The Human Factor in Credit Investing
At first glance, this is a good time to be a credit investor. Admittedly, interest rates, which, at least in the US appear to be turning, could force bond prices to crater. However, savvy investors can use derivatives to disaggregate that rate risk, thereby locking in spreads on investment-grade (IG) credit that currently price in 5-year cumulative default rates of nearly 6%. To put into context, this is over five times the average 5-year default rate on investment grade credit since 1970 (1.1%) and double that of the worst 5-year cohort since 1970 (2.36%).
These spreads make little fundamental sense. IG corporates in the US are sitting on $1.4trn in cash ? enough to cover over five years of maturities. Moreover, QE is facilitating record levels of IG debt issuance, while even the ?hairiest? high yield names seem able to refinance — hardly circumstances in which default rates are set to spike.
But liberality creates licence. Remember that companies are customarily run to maximise returns for shareholders. The companies? senior executives ? the C-suite ? are theoretically there to ?steward? their companies? assets to achieve the greatest return for shareholders. The growing institutionalisation of share ownership — mutual funds, ETFs and hedge funds — has increased the focus on shareholder value maximisation, since investors in such bodies prioritise financial returns over other interests in the companies. Moreover, the executives themselves are often incentivised and have the necessary risk appetite to lead the process.
And therein lies the threat: hoarding cash at nugatory or even negative rates doesn?t do much for shareholder returns. Absent better investment opportunities, shareholders will either demand their cash back or look for managements to jack up returns with historically cheap leverage. C-suites at companies with languishing relative returns often find themselves negotiating with ?activist? shareholders, who seek to force them to adopt more aggressively shareholder-friendly policies. GM, which filed for bankruptcy and was bailed by the US taxpayer, was forced by activists to return $5bn to shareholders. Such action can leave creditors high and dry. Unlike shareholders, who can fire management, the only protection creditors enjoy is the covenants they negotiated into credit agreements. In IG credits such protection is often token.
Unfortunately, no amount of poring over financial models will help credit investors determine which investments are at risk. Rather, they need to understand the nature and motivation of the C-Suite and the structures that contain and channel those motivations, since these are the individuals who decide the degree of financial risk to assume. Look at what senior management have done before; what was their attitude to risk? To creditors? To change management? What boards do they sit on? What kind of social networks do they operate in? Pore over proxy statements to understand their financial motivations. What about the shareholder structure? (In contrast to GM, it is unlikely Ford?s management could have been bullied into a buyback since the Ford family controls voting rights through a dual shareholder structure). And examine governance. Not in the tick-box approach fostered by regulators, but in substance. A company, for instance, might make obeissances to governance norms by separating the CEO and Chair but, if they are related, or close friends, or the Chair is subservient to the CEO, what of it? Finally, credit investors really need to get behind the numbers that companies present. The growth in alternative forms of funding could mean that a company is employing many kinds of leverage that does not appear on the balance sheet: sale-leasebacks, off balance sheet securitizations, reverse factoring, to name but a few.
Over the entrance to Moody?s old building was engraved: ?Credit: Man?s Confidence in Man?. Whatever they got wrong in the last crisis, this much they got right. Credit investment is an act of faith in people ? the company?s executive and board. To understand which credits will be adversely affected by the current surfeit of liquidity, place the human factor ? management ? front and centre in your analysis.
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