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If you invest in lower yielding, investment grade bonds, defaults can decimate your portfolio returns; but the odds that higher-rated bonds will default are usually quite low.
Table 3 gives estimates of one-year default probabilities for each rating category, according to Fitch Ratings. The table shows that investment grade bonds (i.e. those rated BBB or above) typically have less than a 1% chance of defaulting in a single year.
Table 3
Estimated One-Year Default Probabilities for Bonds by Credit Rating
|
AAA |
0.06% |
|
AA |
0.12% |
|
A |
0.27% |
|
BBB |
1.02% |
|
BB |
5.42% |
|
B |
10.43% |
|
CCC |
29.68% |
|
CC |
37.74% |
Source: Income Builder calculations from WSJ Online data, originally sourced from Fitch Ratings
By comparison, high yield or junk bonds, those rated BB and below, have much higher one-year default probabilities.
Credit ratings are an excellent indicator of credit quality. Although the reputations of the credit ratings agencies have been tarnished by the collapse of the sub-prime mortgage sector (in which values of many AAA-rated securitized bonds fell sharply because of the impact of rising mortgage defaults), the value of credit ratings has been proven over many decades.
I prefer to use credit ratings as an initial indicator of the creditworthiness of a bond. After that, I will almost always perform my own credit analysis to confirm for myself the credit rating.
Besides the key credit measures given in the column on the right, I use many of the same measures that stock analysts use, such as profit margin trends, projected cash flows and market share dynamics, to name a few.
Since bondholders have a more senior claim against the assets (and therefore the cash flows) of a company, they typically enjoy a greater margin of safety. Stock analysts must be concerned with the actual levels of corporate profits and cash flows, because variations in these can have a big impact on stock prices.
To be sure, changes in earnings and cash flows do affect the value of a bond. A drop in corporate earnings will usually cause the yield spread to widen, as the market raises its estimate of default risk. However, dollar for dollar, the impact of earnings changes on bond values and yield spreads is typically more muted with bonds than with stock prices. Bond analysts also focus on earnings and cash flows, but they are more concerned about the degree to which the earnings, cash flows and assets provide adequate coverage for their interest and principal payments.
Often, the choice of where to invest in the capital structure can have a big impact on overall returns. Chart 9 shows the relative priority of claims by creditor class.
Chart 9
The Relative Priority of Claims vs. Interests
Secured claims rank highest. As we have seen with Calpine Generating Company and others, secured bonds give investors powerful rights which often ensure the full recovery of principal and interest, even in a bankruptcy.
Financial risk increases as we move down the capital structure. In a bankruptcy, senior unsecured bonds will usually recover less than secured bonds, but more than subordinated bonds. Common equity is at the bottom of the pile. These days, shareholders often get wiped out completely in a bankruptcy.
Knowing the relative priority of a bond’s potential claim against a company is an important part of credit analysis.
Bondholders at the lower levels of the capital structure usually receive a higher yield to compensate them for the added risk, but unless the company’s prospects are good, this slightly higher yield often proves to be inadequate.
THREE KEY CREDIT MEASURES
Debt Service Coverage: This is a measure of the ability of a company to meet its debt service obligations. It is usually expressed as the ratio of earnings or cash flow divided by interest expense. Many analysts use EBITDA (or earnings before interest, taxes, depreciation and amortization) divided by interest expense. Typically, the higher the number the better. So a company with an EBITDA-to-interest expense ratio of 6-to-1 is usually in a stronger financial position than a company with a 1.2-to-1 EBITDA-to-interest expense ratio. But it is important to consider required capital expenditures in the analysis. Many analysts reduce EBITDA by the annual amount of required capital expenditures before calculating debt service coverage. It is also important to compare individual company debt service measures against industry averages. If the company’s cash flows are stable, it should be able to operate with higher debt levels. Thus, a company with a 2-to-1 coverage ratio may sometimes be a better credit risk than a company with 5-to-1 coverage.
Debt-to-total capitalization. A measure of financial leverage. Total capitalization equals the sum of debt and equity on the balance sheet. So the debt-to-total capitalization ratio tells you what proportion of the company’s total capitalization consists of debt. Here again, it is important to compare your company against industry averages, since some industries, like finance companies, usually operate with higher debt levels. It is also important to take into account, by reading carefully the financial statement footnotes, debt that may carried off the balance sheet.
Liquidity. Usually measured as cash and equivalents plus amounts available to be borrowed under bank credit lines. If possible, check the financial tests, called covenants, included in the bank agreements to determine whether the company has sufficient flexibility to borrow from its banks as needed. Compare calculated liquidity to the cash flow that a company generates each year less annual capital expenditure requirements and upcoming debt repayment obligations.
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_________________________________________________________________________________
Originally published February 28, 2008. Updated October 26, 2008.
Stephen P. Percoco
Income Builder
P.O. Box 1409
Mashpee, MA 02649
(732) 763-0763
incomebuilder@larkresearch.com
© 2008 Lark Research, Inc. All Rights Reserved. Information is carefully compiled but not guaranteed to be free from error. Specific reference to any specific security should never be construed as a solicitation to either buy or sell. Reproduction without permission from the publisher is prohibited.