Professional Money Making Ideas

Noninvestment credit issuers and investors

The following covenants are provided by most noninvestment grade issuers and investors in lower investment grade bonds should ask for similar covenant packages in order to avoid a wealth transfer to the equity holders. Attractive covenants represent value for the bondholders and have to be considered in the investment process. Only the most important covenants will be presented at this point. Generally, it can be argued that the covenant protection increases with a decreasing rating class.

Restrictions for the issuance of additional debt by coverage and leverage ratios. The most common are:

(a) Fixed charge coverage ratio: (Funds from operations)/Total debt

(b) Debt/EBITDA or Debt/Funds from operations

Limit on asset sales. This can be of particular importance when a company faces financial distress and tries to sell noncore assets. This policy might not conform to bondholders’ interests. Limit on dividend payments and share buy-back programs.  Limit on certain investments (e.g. outside the core business). Limit on lines and certain guarantees. Limit on certain transactions with the operating companies.

A put option can be very valuable for the bond investor, for example when a company loses its investment grade status due to a large acquisition or a severe deterioration of its business fundamentals.

Analyzing the ranking of a loan

By analyzing the ranking of a bond within the capital structure it is possible to estimate recovery values in the case of distress. Especially for highyield issuers it is also of importance to analyze the group structure of an issuer for restricted groups. Sometimes there might be legal restrictions for certain subsidiaries to upstream dividend payments to the holding company so that not all generated cash flows will be available to service the debt obligations.

Covenants: Covenants are part of a credit agreement between lenders and borrowers. Their purpose is to protect lenders by stating what the borrower must do in order to stay in compliance with the loan agreement. Covenants may protect the bondholder from certain event risks. One problem with covenants is that bank covenants are usually private information which is not disclosed by companies when issuing corporate bonds. If those covenants are breached bond investors come to know in the quarterly or annual filings so they should increasingly demand the disclosure of such covenants.

The implications for a credit investor

A holding company is the issuer of the senior notes which are effectively subordinated to bank debt and debt of the operating companies. This subordination can be alleviated somewhat through an upstream guarantee of the operating companies (subsidiaries). If more debt gets ahead of the bonds the rating difference between the issuer and the bond rating might increase to 2 notches.

The holding company conducts business through its subsidiaries (operating companies) and is dependent on the subsidiaries upstreaming the cash flows through dividend payments. The implication for an investor is to make sure who is in control of the operating assets and what amount of debt actually ranks senior to the respective notes. A considerable equity cushion is always (especially during a crisis scenario) a credit positive for a bondholder because the increase in junior claims always improves the status of all other senior parties in the capital structure.

Indentures of payday loans

After assessing the credit quality of a company by weighing financial, business and management risks, the investor has to focus on some specific features described in the prospectus for every issue. The main parts are:

• Ranking in the capital structure
• Covenants
• Optional redemption
• Change of control
• Use of proceeds.

Ranking in the capital structure: The following statements mainly refer to lower rated (BB-CCC) companies. Their bank debt usually ranks senior (one notch rating difference) to the bonds. The subordination in the capital structure can have a contractual or structural character. The contractual subordination is the typical form in the United States. The various jurisdictions in Europe make the enforcement of a contractual subordination in bankruptcy court difficult so the structural subordination was the favored form/structure for European high-yield deals. The priority of the claim of a debt investor is determined by the position within the capital structure. Industrial holding companies upstream cash from their subsidiaries. If those subsidiaries do not guarantee the holding company debt then it is structurally subordinated to all debt instruments residing at the subsidiary level including trade payables and lease obligations.

Some credit risks are almost impossible to quantify

Event risks are almost impossible to quantify. Some event risks are reduced to a single company and others have an impact on the whole sector. Corporate bond and equity investors have to deal with events that have a negative or positive effect on their investments. Certain event risks are the result of management’s option to change the capital structure of a company which is either bondholder-friendly or to the benefit of shareholders. Other risks can be of legal, regulatory or environmental nature and are out of control for management. Another source of event risks is a company’s miscommunication with investors and unsatisfactory disclosure of certain company facts.

Deciding whether a credit still makes sense

As a last step one can also draw historical charts for the chosen bond in order to see how it performed in the past versus the peer group and market index. This is helpful in deciding whether an investment at the current level still makes sense in a portfolio context. The spread volatility of single bonds is also an important characteristic for investing in corporate bonds. Tight spread levels usually go along with decreased spread volatility.

