not likely to go insolvent. And you would receive a a reasonable return for the risk Also, support the (now) traditional assumption that Bond investing protects against downside risk. So yes, some due diligence to ensure it works in practice seems sensible.
In comparison to common stocks, where any stock in theory could be worth your time, just need to see if it meets your criteria to have a look at. It seems the opposite rationale applies to Bonds. That only a few are actually worth your time, and your job is to filter out the bad ones and find the good ones.
Question 2: There are two main ideas of safety. The business itself is of a decent quality and unlikely to go insolvent. Secondly, the Business can easily cover the debt repayments of the bond. (Graham doesn't seem to set much store on contingent assets...might not be worth the paper there written on.)
Question 3: It looks like Graham recommends two-time coverage of the coupon payment. I would also be interested in understanding why business wanted the bond, and the maturity length. and the interest rate. To understand if worth investing in, while a bond might be safe, it may not offer sufficient return.
Question 4: Security structures...I don't think he really had much time for many security structures. All would need to be considered in a business insolvency scenario, and consider what a fire sale price could be. He was particularly sniffy at hotels etc, as it would be difficult to use for an alternative use.
Question 5: I would be keen to understand how he would expect to pay for the bond (e.g would he do more hours, hire the taxi out on his off-hours. As I believe he would need more income to service the bond.) I would also be keen in understanding if he could set-prices and what the local competition was like. For instance, in London there a lot, and there Uber. While at home in Scotland, there is much less competition, where he would have more pricing power. Also, be keen to understand what protections I would have if he doesn't pay the coupon.
B. Credit metrics, previous history of paying back credit. As it's an individual, I would check CCJ etc. And maybe his credit score on Experian. (If he was a business I would do something similar.) I would also look at cashflow, and see if the business could currently pay the coupon at twice coverage. And then take into account of any additional plans he had for earning if he owned a taxi and see if that made a difference.
C. The most obvious change would be time-period to pay back the loan. while for a seven year period, I would have to assume he would either need to buy-a new taxi at year 5 ($100) or he would look for a new bond as well at year 5 and be paying off two loans in years 6 and 7. And whether the business could afford that.
D. I would want the bond secured to the taxi....downside of course, if he defaults in year 4 or 5 I get a worthless asset. But I would get good protection in year 1 and 2. I would secure the loan, But I can see Graham not being that fussed by it.
Question 6: Not had time do. (will have a dig about how I can find info about a corporate bond as a retail investor.)
AI prompt: Could you be a great Bond analyst to help me analyse a bond to understand it's creditworthiness, whether the business will still be solvent for the length of the bond, and whether understand any contigent assets and the risks. And also help me understand if the bond is of a good quality would offer a reasonable return for the risk. I would then do series of follow-ups. (Ie is it a growing industry, is bond coupon rate have two time coverage.) What the business cashflow like? What do S&P and Moody's think of the bond etc. Has the company defaulted on previous bonds. (I'm personally not a fan of a really large initial prompt as I prefer chatting more.) I would also prediocally ask, whether the answer was correct. If I really wanted to ensure accuarracy, I would ask I needed the correct answer or else my boss would be very unhappy and fire me. (For some reason that improves the quality of the answer.)
1. Investing in High Grade fixed income securities is an investment of limited returns – i.e. in exchange for limiting participation in profits, the bondholder obtains prior claim and a definite promise of payment. But neither priority nor promise is itself an assurance of payment. Since the chief emphasis must be placed on the avoidance of loss, bond selection is a negative art. It is the process of exclusion and rejection rather than search and acceptance. Therefore, to avoid loss, there are no penalties for rejecting a good bond, but penalties for accepting a bad bond.
In general I agree, in most times all these hold, however during depressive periods or crisis or intense pessimism of an industry, it may be possible to have more equity like returns when the bond price drifts far below the principal. Assuming interest and free cash flow coverage is adequate.
