The Importance of Credit Analysis in Today's Corporate Landscape
October 2006
Over the past several years, U.S. corporations have enjoyed a substantial run of global economic expansion, improved earnings growth, and replenished balance sheets. This environment, combined with unprecedented market liquidity and historically low default rates, has created what appears to be a relatively benign credit environment. However, we believe there are three considerations other than traditional balance sheet and income statement analysis that should be at the forefront of investors’ minds: financial policy, idiosyncratic risk, and possible defensive postures.
Financial Policy
As the corporate sector struggles to maintain organic earnings growth
and shifts its attention away from balance sheet repair, bondholders
watch in trepidation as mergers and acquisitions and equity-friendly
announcements flood the markets. While this behavior should be a
concern to bondholders, it must be considered within the context
of the entire corporate structure. Free cash flow directed to stock
buybacks may ultimately be a positive influence as the resulting
equity performance could hold corporate raiders at bay. Additionally,
free cash flow directed at acquisitions could provide the basis
for earnings growth for many years to come. While this systematic
risk persists at different levels for different industries, it is
important to determine at what level this activity is truly detrimental
to the bondholder. In this environment, where balance sheets are
healthy and earnings growth is difficult to come by, a balance of
both creditor and equity concerns may be warranted. We must understand
managers’ long-term views and aspirations for their organizations
and their industries to understand how they may deploy current and
future cash flows.
Idiosyncratic Risk
Part of the strong liquidity mentioned previously can be attributed
to the emergence of nontraditional investments, such as hedge funds
and private equity firms. While these sources can be credited with
spread tightening, as money is put to work in traditional cash bonds,
they can also be attributed to spread widening, as private money
looks to exploit under-leveraged companies with weak equity performance
and large cash balances. Companies with this profile often become
targets for leveraged buyouts. While Wall Street firms have developed
various screening methods to determine which companies may be attractive
to private equity firms, determining this type of idiosyncratic
event risk often requires a more fluid analysis that incorporates
the financial policy of the companies discussed above, as well as
an understanding of the cash needs for the company and the cyclical
nature of the industry and the specific business. Holding a large
cash balance or holding less debt than capacity may not leave a
company exposed to a leverage buyout, but determining whether this
is truly a risk is an emerging and critical role for credit analysts.
Finally, company-specific characteristics, such as family ownership
or community presence, may also play a part in these analyses.
Defensive Postures
A final focus in this low-yielding and decelerating growth environment
is the consideration of defensive posturing. While pure alpha players
such as hedge funds and equity houses search for yield, so too do
traditional long-term holders. Inherently, incremental yield has
become increasingly difficult to achieve, and many investors reach
for yield without full consideration of the underlying fundamentals.
As the proverbial tide lifts all boats, downside risks increase as
investors get paid less for growing event risk and the potential
for a slowing economy. Market inefficiencies are difficult
to find as investors shun the cyclical nature of the economy, the
market, and individual companies. Thus investors push up the valuations
of companies, sometimes regardless of their potential. Selection
of companies that offer competitive yield premiums and the potential
for fundamental improvement then becomes crucial.
Summary
The confluence of historically tight yield spreads, heightened event
risk, and the entrance of additional financial players such as hedge
funds points to the critical importance of an experienced credit
research team. We believe there is an asymmetric risk/reward profile
in the current environment. Therefore we believe that the prudent
approach is to maintain a cautious stance until the market prices
risk more favorably.