We see that the spread change over a 1-month period for selected European automobile bonds. Keeping track of these movements helps to identify bonds which underperformed or overperformed the peer group. A mispricing can occur due to technical factors.

The loans which offer the best value

After making the decision on the company level, the bonds which offer the best value have to be selected. For this purpose all bonds of the issuer including credit default swaps are plotted in a diagram. This exercise is performed for Deutsche Telekom and Ford Motor Credit. If investment restrictions allow to invest across currencies the investor has to decide about the relative attractiveness of bonds issued from an issuer in different currencies. The expectations about the curve shape in Euroland and the United States have to be incorporated in the decision process. At this point, we want to highlight that in the past US$ denominated bonds experienced a higher volatility than Euro denominated bonds from the same issuing entity. Therefore, it is justified that US$ bonds trade at a premium to Euro bonds of same maturity. Off-the-run bonds usually trade on a discount to on-the-run bonds but an investor has to consider the lower liquidity of those issues and evaluate whether the higher spread level compensates for this illiquidity. Sometimes technicals rather than fundamentals can drive the credit spread of single issuers so that one can position accordingly on the credit curve. Generally with increased uncertainty about an issuer it is appropriate to overweight the shorter maturities and underweight the long end of the credit curve. From a relative value perspective steep credit curves indicate value in the long end while flat credit curves favor the shorter maturities.

The main drivers of the credit market

Analysts use many ways to demonstrate the relative attractiveness of a specific bond. Some examples follow next:

Free Cash Flow: One of the risk metrics for corporate bond investors is cash generation. In a relative value framework companies can be grouped by the change in free cash flows and their respective spread levels. Companies with positive free cash flows and high spread levels have outperformance potential in the future. The change in free cash flow can also be compared with leverage ratios like debt/EBITDA. Highly levered firms with corresponding higher yields but forecasted future increase in free cash flow have the potential to outperform.

Sales: Agood tool for evaluating companies is to put their sales figures in relation to CAPEX. Since CAPEX is an important determinant in balance sheet repair, we should look for companies with an expansion in sales and decreasing capital spending. Sales growth can also be put in relation to debt levels. The ideal company for bondholders will grow its sales and pay down debt at the same time.

Return on invested capital (ROIC): ROIC is a measure of how efficiently a company spends money. For this purpose annual averages of ROIC can be plotted in a matrix versus the ratio of CAPEX/sales. Companies with high CAPEX/sales ratios and low returns on invested capital are poised to underperform at times when fundamentals are the main drivers of the credit market.

Coming up with a payday loan decision

After completing all the steps in the analysis the results have to be put together in order to come up with an investment decision. Clearly many factors impact the credit quality of companies and perhaps most important are qualitative “soft factors” and their interpretation is very subjective. We summarize all important qualitative and quantitative factors and comment on what an investor should be focusing on. They consider fundamentals, technicals and valuation. The task is to bring all factors together and generate performance-enhancing investment decisions. For this purpose the various factors can be weighted according to their importance whereas the weights are set by the analyst. This means to pick a company with the highest outperformance potential out of a universe.

In the ideal case, investors will pick companies with the following fundamental characteristics and an attractive valuation versus the peer group so that high outperformance potential is given:

• Better and continuously improving average credit ratios than the peer group
• Commitment of management to a defensive financial policy and high credibility of the management team
• Positive outlook about future earnings
• Generation of free operating cash flows
• Operative outperformance versus peer group
• Asolid market position in its core business areas
• Asound liquidity position and multiple sources of available financing
• Favorable outlook for the business cycle
• Spreads which offer a relative attractiveness versus peer group because all positive developments are not priced in the spreads yet.

Strong link between equity and credit

In February 2003, A hold revealed accounting irregularities and both the equity market and bond market reacted very negatively to the news about fraud. Bonds began to trade on the expected recovery value but recovered since then as the equity value of the firm began to rise and it became apparent that the company would be able to survive in the long term.

WorldCom is another good example for the strong link between equity and corporate bonds when asset value drops below a certain threshold. In February 2002, WorldCom disclosed significant asset write-offs and accounting concerns persisted over the next couple of weeks.

Finally, liquidity concerns pushed the company’s equity and bond prices to distressed levels. WorldCom applied for Chapter 11 and the bonds traded down to around 15–20 cents on the dollar in July 2002.