Many income focused investors like the idea of owning individual bonds. The advantage of a bond over a bond fund is that a bond has a fixed maturity date and a fixed interest rate. If held to maturity, the price movements of the bond can be ignored while an investor collects the stated interest and gets repaid at maturity (only a bankruptcy can undermine this income). A bond fund removes the best features of a bond, since the fund has no maturity date, and the fund's returns are subject to daily buy and sell actions of random investors. The fund manager is often forced to buy and sell bonds in reaction, sometimes at the worst times. But buying and maintaining a bond portfolio requires careful credit analysis.
This article is the first in a two part series that discusses the key elements of corporate credit analysis for fixed income investing, with a focus on high yield credit. Many investors look to the credit ratings of the major agencies, Standard & Poor's and Moody's, as a way to quickly assess the quality of a credit, with the familiar, A, B and C ratings modified with extra letters or plus/minus signs. While the credit rating is certainly a useful data point, it should not and cannot be used as a substitute for fundamental credit analysis. The mortgage crisis, where the rating agencies somehow rated certain tranches of subprime debt investments as AAA proved the weakness of the letter rating system. Each of the ratings agencies also have their biases, which is why certain credits have oddly split ratings (e.g. in an extreme example, a few weeks ago Moody's lowered the rating for the city of Chicago to Ba1 while S&P has it at A+).
Credit analysis typically incorporates various factors and statistics which all together create a "picture" of the credit. This system of credit analysis that I use is based on formal credit training and more importantly, 20 years of institutional fixed income investing at various investment banks, CLO funds, and specialty mezzanine lending funds. The credit factors described here are those that can be applied to most operating companies. Note that each company and industry will have its own set of credit factors and it is assumed that as part of analyzing a company's credit an understanding of its business and key strengths and weaknesses is required.
The focus of this article will be on public companies as the information one needs is easily available. In general, one of my key rules is to avoid bonds issued by private equity groups as part of a leveraged buyout. These issues tend to be leveraged far higher than public companies, and experience shows that when things go wrong private equity groups will do whatever they can to undermine the bond holders [Ceasars Entertainment (NASDAQ:CZR)is a recent example].
Remember, the goal of credit analysis is to determine whether a company can pay its debt obligations and comfortably operate long term without threat of bankruptcy. This differs greatly from stock analysis which requires the analyst to make a case why the current stock price does not reflect the company's true value.
Debt to Total Capitalization Ratio - The first key metric is the market capitalization compared to the total value of the company. Using a house as an example, a $1 million home purchased with a $200,000 down payment and $800,000 mortgage would have an 80% debt to total capitalization ratio, or loan-to-value (debt to equity ratio measures the same thing as well). In general I typically like to see not more than 50% of capitalization comprised of debt. Certain industries can carry more debt than others, but red flags begin to go up if debt comprises more than 2/3 of total capitalization (private equity often uses 70%-80% debt). Let's look at an example, such as high yield issuer Rent-A-Center (NASDAQ:RCII). The company has a $1.6 billion market cap and a $2.4 billion enterprise value (or total capitalization), with about $800 million of debt (net of cash). In this case Debt to Total Capitalization comes to 33%, which means that there is plenty of equity value in this company relative to the debt. Book value statistics are less useful than market value, although in certain industries, such as some segments of financial services, book value may be more relevant.
Let's look at an example of a bond that is trading at a deep discount, at virtually distressed levels. ION Geophysical (NYSE:IO) bonds (8.125% of 5/15/18, CUSIP 462044AE8) are trading at around 77-78, yielding over 18%. The depressed price level conforms to the credit ratings, which for Moody's is Caa2. However, the Debt to Total Capitalization Ratio tells a very different story. Based on the most recent stock price the company has about a $250 million market cap and a $288 million enterprise value - or only about a 15% Debt to Total Capitalization Ratio, which is attractive as a debtholder. The capital structure to a large extent reflects a balance sheet that has $182 million of debt and $144 million of cash, or only $38 million of net debt. But the market still values the company's equity at around $250 million, or more than 6x the net debt level. Is this bond a buy at these nearly distressed price levels? I'm not making any recommendations here but simply pointing out how in this case the company's Debt to Total Capitalization Ratio seems to strongly contradict the Moody's rating and where the bonds are trading. If the bonds are really worth only 77 cents on the dollar, shouldn't the market cap be worth virtually nothing?
