This article was originally published in The WIRE on 3 November 2014, and again on 24 October 2016
Last week, I reviewed the Top 10 tips for assessing a bond. This articles goes one step further and provides some tips on assessing the company that issues the bond
While some of the criteria are similar to those we use for assessing a company for share investments, there are critical differences when assessing it from a bond perspective.
For instance, there is the way we consider a company’s growth prospects. Strong growth prospects are positive for a share investor as they should drive higher share prices and dividends. However, it can be a negative for a bond investor as the company will likely be taking on more debt and risk, and investing capital that may not return a profit.
There are many other criteria which bond investors use that are different or less important, for share investors. The training needed to become a credit analyst takes years but below are my top six tips for my assessing a company.
1. Assess the “survivability” of the company
This is the number one consideration for bond investors. Do you think the company will be able to survive for the term of the bond, thus paying you interest and returning the face value at maturity?
A company that is consistently profitable and more importantly creates a positive cashflow, makes a great bond investment. Its consistency might be considered “boring” by a share investor, but its reliable earnings and cashflow will pay your interest and principal when due.
Bonds in companies that are cyclical or have reported years of consecutive losses can still be sound investments. That is because the companies have other assets or means of funding to make sure bond investors are paid their interest and principal on the due dates. It is common for companies to have significant losses due to non cash write downs but still maintain strong cashflow metrics.
Here are some other questions worth asking to help you assess survivability:
a) What assets does the company have that it can draw on or sell?
b) Does the company have any undrawn bank lines of credit? c) Has the company issued any bonds in the international market?
d) Is there any evidence of large beneficial share investors?
If needed, large share investors can be called on to support the company in a stressed position. For example, during the GFC, Warren Buffett supported Goldman Sachs and Swiss RE, helping to assure their survival.
e) Is there a possibility of government support – is it an essential service?
The government may support some essential services in times of stress. During the GFC, the Australian government stepped in to guarantee debt of our banks, helping them to issue bonds in the global market and achieve a lower cost of funding.
f) Equity buffer
Every company has a capital structure which shows the priority of payments in liquidation. Bonds sit higher in the structure than shares and must be repaid first, making them lower risk. Share investors are in the first loss position and must be wiped out in full before bond investors will incur a loss. In this way, it’s important to know what the “equity buffer” is supporting your bond investment.
2. Consider where the company is domiciled
What are the legal, political and economic conditions of the country?
3. Consider the industry risks – would any of these stop you from investing?
Issues to consider include: trends, business cycles, key influences, changes in consumer preferences, changes in technology, barriers to entry, competition and regulation. When you evaluate an industry, your analysis should involve the industry’s short and long term sales growth trends and potential.
4. Assess the business risks
Business risks can be defined as the factors that affect a company’s financial performance and influence the specific strategies its management employs. Often, it’s the underlying factors which are important. For example, if competition is based on price, a key consideration will be the company’s cost base.
5. Management performance can be critical to your decision making
What is the company’s corporate strategy? Is it appropriate and do you think it will be successful? Has management successfully implemented past strategies or altered course when they’ve been unsuitable?
6. Review the financial statements including the cashflow, profit and loss and the balance sheet
Historical performance and projections will provide clues as to the company’s ability to repay its debt and the ability to withstand financial shocks. A peer group comparison of key metrics will help you understand the company’s strengths and weaknesses. Keep in mind – a bond investor’s primary focus is cashflow. Profit numbers can be impacted by accounting treatments, non cash revaluations, provisions and write offs, but cash is cash.
Taking the time to investigate and assess the above will help you to decide if investment in the company’s bonds meets your investment hurdles.
I think it’s important to review as many different sources of information as possible. But remember, the drivers for bonds are different to shares, and bonds will always be lower risk than shares in the same company.