Professional Money Making Ideas

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.

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.

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.

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.

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.