Do you manage your own portfolio and invest in fixed income? If so, you probably read the odd financial statement, and it’s not easy to know what the pros look for.
Consider some of these tips for buying corporate bonds, particularly after years of low interest rates have encouraged companies to take on record levels of debt.
How much debt, due when?
The most important balance sheet measure for fixed income managers is debt to EBITDA (earnings before interest, taxes, depreciation and amortization), a key metric that helps determine a company’s debt rating.
Asset managers look at whether the debt on the balance sheet is growing, with higher ratios acceptable for certain sectors. Fast-growing sectors, for instance, might see companies accumulating more debt as their revenues and cash flows also climb.
A company in the telecom and general industrials space, with a BBB or BBB+ rating, should have a ratio of two-to-three times debt-to-EBITDA, says Jonathan Allen, fixed income director for TD Asset Management, whereas infrastructure names could have a ratio of 15 times. An acceptable leverage ratio can change depending on several factors, like how the sector is performing as well as revenues and cash flow stability.
A newsprint manufacturer, for instance, operating in a sector of secular decline, should have a lower debt-to-EBITDA ratio of four to five times leverage, says Daniel Cooper, portfolio manager for Mackenzie Investments, adding that its acceptable debt level can change according to what the borrowing is funding.
And check how soon the debt is due.
“The first thing I look at is, how much debt do they have coming due? What’s the debt maturity schedule?” says Soami Kohly, fixed income portfolio manager for MFS Investment Management. “I’m always wary of companies that have a high percentage of their debt coming due in the next five years.”
What’s the debt for?
Issuing bonds to fund dividends or share buybacks is a red flag for fixed income managers, especially for companies already well-leveraged.
In today’s low-yield environment, companies are looking to grow dividends, and if they “can’t do it through cost cutting, the next step is to look at financial engineering, or rather, adding debt to buy shares,” says Jonathan Allen, vice-president and director for TD Asset Management. He watches for new management teams, who often come in hoping to impress shareholders with dividend hikes or share buybacks that push up share price.
In an exceptional example, Yellow Media, owner of the Yellow Pages directory, used debt a few years ago to sustain its dividends—even as revenues and earnings dropped. “They did that for much longer than they really should have,” Cooper says. “Ultimately, they [almost] went into bankruptcy.”
What to do with a company already well-leveraged that wants to use debt for dividends? If it’s in a declining sector, “that’s definitely when we push back, or avoid, or sell the name,” Cooper says.
Cash flow and liabilities
Free cash flow, and whether it’s growing, is key to whether a company is bringing in enough to pay down debt and improve its leverage ratio. Caryn Rothman, a fixed income analyst for Manulife Asset Management, looks at cash flow through assets.
“We spend quite a bit of time thinking about how those assets are going to turn into both net income and, more importantly for us, cash flow,” says Rothman, who follows retail and healthcare names.
The asset mix allows her to evaluate the quality of assets, the firm’s business model and future cash flows. A retailer’s balance sheet would show inventory, receivables and real estate—offering a glimpse of the company’s ability to meet debt obligations. An auto parts company disclosing a lot of property, plant and equipment might draw from future cash flows for maintenance and capital expenditures.
Cooper says he also looks for instances where asset depreciation levels are higher than the company’s capital expenditures, indicating that it’s underinvesting in assets like property, plant and equipment. “We’re seeing it in the energy space right now, where companies aren’t able to maintain production. They’re underinvesting in their wells and their basins,” he says.
Kohly also looks at pension liabilities, a bigger problem for many manufacturing companies, because they can be a drag on cash flow as the liabilities take priority. “Cash flow gets diverted there before it gets paid to us [bondholders],” he says.
Other red flags
Always read the footnotes. More adjusted numbers are showing up in financial statements, and it’s often unclear what they represent.
“Valeant Pharmaceuticals was a pretty good example of that,” Rothman says of the floundered company that came under scrutiny for accounting irregularities and expansion driven by acquisition. “What is cash earnings? What is pro forma projected? You’re buying companies and adding synergies from things you’ve bought, and you don’t have clarity into the reporting because there are so many transactions going on.”
If a company isn’t transparent about a number, it’s a red flag, Rothman says. A company may write down a large goodwill or intangibles number over time without explanation, for instance.
Adds Allen, who also sits on a board for Chartered Professional Accountants Canada: “There are just so many non-GAAP measures now, and non-GAAP adjustments, where companies are creating their own adjusted EPS and adjusted EBITDA. There’s no consistency.”