Last month I reviewed the top 10 tips for assessing a bond. This article 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 its growth prospects. Strong growth prospects are positive for a shareholder 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 that bond investors use that are less important, or different, for share investors. The training needed to become a credit analyst takes years but below are my Top 6 tips for 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 and thus pay you interest and return face value at maturity?
A company that is consistently profitable and more importantly generates 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 shareholders?
If needed, large shareholders 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 than shares. Shareholders are in the first loss position and must be wiped out in full before bondholders 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 prohibit you 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 inappropriate?
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. And remember bond investors’ 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.
Copyright The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.
Disclaimer Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.
No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.
FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.
FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.
An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.
The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.