A helpful guide for corporate bond investors

By Andrew Allentuck
Globe Investor magazine online, March 7, 2008

There's a saying in bond investing — government bonds don't have stories, but corporate bonds can have long tales.

All investors need to know about government bonds is how they respond to changes in interest rates. But corporate bonds also trade on a company's prospects for paying interest and repaying principal on time. For bond investors, it is vital to ensure there's a good chance that they will do both.

Here is a list of the most critical things a prospective investor in a corporate bonds should check:

What is the ability of the company to service its obligations?

Check financial statements for earnings margins, amount of interest and fixed charges a company has to pay, balance sheet liabilities, and the candor of disclosure, including contingent liabilities, says Sunil Shah, vice president for fixed income and portfolio manager at Sceptre Investment Counsel Ltd. in Toronto.

"Assess the company's ability to be a profitable venture over at least six months. It is hard to see farther than that, but you have to try."

Sources include company investor relations departments and websites such as www.sedar.com for Canadian bonds and www.sec.gov for U.S. bonds.

"The main thing to look at is the likely future health and resilience of the company," Mr. Shah says. "That tells us how much we are being paid to take a risk. The more we are paid for taking risk, the more comfortable we are with that risk."

Liquidity

Determine how much money is available in committed lines of credit, how much debt has to be refinanced, and how readily a company can access capital markets through offerings of shares, securitizing or monetizing assets, says Edward Jong, vice president for fixed income at Mak Allen & Day Capital Partners Inc. and portfolio manager of the FrontierAlt Opportunistic Bond Fund in Toronto.

Event risk

Every company can have its fortunes made or broken by events. In general, the lower the leverage a company has - the less its assets are used to support borrowed money - the more resilient it can be if problems strike.

"It is the ability to survive an adverse event that is the issue," Mr. Jong says. "The less competition a company has, the more it can survive a problem. And the more money it has in the bank, the tougher it is. You want a secure niche and deep pockets."

Debt coverage

As the quality of a bond declines, the analysis becomes even more critical. The ratio of debt to cash flow is a gauge of risk. If debt is four times cash flow, the company could be okay, says Barry Allan, president of Marrett Asset Management Inc. in Toronto, a specialist in managing junk bonds.

If the ratio is five times cash flow, the bond is a lot riskier, Mr. Allan says. At eight or nine times, the bond will be distressed, at or near default, he notes. Pay attention to financial news, he urges.

"The market is very sensitive to every quarterly result. There are few situations where debt to cash flow ratios are rising and the market fails to notice," he says.

A case in point where debt overwhelmed cash flow is Quebecor World Inc., which sought creditor protection in January. The company, which started with one press in 1954, became the biggest printer on the planet. But expansion into Latin America and Europe left it with a $1-billion bill for retooling that involved disposing of 21 plants and eliminating 5,000 jobs.

Capital structure

How does the company deploy its capital? Where does a bond rank in relation to other debt? Is it senior debt or subordinated? Every company is different, but this has to be checked in a company's statements. Read the covenants, which are the company's promises to keep certain conditions and are available online. "But remember that the covenants are not going to protect you if the company is going bankrupt," Mr. Allan says.

Governance

Management quality can be important in assessing bond risk. "Management shows up in performance, but there can be an issue of the willingness of management to subjugate bondholder interest to that of stockholders," says Brad Bondy, vice president for fixed income at Genus Capital Management Inc. in Vancouver.

Accounting quality

If a company's earnings are rising much faster than its cash flow, something might be amiss, says Mr. Bondy.

"Nortel Networks is a classic. It had rising earnings and, at the same time, its balance sheet debt was going up. In fact, it had negative cash flow. For some companies, there can be reasonable explanations, but you want to know why it is happening."

Nortel investors have reason to wonder if the company's financial statements can be relied on, Ms. Pratt says. After several restatements of earnings, departures of senior management, and numerous regulatory actions, investors are left hoping the latest earnings reports are reliable, she adds.

"The company is downsizing in recognition of its failures. Now, the company's expenses are too big for its revenue. It has to shrink itself and get its operations in line with its numbers."

The Nortel story is not closed. Its bonds, trading as high yield, U.S. dollar-denominated debt, have single B ratings that puts them deep in junk territory.

Mood of the market

Today, the market is wringing its hands over corporate debt. Currently, the average yield for A rated bonds issued by chartered banks and due in 10 years is 5.63 per cent, compared to an average yield of 3.63 per cent for 10 year Government of Canada bonds. That's a spread of 200 basis points [there are 100 basis points in one percentage point]. A year ago, the spread on comparable bank bonds was just 55 basis points. "With these kinds of spreads, it pays to do your homework," Mr. Bondy notes.

Special to The Globe and Mail