David McEwen reveals seven important things you should look at before you invest in a corporate bond

By David McEwen*

The quality of a bond is only as good as the borrower’s capacity to repay its debts.

Therefore, it pays to check out some key figures about a bond issuer before taking up its offerings. The following are particularly useful when checking out bond issues by companies.

Gearing

Debt can accentuate a company’s profits if is invested at a return greater than the cost of interest, hence the reference to its ability to ‘gear up’ returns (the term ‘leverage’ is also used for the same reason).

However, if gearing is too high, then servicing or repayment of debt becomes an issue when life doesn’t go according to plan (and when does it ever?)

Gearing is expressed as shareholders’ funds divided by its debts, and represents the margin of safety in the event of losses or a sharp fall in the value of the borrowers assets.

From a bondholders’s perspective, a low gearing level is preferable as that reduces risk of non-repayment since, if necessary, assets can be sold to meet obligations. Look for companies where debt is no more than a third of total assets.

Liabilities

As well as borrowings, companies incur financial obligations in the normal course of business, such as purchasing stock on commercial terms that require payment in 7 or 30 days.

Since this is also a risk to bond holders if such liabilities are too large or cannot easily be repaid, only invest in companies where debt plus other liabilities is no higher than 50% of total assets.

Business risk

This refers to the possibility that an outside party will not be able to meet its obligation to the company. Beware of companies that have only a small number of large clients, or where one client represents a large proportion of total revenues. 

Associated party risk

The risk rises even further if that handful includes directors or other parties related to the company. Beware of companies that have a number of business dealings with directors or senior executives or lend significant amounts to them.

Quality of assets

Items that are shown on a company balance sheet as having a certain value rarely achieve full price during a distressed sale, such as if a company goes into liquidation or has to restructure to meet its debts. This is another reason to ensure a high proportion of assets relative to liabilities.

Liquidity Profile

Company balance sheets show debt as either short-term (payable within 12 months) or long-term (longer than one year).

The more debt that needs to be paid within a year, the higher the risk unless it has an equal value of assets or expected income to cover those debts. If not, the company will have to refinance its debt and any difficulty in doing this would affect bondholder payments.

A useful rule of thumb is to look for a company where the ratio of short-term debt to short-term assets is 1:1 and that long-term debt is no more than two times its annual net profit.

Net operating cash flows

This is the amount of money received by a company after it has paid all its bills. Any surplus can be used for retiring debt or investing in the business and is a useful buffer against business setbacks.

Never, ever invest in a company that wants to borrow from you if its operating cash flows are negative.

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David McEwen is an investment advisor and writer. A free trial of his weekly newsletter, McEwen Investment Report, is available from http://www.mcewen.co.nz/free_trial

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