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What Credit Analysis Does BondSavvy Conduct When Evaluating Investments?


BondSavvy uses credit analysis to identify undervalued corporate bonds it believes can outperform the market.  To evaluate potential corporate bond investments, we must understand how bonds are priced relative to their credit risk and interest-rate risk.  Please see the below table that was part of the March 18, 2018 edition of The Bondcast, a subscriber-only webcast series where we present new corporate bond recommendations.  It reviews certain of the key metrics that are part of our credit analysis.  Below the table is a description of the select terms.  Click to view this sample edition of The Bondcast and read this blog post for a more comprehensive list of the factors we consider when evaluating new individual corporate bond investments.

Figure 1: Preview of BondSavvy Credit Analysis



Comparing Bond Pricing to Credit Metrics
Due to the many weaknesses of corporate bond ratings, it's essential for bond investors to see how key credit analysis metrics such as leverage ratios and interest coverage ratios compare to how a corporate bond is priced.  Figure 1 shows us the dollar price of the four recommended bonds, as well as the yield to maturity and the spread to Treasury, also known as the credit spread.  Since maximizing total return of each corporate bond recommendation is our goal, we want to identify bonds that have relatively high YTMs, high credit spreads, and low prices relative to the corporate bond's default risk.  If a corporate bond's credit spread is high relative to the issuing company's default risk, the credit spread could decrease over time, which could cause the bond's YTM to fall, and the bond price to increase.  In addition, with a high relative yield, we would receive recurring income that is higher than corporate bonds the market perceives to have similar default risk to our recommended bonds.  This is possible for investors in individual corporate bonds to achieve since a large portion of corporate bonds are owned by large institutional investors that, in many cases, blindly follow corporate bond ratings to assess the default risk of a bond.  Corporate bonds are regularly misrated due to the flawed methodologies bond rating agencies employ, which creates opportunities of individual corporate bond investors.

All four recommended corporate bonds shown in Figure 1 were priced below par value at the time we made this set of bond recommendations.  Bonds are priced as a percentage of their face value, so the offer price of the Alphabet '26 bond (CUSIP 02079KAC1) was 91.03% of the bond's $1,000 face value, making the offer price of the bond $910.30.  When possible, we prefer to buy corporate bonds at a discount to par value, as these bonds, generally speaking, can have greater upside than bonds trading at a premium to par value.  

Leverage Ratio: 
Total debt divided by EBITDA. If this ratio is low (1-2x), it means the company has a low amount of indebtedness (“leverage”) relative to its earnings. High-yield issuers typically have higher debt levels relative to earnings and have leverage ratios typically between 4-8x. Note that “EBITDA” is an acronym for Earnings Before Interest, Taxes, Depreciation & Amortization. It shows how much cash a company generates from operations and what it has to pay its interest, taxes, and capital expenditures.  Please read this blog post for a full discussion on how to calculate and use leverage ratios when conducting credit analysis.

Interest Coverage Ratio:
EBITDA divided by interest expense. The higher this is, the more cash flow a company has to 'cover' or pay its interest expense. If interest coverage is low, a company may have difficulty paying interest if its business hits a rough spot. Interest coverage is often 2-5x for high-yield issuers and often over 10x for investment-grade issuers. 

Financial Performance Trajectory
While corporate bond investors don't require the issuing company to grow rapidly, the company's growth trajectory can impact the leeway we give bond issuers on certain credit analysis ratios.  For example, if we evaluated two bonds with similar pricing, we may select a bond with slightly worse credit ratios in the event the forward-growth picture of the issuing company is stronger than that of the other issuer.  In the wake of COVID-19, many corporate bond issuers pulled their 2020 financial guidance.  While we could understand this for Q2 2020, those who continued to blame 'uncertainty' for their lack of any forward guidance raised concern about future prospects of their business. 

Southwest Airlines, a company that had its business crushed by COVID-19, has been extremely transparent, as it regularly files 8-Ks with the SEC to provide updates on its business and cash burn.  The company was able to raise billions in new capital to help it get through the crisis, and the regular updates it provides investors have enabled us to assess how the company's turnaround is progressing.

As shown in Figure 1, we review the company's recent revenue and EBITDA growth to evaluate its growth trajectory.  We will also compare any forward guidance a company has provided to its historical financials to determine whether its credit ratios should improve or worsen.  

Capital Allocation
Capital allocation describes what a company does with the profits it earns from running its businesses.  A company could have strong credit ratios today; however, if it wastes significant portions of cash flow on stock buybacks, such financial management practices could come back to bite.  From a bondholder's perspective, we like to see capital allocation skewed toward debt paydown and capital expenditures.  Some level of merger-and-acquisition activity can also be productive; however, we generally stay away from bond issuers that have recently announced or completed mega deals, as these can often take a fair bit of time to evaluate their success and can come with high levels of risk.

Upcoming Maturities
If a company doesn't have a bond maturing for seven years, chances are it's going to be money good between now and then unless the company can no longer cover its interest payments.  If, however, a company has many near-term maturities, is struggling financially, and has questionable ability to refinance its upcoming maturities, the bond issuer's default risk increases.

Liquidity
We want to understand all sources available to pay for interest expense, capital expenditures, and upcoming debt maturities.  To do this, we evaluate the company's cash on hand, investments, and capacity on any bank lines of credit.

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