Bottom-Up Corporate Bond Analysis: Key Factors for Investors

As is well known, there are two basic strategies in investment research generally, and specifically in bond research – often referred to as the top-down and bottom-up bond analysis. Gimme Credit analysts use bottom-up bond analysis. It is our core ethos, which focuses on individual company analysis starting at the micro level. While industry trends and macroeconomic factors are considered contextually, they are considered secondary and less influential but certainly not ignored.

A top-down approach focuses on macroeconomic analysis and market and sector trends and eventually drills into individual company credit analysis. However, due to broader economic analysis, this strategy can make it challenging to identify undervalued (or overvalued) corporate bonds, especially if the sector performance is at odds with individual issuers

When analyzing a company’s credit rating, a foundational element is in examining income statements, balance sheets and cash flow, analyzing metrics such as:-

• EBITDA margins
• Free cash flow yield
• Interest coverage ratio
• Net debt/ EBITDA

It’s also important to appreciate leverage ratios as these can cast a very different light on a company’s finances. For example, a relatively high level of debt might appear unsustainable, but if supported by robust internal cash flow, this may not be a problem.

The fundamental analysis of company balance sheets is complemented by a review of earnings and their sustainability going forward. Many companies issue adjusted financials, but we prefer to work from actual financials and make our own adjustments which could take into account:-

• One-off items
• Non-cash charges
• Capitalized expenses

While there are legitimate reasons for adjusting company financial statements, they can also mask operational challenges. It’s important to remember that the company’s finances reflect the quality of management, which will impact any corporate bond recommendation.

The value of financial ratios is best demonstrated when the figures are calculated using a consistent methodology. These ratios can be extremely useful when comparing and contrasting historical figures as well as when calculating relative value to the broader sector.

One of the more basic credit metrics is the credit spread, the difference between Treasuries, investment-grade, high-income, and emerging bond yields. While this reflects market sentiment at the time, it can identify potential imbalances in specific company bonds’ risk/reward ratio. Yield spread analysis can also help determine the relative value of bonds issued by the same or different issuers.

Other technical factors which can help when assessing a company’s creditworthiness include:-

• Debt to equity ratio
• Return on invested capital
• Interest cover

Gimme Credit uses an in-house credit scoring system rather than third-party credit rating agencies, which enhances our flexibility and reaction times. Our scoring is much simpler than the credit rating agencies, reflecting the expected direction of the company’s finances over a six-month period.

In a perfect world, a bond issuer would operate in a growth industry and hold a strong market position. Consequently, it’s crucial to appreciate the industry dynamics and the issuers’ market position when researching corporate bonds.

This helpful model considers the impact beyond the issuer and their direct competitors in assessing future growth prospects. There are numerous factors to consider, such as:-

• Competitive rivalry
• Supplier power
• Buyer power
• Threat of substitution
• The threat of new entrants

When planning for the future, a successful company may be tempted to look inward rather than outward, which is a form of confidence bias. Porter’s Five Forces Analysis helps identify and assess broader issues.

Even where an issuer has a relatively stable market share, protected by a competitive moat, there may be restrictions on short, medium and long-term sector growth. This could prompt management to look elsewhere, risking finance on new projects with less certainty and visibility.

While a company’s financials are paramount when assessing creditworthiness, its internal management and corporate governance structure are also critical. Management’s track record is a significant factor when considering the relative value of bonds, whether looking at the broader corporate governance framework, ESG credentials, or even executive compensation alignment.

Other aspects to consider include a company’s dividend payout policy, share buyback history, capital allocation, and return on investment. This strengthens our policy of using unadjusted financials, as adjustments can mask management shortfalls. The true value of any management team tends to emerge in challenging times, whether specific to companies, sectors, and markets and how they react.

The greater the buffer between funding available and finance required, the less the risk which will impact the risk/reward ratio. We need to get close to this detail, and bottom up bond analysis is the only way.

Liquidity ratios such as the quick ratio (including cash and liquid assets) and current ratio (also including company assets) provide valuable indicators of the relative liquidity of an issuer. Management may also have access to unfunded credit lines, commercial paper markets, and other short-term finance tools, which must be considered when analyzing liquidity and cash flow.

While the bottom-up bond analysis approach lessens the significance of macroeconomics, it’s important to appreciate the assumed direction of interest rates and the cost of finance. Stress-testing cash flows under various adverse scenarios could reveal shortfalls or strengthen the case for buying specific bonds.

One factor often overlooked by investors is event risk and covenant analysis, which can identify potential negative and positive scenarios that may not be obvious at first glance. Although predominantly used to protect bond investors and bring a degree of clarity to the market, they can also be counterproductive in some circumstances.

For example, if the coupon on a bond diverges from base rates more than a predetermined level, the issuer may be able to redeem early. On the other hand, a merger and consolidation covenant could oblige the new entity to assume all obligations connected to the bonds in issue. Even though many of these scenarios may never emerge, they need to be considered when assessing the relative value of corporate bonds.

Again, only an approach which looks at the legal structure of the business from the ground up would help ameliorate this kind of risk.

As you can see, there are numerous factors to consider when using a bottom-up bond analysis approach to corporate bond analysis. Issues such as unadjusted balance sheet financials to basic cash flow, sector strength to the industry outlook and relative value are just a snapshot of the analysis process. It’s important to appreciate that while the focus is on individual issuers and their bonds, the outlook for the sector and the economy is also considered, although more of a secondary consideration.

If you would like to know more details about the way we arrive at our bond recommendations, visit our bond research page.