Bondsavvy uses credit analysis to identify undervalued corporate bonds it believes can achieve higher investment returns than the leading bond funds and ETFs. To evaluate potential corporate bond investments, we must understand how bonds are priced relative to their credit risk and interest-rate risk. Please see Figure 1 below, which was part of a previous 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 items our credit analysis includes.
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Figure 1: Preview of Bondsavvy Credit Analysis
Comparing Bond Pricing to Credit Metrics
Due to the many weaknesses of corporate bond rating methodologies, 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 the total investment 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.
Finding corporate bonds with compelling relative values is possible for investors in individual corporate bonds since a large portion of corporate bonds are owned by large institutional investors, bond index funds in particular. These investors, 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 for 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 par value, so the offer price of the Alphabet '26 bond (CUSIP 02079KAC1) was 91.03% of the bond's $1,000 par 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.
The leverage ratio equation is 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. Issuers with bond ratings below investment grade often have higher debt levels relative to earnings and have leverage ratios typically between 3-6x. With a small number of outliers, over its history, BondSavvy has generally recommended corporate bonds issued by companies with leverage ratios between 2-4x. For corporate bond ratings, leverage ratios often have less weighting than certain fuzzy metrics such as diversification and 'innovation.' Bond ratings' focus on certain 'feel-good' metrics causes many bonds to be misrated, so the savvy bond investor can find values often ignored by most investors.
Please 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.
Interest Coverage Ratio:
The interest coverage ratio equation is 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, was extremely transparent, as it regularly filed 8-Ks with the SEC in 2020 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, at times, 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.