2. Graham believes that safety is provided by the ability of the issuer to meet all its obligations measured under conditions of depression rather than prosperity. Lack of safety cannot be compensated for by abnormally high coupon rates. In order to test for safety, the selection of all bonds should be subject to rules of exclusion and to specific quantitative tests.
Yes I agree with this. When a bond is not able to meet its obligations and goes into default, specific remedies may not result in the protection of coupon and principle. Asset sales to pay down debt may not be sufficient as there is shrinkage of property values when the business fails i.e. fire sales to raise cash may not get best prices, asset values currently on the balance sheet may be more optimistic than realistic as it’s the job of management to get the lowest interest rates. Voting control to direct cashflows to payment of coupon and principal depends on cash availability. Receivership may lead to delays and a debt payment structure that is not to the benefit of the bondholder but rather to the capability of the company i.e. the coupon may be lowered to what the company can realistically shoulder, and the maturity date dragged out.
3. Graham has previously used earnings before interest and tax to measure the fixed charge coverage.
I would prefer to use free cash flows after capex as a measure for coverage instead, as income statement figures can be subject to much more “creativity” and it’s really cash that pays down debt and interest.
Given how managements are compensated by stock options/equity today, I would be wary of how managements manage their capital structures i.e. what is the purpose of maintaining debt – are they paying huge dividend payments instead of paying down principal? What is the purpose of raising debt - would proceeds be used for dividend payment? These may not be inherently destabilizing as high grade bonds would imply a company with sound financials and adequate cover, but it does give some insight into how managements view stakeholders.
4. Overextended pyramided capital structures which absorb almost all earnings with hardly any margin available to withstand moderate setbacks and shrinkage in profits. These were inferior as it was not due to the weakness inherent in the businesses but rather the recklessness of financing methods. The business i.e. utilities can be stable through cycles but unsound financing methods can cause collapse.
5ab. Currently, is there any debt? Are there plans to take on more debt? How will this additional debt be ranked? Is the debt backed by the cab as collateral?
Assuming that there is no other debt, and this is a more similar business to railroads, compared to public utilities or industrials – transportation sector, where the cab, similar to the railroad car, can be sold off without much issue. Graham recommended a 2x fixed charge for investment bonds. (Pg 190, 6th edition).
Interest charges on the bond would be – $5
Fixed charges earned – 2x $(10/5)
Straight line depreciation would imply a depreciation charge of $20 a year. Assuming the depreciation is a non-cash expense, there is no actual cash outflow, and the principal can be paid back in 5 years - $20*5. Assuming that the cab driver has history of paying back debts.
5c. If he is able to sell the car at residual value with no issues:
3 year maturity – At year 3 he has cash flows from total depreciation charge of $60 ($20*3)and $40 residual value $(100-60) from sale of cab. At worst, the driver cannot sell the cab below $25 ($(40-15) - he has $5 of cashflows yearly after paying interest. So after 3 years, if earnings are retained he would have $15.)
7 year maturity – he would have rolled the $100 from 5 year cash flows from depreciation into a new cab at year 5. At year 7, he would have $40 of cashflows from 2 years of depreciation charges, and $60 of residual value from the sale of cab. The minimum sale value of the cab is $50, per explanation above.
I don’t think my assessment would change.
5d. I think most important for Graham would be the interest charge cover in the ordinary course of the business, and if any additional debt is added. To the degree of additional debt added, security might matter. I agree with Graham.
6. I am not able to search for specific bonds.
All of the bonds above are considered investment grade. The ‘-‘ sign denotes a negative outlook and an increased probability of a downgrade. While these are investment grade bonds, they all require regular monitoring for deterioration, as, under stressed conditions, the deterioration of the underlying businesses can cause these bond ratings to slide below investment grade. (https://www.spglobal.com/ratings/en/regulatory/article/-/view/sourceId/504352 table 42- credit stability as a limiting factor on ratings.
7. I will need to get back to this – I am not sure exactly what a thinking model is or how I can feed that into AI. I am only able to do basic questioning.