Downside Protection

Along with looking at an investment on a worst case basis, you need to understand the amount of downside protection that the investment offers - how much can the price drop and what will support it. For example, downside protection is often, in part, determined by a bonds priority in the issuers capital structure. If bonds are senior and secured, they usually have a first claim on the assets backing them. In that case you can determine by how much the market value of the asset backing that particular bond covers the bond. If bonds are unsecured (and are below other bonds in priority), you can use historical rules of thumb based on recent or past events and relative valuation levels (for example, relative to cash flow generated) to get an idea of what an unsecured debt position is worth in bankruptcy or a restructuring. These rules of thumb often depend upon what industry the issuer is in and on other factors (see below).
 

You also need to understand the amount of an investment’s expected return, and its upside potential or the amount of return you would receive under varying scenarios such as "expected" and "best case." The upside on a bond is usually limited by its security characteristics such as its call schedule or sinking fund schedule. There are some cases where the downside protection is weak but the upside potential of a business is very strong. In this case, since a bond's upside is usually limited by a call of some sort, a much smarter way to get involved is to own equity where you have essentially unlimited upside but even greater downside.