Protect portfolios from bad corporate bonds

In 2013, when chemicals giant Dupont Co. announced it would spin off its performance chemicals company, Chemours Co., investors didn’t know Chemours would soon be dropped into hot water.

Information was about to emerge that would be critical to investors buying either Dupont or Chemours securities: wells and waterways in Ohio and West Virginia were contaminated with a toxic chemical that Chemours used to coat Teflon.

Dan Cooper, vice-president and portfolio manager for Mackenzie Investments’ fixed income team, recalls that these environmental liabilities weren’t reported “front and centre.” He saw them buried in a 2015 offering memorandum for Chemours bonds, which noted significant environmental liabilities that “could be material” to its results, and the company would be “required to indemnify DuPont for uncapped amounts.”

Cooper’s firm sold the small bond position it held. Today, cleanup operations and lawsuits are ongoing, with Chemours facing over a billion dollars in liabilities, largely through thousands of lawsuits claiming illness or death from the chemicals.

“You can’t rely solely on the financial statements and the notes. Sometimes you have to go into more depth, into the risk factor section, or the liquidity section or the capital structure section. All are important in their own ways,” Cooper says. “You’ve got to be cognizant of it, and make sure you’re adequately compensated for those risks.”

Debt watchers

Fixed income PMs and their researchers, well-aware of the global credit boom and the effects of cheap financing, are scrutinizing financial statements for overall corporate health, debt levels, red flags and, importantly, what companies are doing with their debt.

When leverage is at an all-time high, payback is questioned, especially amid recent speculation of inflationary pressures and rising interest rates. Financial statements are combed and corporate track records reviewed to understand a company’s ability—and willingness—to meet its obligations.

“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.”

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 are looking at whether the debt on the balance sheet is growing, and if so, what it’s funding. Higher ratios might be 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 Cooper, adding that its acceptable debt level can change according to what the borrowing is funding. He holds Resolute Forest Products, he says, in part because it’s using debt to expand into tissue paper and move away from less-stable newspaper products.

Financial engineering

Issuing bonds to fund dividends or share buybacks has become 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,” Allen says. 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.

‘Trumpflation’ expectation spurs bond sell-off

Donald Trump’s surprise victory on November 8 rattled bond markets.

Trump’s plan for massive tax cuts and government stimulus, combined with a more protectionist approach to trade, triggered expectations of rising inflation and interest rates in the U.S. and a sell-off in corporate and government debt.

Bond prices sank and yields skyrocketed in the week of the vote, wiping more than US$1 trillion in value from bonds globally. Ten-year Treasury yields reached their highest point since January.

Ray Dalio, founder of the Bridgewater Associates investment management group, declared in a LinkedIn post: “[W]e think that there’s a significant likelihood that we have made the 30-year top in bond prices. We probably have made both the secular low in inflation and the secular low in bond yields relative to inflation.”

This so-called financial engineering may also come in waves for each sector as companies respond to competitors. In 2013—amid Target Corp.’s entry into Canada and Walmart’s expansion—Empire Co. (owner of Sobeys) bought Safeway Inc.’s Canadian division.

The same year, Loblaw announced it was buying Shoppers Drug Mart. With few options for acquisitions or spinoffs—aside from the 2014 purchase of a stake in Quebec bakery chain Première Moisson—Metro Inc. substantially increased its share buybacks, boosting its stock 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

Free cash flow, and whether it’s growing, is key to whether the 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 at 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, for instance.

“What’s the mix of assets on a balance sheet? Is it goodwill? Is it property, plant and equipment? Is it inventory? Is it account receivables, and how have those trended for the business over time?” Rothman says.

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.

Adjusted numbers, and 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. Inconsistencies year-over-year can also raise eyebrows.

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.”

Credit ratings

Bond prices are relative to their ratings, making it important to scan financial statements and information from management for leads about creditworthiness. Perhaps management has indicated a company change that hasn’t yet been reflected in the ratings. The idea is to sell bonds before they’re downgraded or buy before they’re upgraded.

TD assigns its own ratings to companies, which could differ materially from the ratings agencies because they factor in headwinds or coming events. Agencies, Allen says, having themselves become more formulaic due to regulations, have removed subjectivity.

Allen’s firm uses more subjective information like future events. It might assign a higher rating to a company involved in an infrastructure project, for instance, if the government has a high level of commitment to it.

Weathering a storm

All of this makes understanding a company’s ability to repay debt the easy part. The hard part is predicting outcomes. Having lived through the 2008 crisis, and in preparation for the end to this credit cycle, PMs have been looking at companies’ liquidity.

“Do they have enough cash on hand, and do they have access to bank facilities or credit lines that won’t disappear when push comes to shove, when things turn negative for them?” Allen says. “The industry spends a lot more time looking at liquidity in worst-case scenarios.”

Rothman adds: “I can’t predict the future, but I can say, ‘Here are all the things I think could happen,’ and assign a probability to that.”

Debt binge

While bond yields have surged since the U.S. election, companies continue to hold record levels of debt on years of ultra-low interest rates.

In Canada, non-financial corporate credit was 112% of GDP in Q1 2016, up from 89% in Q1 2007, says data from the Bank of International Settlements. In the U.S., non-financial corporate debt is much lower at 72% of GDP, but up from 66% in Q1 2007, the year before the financial crisis.

The BIS data showed total debt for Canadian governments, companies and households was nearly US$4.5 trillion in Q1. That’s 288% of Canada’s GDP and a higher proportion than that of the U.S. (252%), U.K. (266%) and Italy (277%).

In the U.S., members of the Fed are worried. Deep in the minutes of the September meetings, it was noted: “[a] few participants expressed concern that the protracted period of very low interest rates might be encouraging excessive borrowing and increased leverage in the non-financial corporate sector.”

Caryn Rothman, fixed income analyst for Manulife Asset Management, says: “Folks do tell me that leverage is increasing. We need to see earnings growth follow in order to support that, long term. You don’t want to be increasing your obligations when your revenues and profits are not increasing at the same rate. You can’t do that indefinitely.”