And do not forget – coupons on bonds are contractual; a dividend is not. Instead, a dividend represents a promise – best endeavours. Additionally, bonds rank higher in a company’s capital structure than equities, which provides further relative downside protection in a worst-case scenario (default). Long-term average recovery rates for high-yield bonds are north of 30 per cent. Equities, by definition, recover very little after restructuring or liquidation.
Investing in high-yield bonds, the emphasis is different. The focus is on the avoidance of downside risk, and this entails in-depth due diligence. While the high-yield manager will perform a great deal of cash flow modelling, the main focus should be on the sustainability of the investment’s capital structure. And while it is important to understand the potential upside of any investment, it should be understood that the vast majority of return in high yield comes from the coupon. If you can avoid the ‘blow-ups’ – instances where companies lurch towards default – this will stand you in good stead.
Just like the equity analyst, the high-yield investor will examine a company’s balance sheet, its covenants, its net income statement, cash flows, liability structure and legal jurisdiction. However, the emphasis is different. High-yield investors are less interested in the growth story and more interested in ensuring that they are being paid the appropriate level of income to offset the downside risks.
Take the customer base. It is much better to invest in a business with 500 customers than in one with 20 customers. In the latter instance, the loss of a big contract could impair the company’s credit quality. But in the case of the larger company, a much more diverse revenue base represents more of a hedge against the loss of a few contracts.
When scrutinising the ongoing investment requirements of the business, while many analysts will focus on earnings before interest, tax, depreciation and amortisation (Ebitda), it is important to look at this figure after capital expenditure.
The reason? A company can cut dividends. But what are the investment requirements of the business? If times become tough, can it afford to pare back capital expenditure? If so, it can continue to preserve cash flow and thus easily service the debt structure.
High-yield analysis involves looking at the downside in every scenario: higher costs; lower revenues; lower cash flows. They should look closely at covenants. If a company is going to trigger covenants, that could potentially signal default. Are the company’s bankers motivated to show forgiveness and forbearance in such a scenario?