During those periods equity-based techniques work quite well in measuring and monitoring potential credit risk. We have to consider as well that the sensitivity of debt to equity also increases with the leverage of a particular company. The underlying business risk and asset volatility determine the level of sensitivity. Higher risk companies display a greater uncertainty about future earnings and cash flows hence have a higher volatility and will have a greater sensitivity to increasing leverage (here measured as total debt/(total debt _ market cap)). The VIX Index is in certain periods a good measure for credit risk and works especially well for highly levered companies. For Ford a high correlation of 90 percent was observed for the period October 1999 to February 2004.
Ford serves as a good example. As long as Ford’s stock price traded above a certain level (here: around $14–$15) the
correlation between the stock price and credit spreads was low. As soon as Ford’s stock price dropped below this range a threshold was passed where investors started worrying about the value of the firm and its ability to cover all indebtedness. Corporate bond investors began to demand a much higher risk premium because of the fear that their investment was not covered sufficiently by Ford’s asset base. For the period between July 2002 and November 2003 Ford’s stock traded in the range of $6–$13 and we find a very high correlation between Ford credit spreads and equity of _85 percent.
The analysis of corporate bonds has to incorporate the stock performance of the particular issuer even though the asymmetric risk profile does not allow to participate in the growth of a firm. Due to the limited upside for corporate bonds and almost unlimited downside, when a credit actually begins to be distressed, market participants tend to worry about the value of the assets relative to the ability to pay off all debt. The relationship between a company’s equity and debt starts to become nonlinear when the stock price falls below a certain threshold. The equity price is a good proxy for the value of the assets of a company. The following definition establishes a relationship between the equity price of a company and its leverage:
Leverage ratio _ Total debt/(Total debt _ Market capitalization) Market capitalization _ (number of common shares _ equity price) The deterioration of the ratio (Total debt/(Total debt _ Market cap) ) above the range of 60–70 percent will result in massive spread widening and is hence a very good indicator of worsening credit quality of a company.
This ratio will especially deteriorate in times of falling equity markets (crisis scenario) and will bring additional pressure on the credit spreads.
Once again the importance of management’s integrity has to be pointed out because it is the management team which puts the business strategy in place and determines the risk profile of the company’s business and hence to a large extent its performance. We highlights some of the dimensions that the management has to consider by formulating the business strategy. Hereby the company can develop its local markets but can also choose to expand into new markets and diversify its product portfolio at the same time. A lot of noninvestment grade and lower investment grade issuers are global market leaders in their respective niche segments and benefit from outsourcing trends of their large investment grade counterparts. The business risk increases with increasing market expansion and increasing product differentiation and vice versa.
By evaluating the management team the following questions should be answered:
To what extent do bondholders pursue the same goals as the management team?
What is management’s financial philosophy?
Does management demonstrate enough commitment and what incentives systems are in place, for example, which employees qualify for a stock option plan?
How successful is management in achieving their goals?
How is the management performance monitored and how is compensation structured?
Does management or the strategic investor have an exit strategy in place?
Is the management team experienced enough in leading a highly levered firm?
How flexible is the management and how fast can it adapt to a fast changing business environment?
Is the management willing and able to adjust its business strategy to its financial situation?
How is the decision process structured, for example, is there a strong management team in place or a strong equity sponsor, a strategic investor or are all important strategic decisions made by a single person?
Are efficient information systems in place and available to support the management decisions at any time?
Does the company implement an efficient cash management system and how are the company’s resources controlled?
Are there sufficient communication channels across all job levels in the company?
How is job satisfaction measured?
How effective is the public relations policy and how important are investor relations for the company, for example, is the management able to communicate the right business strategy?
Does management assign the appropriate importance to execution risk and event risk and can the proposed strategy be implemented?
The wrong strategic decision made at the wrong time can result in a serious deterioration in the financial profile of a company. Aloss of investors’ confidence in the management team can have a direct negative impact on the trading levels (spreads) of the bonds. A conservative management team is favorable for bondholders because too aggressive strategies usually favor only shareholders. Alot of companies have incentive systems in place in the form of employee stock option plans. Especially senior management is compensated on the basis of the company’s stock performance. This easily leads to business decisions, which result in a wealth transfer from bondholders to shareholders. Bondholders do not necessarily participate in increasing equity prices if for example an aggressive growth strategy is
largely debt-financed.
Companies pursuing a bondholder friendly policy which are focused on balance sheet strength will reverse wrong strategic decisions early and take into account the small likelihood of selling a future top-performing business.
The company size has to be considered always when evaluating thecredit quality of an issuer. The size of a company can be determined either by its total assets, market capitalization, sales or the number of employees. It can be argued that large companies usually have a better market position than small- and medium-sized companies because large companies are more diversified and have different income streams (product lines). These companies have a better access to the capital markets especially in a crisis scenario (slowing economy). The argument “too-big-to-fail” is particularly right for European issuers. In Europe, politics play a big part in business decisions and it is not an uncommon practice that a government steps in and bails out a distressed company when too many jobs are at stake.
Large diversified companies usually generate earnings and cash flows from various business units. Some businesses are strategically important and others can be considered as noncore businesses. According to the market attractiveness (measured by market growth rate) and the business strength (measured by relative market share) management has to decide about the allocation of their resources. For corporate bond investors the financial discipline of companies is a key investment consideration.
Businesses in maturing markets with low growth rates but a solid market position will generate positive cash flows. These cash resources should be invested into projects in attractive fast growing markets where it is likely that the company will be able to achieve the necessary market size. If a situation occurs when a business burns a lot of cash and struggles to improve its market position then the prospects of contributing to the overall performance of a company shrink. It then depends on the management team to decide about a divestiture of such loss-generating businesses.
The SWOT analysis offers a convenient way to capture the operating risks of a company. The current strategy of a company is compared with the changes taking place in the business environment. This approach tries to incorporate the strengths and weaknesses as well as the opportunities and threats of a company in a single model and helps to identify the major drivers for success and the major reasons for failure at the same time.
By forecasting future developments and changes in a company, analysts have to be able to recognize “weak signals” in the form of badly structured information as preliminary signs of discontinuities. This task is particularly difficult, because companies try to keep detailed information from the investors in their quarterly and annual reports and during one-on-ones they never give clear statements regarding operating margins in their business units, financial forecasts and liquidity positions. The focus of forecasts is on market development strategies, because sales growth is strategically very important particularly for external investors like creditors.
Coming back to the effect on credit spreads movements, it can be said that the spreads will tend to widen when one or more of the next points are true for a corporate bond issuer:
A weak market position implies high investment costs in order to gain market share (costs resulting from the acquisition of new clients and external growth). The financial results will deteriorate in the short- and medium term. Generally, the cash requirements will be high when the market growth is high, independently of a low or high market share.
Weak numbers in top-line growth are a good indicator of problems on the operations side of a company’s business or a bad marketing strategy.
An environment with a high degree of price competition allows a differentiation against the competitors only by increasing the product quality. The provision of value-added products results in a higher budget for R&D.
Regulatory restrictions lead to an increase of operational risk. Products being in an early phase of their life cycle generally do not generate positive cash flows. Cyclical companies are always more impacted by economic downturns
than defensive (noncyclical) companies. Negative industry trends (e.g. high energy costs, change in consumer behavior, overcapacity and regulations) impact the credit quality of all companies within a sector.