When making a risk assessment of a company's debt, it is cashflow rather than earnings that is crucial because it is the source of the coupons paid out to investors
During 2002, a number of high-profile corporate casualties, combined with an uncertain economic background, rising tensions in the Persian Gulf and equity market volatility weighed heavily on corporate bond markets and meant that investors had a somewhat diminished appetite for credit risk.
Indeed, issues from AAA rated supranationals and corporate bonds on a higher credit rating (AA and A rated issues) performed relatively well.
This was at the expense of BBB rated issues (the lowest rating within the investment grade sector) offering higher yields with commensurately greater credit risk. Last year was also characterised by the number of fallen angels (such as Fiat, Alcatel and Ericsson) that lost their investment grade status, downgraded to the high-yield sector by the rating agencies.
However, it is all too easy to overlook the fact that there are a number of positive influences at work in credit markets. The process of corporate restructuring is well under way and a significant number of leading companies have already taken the opportunity to reduce gearing levels and restructure their balance sheets through embarking on debt reduction programmes, while cutting expenses and strengthening cashflow. In the UK, examples can be found across a wide range of sectors and include the likes of British Telecom, Tate & Lyle, Alliance & Leicester, GlaxoSmithKline and drinks group Diageo.
Despite tight credit conditions companies with sound business plans and predictable cashflows have been able to weather the storm and successfully access capital markets through bond issuance.
In recent years, there has also been growing awareness among institutional investors in the UK (particularly pension funds) of corporate bonds as an alternative asset class to the UK gilt market, the traditional home for pension funds and other institutional investors seeking bond exposure. Figures from Merrill Lynch indicate that the market in corporate and other non-government bonds denominated in sterling is now larger than the UK gilt market, totalling over £236bn.
The growth in the market can be illustrated by the fact that during last year, in what was a difficult period for corporate bonds, the market in investment grade sterling bonds (issues with a credit rating of BBB or above) grew by £28bn.
The sterling investment grade market comprises a diverse range of 664 issues, from the AAA-rated European Investment Bank through to names like Legal & General (rated AA), Tesco (rated A) and at the lower end of the credit spectrum Carlton Communications (rated BBB).
Several factors have been behind the growth in the market for corporate bonds, both in terms of demand and supply. On the supply side, the decreased availability of cheap bank loans and the need to finance corporate expansion and restructuring has fuelled an upsurge in borrowing through capital markets.
Unlike the US, where corporations have long been utilising the option of debt funding through the capital markets, until recently many companies in the UK and Europe have steered clear of bond issuance and relied on strong relationships with the banking sector as a source of debt finance.
The corporate sector has been keen to tap the capital markets at a time of growing demand, in particular from institutional investors.
Events last year clearly illustrate that assessing the associated risk of investing in corporate bonds is equally as important as the potential long-term returns. One of the characteristics of corporate bonds as an asset class, in contrast with equities, is their relatively asymmetrical risk. They offer limited scope for capital gains, as the bulk of the return to investors is in the form of a relatively high income, but potentially unlimited downside with the ultimate risk of default.
It therefore follows that minimising portfolio risk has to be a consideration of paramount importance. In other words, avoiding the losers is equally important as spotting the winners.
To minimise risk, it is vital that to consider the creditworthiness of a company when selecting securities for inclusion in a corporate bond portfolio. In practice, there is some overlap between the criteria used in credit analysis and that employed by equity investors.
For example, it is important to assess industry and sector trends, taking into account secular and macroeconomic factors.
Having assessed industry trends, the next stage is to review the position of a company in the context of its industry. This process can be divided into two elements, business risk and financial risk. Business risk essentially is concerned with assessing a company's strength of franchise ' the quality of resources that enables the company to sustain and increase its competitive position within its markets.
This includes factors such as the strength of brands, intellectual property, scale, financing capacity and the quality of assets. In addition, it involves an assessment of quality of management considering factors such as strategic direction and the ability to innovate and/or acquire.
Unlike business risk, where once again credit and equity analysts will employ similar criteria, there is divergence between the two areas when evaluating the level of financial risk. For equity investors, the primary concern is the company's earnings outlook, whereas for investors in corporate bonds it is cashflow that is of paramount importance. This is because it is out of cashflow that coupons are paid and ultimately principal is returned to bond investors. There are a number of measures to focus on in assessing financial risk, for example the level of gearing and the interest coverage ratio. The latter measures a borrower's ability to meet interest commitments and is the number of times the interest charge is covered by cashflow. This measure will, of course, vary over time and it is therefore crucial for bond investors to gauge the sustainability of a company's cashflow and how volatile it is likely to be.
One way of measuring sustainability is through scenario analysis, for example in a worse or stress case ' such as an economic recession ' whether there is sufficient cashflow for debt repayment. If there is not, then it becomes important to assess what other sources of finance, such as access to capital markets and the ability to dispose of non-core assets, are available to a company experiencing a pronounced downturn in trading conditions.
While the rating agencies such as Moodys and Standard & Poor's offer a comprehensive coverage of the corporate bond market and are a useful starting point in assessing risk, it is important for professional investors to supplement an external ratings service with their own company analysis. Not least because there is a strong view in the corporate bond markets that credit ratings tend to be lagging indicators, whereas investors are focused on anticipating changes.
Second, it is not the function of ratings agencies to factor in specific event risks. Examples of specific event risks include debt-financed acquisitions and share buy-backs. Share buy-back programmes have been a feature of the UK corporate sector in recent years as companies have opted to return cash to shareholders. While this is positive for equity investors it reduces the cash available to meet the requirements of bondholders, and may even result in a lowering of the borrower's credit rating. Furthermore merger and acquisition activity also impacts on bondholders. Debt-financed acquisitions will have the impact of lowering the interest coverage ratio and increasing the level of gearing.
Risk should not only be assessed at the security level, but also controlled at the market and portfolio level. As with equities, it is important to remember that macroeconomic factors will be significant in determining the returns from a corporate bond portfolio. Therefore, there are often opportunities for astute fund managers to enhance returns, whilst reducing risk through sector diversification, from portfolio construction at the industry as well as individual security level.
Previously, corporate bond investment has been treated as an adjunct to government bonds, but the growth of the sterling bond market and the resultant need to be focused on the corporate sector warrants coverage as a separate asset class. Specialist active fund management of corporate bond exposure is essential to maximise returns whilst reducing the inherent risks of this asset class for retail investors.
Last year was characterised by the number of fallen angels that lost their investment grade status and fell into the high-yield class
Risk should not only be assessed at security level but also at the macro and portfolio level
Last year, in a difficult time for corporate bonds, the market in investment grade sterling credit grew by £28bn
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