Compare this to Swift Energy (NYSEARCA:SFY), rated B2 by Moody's. In this case the equity value is only about $100 million versus a $1.2 billion total capitalization. This means that debt comprises 90% of the value of the company, and equity only comprises a small sliver here. Swift's bonds are trading in the mid-40s - in this case correctly reflecting what the market is telling us about this company, which is that it's not worth much more than what it owes, and there is good likelihood it's worth much less. In this case the stock price is more like a call option. Here the Debt to Total Capitalization Ratio is revealing and an indicator to avoid these bonds unless you are a distressed investor, which requires a different set of analysis.
Debt to EBITDA - The ratio of total debt to EBITDA, also known as the Leverage Ratio, is the most basic measurement of the debt level a company holds relative to its profitability (an explanation of EBITDA and similar financial measurements will not be covered here). The ratio compares a company's debt against its core profitability, stripping away "noise" such as non-cash items, one-time events, and accounting adjustments like write-offs. I typically look for ratios of between 2x and 4x, although various industries operate comfortably at much higher leverage levels, and it is necessary to know which market segments can sustain higher leverage. For instance the cable television industry has successfully operated at leverage levels of 4x-6x for decades. Generally companies with a high degree of recurring revenue and attractive assets can operate at higher leverage levels.
Like all the other factors, the Leverage Ratio is only one piece of the puzzle. In many cases the ratio may be reasonable, but the company incurs high capital expenditures that offsets the low leverage. For example, many companies in the oil & gas industry suffer from this problem, such as Sandridge Energy (NYSE:SD). This company reported $182 million in Q1 2015 EBITDA, which on an annualized basis results in total leverage of about 4.6x. High, but not enough to justify bonds trading in the 50s. But capital expenditures of $322 million in the same quarter means that Sandridge had to spend far more than its EBITDA on cap-ex just to generate this level of EBITDA, even though the industry is in a major downturn. In this case the headline leverage level is not useful.
One of the main reasons I avoid private equity related bonds are the high leverage levels typical in these transactions. The market justifies the high leverage levels by the high multiples paid for these companies, the large amount of cash equity invested by the private equity groups, and the "prestige" of the transaction. For example, earlier in 2015 private equity group BC Partners acquired pet retailer PetSmart for $8.7 billion, funded with $6.2 billion of debt, resulting in a 7.25x adjusted Debt to EBITDA ratio according to Moody's. Yet Moody's gave the company a B1 corporate credit rating. In my view few, if any, companies should be leveraged at over 7x, especially a retailer, and no matter the merits of the company I would not touch these bonds. Not much has to go wrong for a 7x leveraged company with few assets to go bankrupt.
Did the company survive 2008-2009? The third credit metric is not a conventional statistic but has become an important factor in the last five years. Following the crash in 2008-2009 those in the lending industry had an easier time figuring out which credits were best. Those companies that survived the downturn reasonably well (even if results were significantly down) seemed like a good bet. This same data point is still very useful in credit analysis today. Check the stock prices and general operating results for companies going back before and through 2008-2009. If they are thriving today this is a good indicator that management knows how to navigate a recession and is likely to survive the next one. While past performance is not indicative of future results, it is one more piece of information in evaluating a credit.
One example of a company whose historical performance in 2008-2009 is indicative of strength is KB Home (NYSE:KBH). The company, one of the largest homebuilders in the U.S., was founded in 1957 and operates across the U.S. As expected from a real estate boom and bust, the company was crushed from its previous high flier status, with revenue declining from $9 billion at its peak in 2006 to $1.3 billion in 2011. Nevertheless, at all times the asset base was comfortably larger than its debt and the company slowly recovered with revenue about doubling since its low point. A key factor for KB Homes is asset value, with total inventory valued at $3.25 billion, which is comprised of $2.3 billion of land and $950 million of homes under construction. In fact, the total enterprise value for KBH is $3.6 billion, which just about equals the book value of its inventory and cash and comfortably covers its debt of $2.8 billion (thereby giving no value to its actual business, just its raw assets). Without going further into KB Home, the point is that the B2 corporate rating does not give much credit to the company's resiliency during the worst housing crisis in decades.
Part II of this article will cover several other key credit factors that are equally important in analyzing and assessing a credit.
Please see the Downtown Investment Advisory profile page for important disclaimer language.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author has positions in IO, RCII and KBH bonds in personal and/or client accounts.