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PODCAST: The Importance of Credit Quality in Selecting Fixed Income Investments

Podcasts

  • Transcript

    [MUSIC PLAYING]
    Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, president of BMT Wealth Management.

    [JENNIFER FOX] Hello, everyone. We’re excited to discuss the importance of credit quality in selecting fixed income investments. I’m here with Jim Barnes, senior vice president, director of fixed income at Bryn Mawr Trust. Jim, there’s been much discussion regarding the corporate bond market and the overall financial health of its issuers. What exactly are the markets focused on?

    [JIM BARNES] There are a few things, Jen, that the market’s been focused on. First, increasing corporate debt levels. Since the 2008, 2009 recession, corporations have taken advantage of low borrowing cost, and collectively increased the amount of outstanding debt on their balance sheets. Intuitively, from a financing perspective, it makes sense for firms to borrow when interest rates are low. However, given the amount of outstanding debt that’s accumulated over the years, investors are concerned some corporations may have gone in over their heads.

    Second, coinciding with higher corporate debt levels, are simply higher interest rates. The Federal Reserve has been more aggressive in raising interest rates the past couple of years, which has contributed to higher borrowing costs for corporations. Investors are concerned that more debt combined with higher funding costs will ultimately lead to much higher interest expense down the road.

    And lastly, there are concerns about the economic growth. Many believe US economic growth will decelerate this year, given less accommodative monetary and fiscal policy. A slowing US economy will be an ultimate drag on corporate revenues and profits that translates to less money available for companies to use to pay both interest and service their debt.

    [JENNIFER FOX] Jim, it sounds like we’ve got a lot of headwinds coming our way. So we’ve got an environment consisting of high debt levels, increasing interest expense, and declining revenues and profits. So what do you and the fixed income team at BMT focus on when doing credit analysis for an issuer?

    [JIM BARNES] I’m not overly concerned with today’s environment, but I think it is always important for investors to do their homework prior to any investment. The environment for corporations is changing, but that does not mean firms are not prepared. The issues noted above will impact companies in different ways, depending on how each company is financially positioned.

    For example, a company may have issued a lot of debt, however much of that cash has yet to be spent. So while the amount of debt outstanding is high, so is the firm’s cash balance. High cash balances are a positive when looking at a firm’s overall liquidity.

    [JENNIFER FOX] So that makes sense. Other than having high cash balances and liquidity, what are some of the other reasons corporations are issuing debt? At the start, increasing cash balances doesn’t seem like that bad of a thing.

    [JIM BARNES] Companies have issued debt for a variety of reasons, and some more productive than others. Mergers and acquisitions, stock buybacks, and dividend payments to shareholders have been very common. Many firms have also simply chosen to reinvest back into their business, either through capital projects or increasing their working capital. Whatever the reason, it is important to monitor the firm’s cash flow or the amount of money at the firm’s disposal to service its debt. Having the ability to generate high levels of cash is a positive when reviewing the financial health of an organization.

    [JENNIFER FOX] So Jim, earlier you mentioned taking into consideration a firm’s cash position with outstanding corporate debt. What else do you think is important to review when selecting fixed income investments?

    [JIM BARNES] I think you have to look at different financial metrics, such as the leverage and coverage ratios, combined when assessing the financial health of a firm. A starting point is to make sure the firm has a manageable debt level given its overall size, as well as its ability to generate enough cash flow to service its debt.

    With this in mind, we will look at the amount of outstanding net debt– so that’s debt less cash– relative to the firm’s EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. This metric gives us an idea of how much debt the company has relative to its size, as well as its annual cash flow generation ability.

    Another common ratio is comparing the firm’s EBITDA to the amount of interest expense the firm pays out each year. This metric speaks directly to the company’s ability to service its debt from its earnings each year. A high number means a company has plenty of cash to pay its debt service obligation each year, which is definitely a good thing.

    [JENNIFER FOX] It is a good thing. But are you concerned that corporate credit quality will deteriorate?

    [JIM BARNES] It’s very important to remember that the economy moves in cycles, meaning good times follow bad times and bad times follow good times. The US economy has been in expansion mode since 2009, roughly 10 years. It’s only natural for a period of economic weakness to follow a period of economic strength.

    Currently, the cycle appears to be turning to the downside, although there is much debate regarding the timing. As for corporate deteriorating credit quality, it’s natural for companies to face more challenges when economic conditions aren’t as benign. I think the environment is changing, but I believe that corporations will adapt to it, as well.

    Corporations will likely adjust their financing of business activities in coordination with the overall health of the economy. With that in mind, companies will vary in how they are financially positioned, as well as the path they choose to navigate any tough economic times. This brings me back to my initial statement, that it is always important for investors to do their homework prior to any investment.

    [JENNIFER FOX] So Jim, does anything stick out to you as being different from a credit perspective when comparing this business cycle to prior cycles?

    [JIM BARNES] Well, given the duration of this expansion and a long period of benign borrowing cost, corporations have had ample time to take advantage of it. The rating agencies have certainly noticed, given the number of credit ratings assigned to issuing firms. There are generally two broad types of classifications– investment-grade ratings and junk. The former category is for the financially strong companies, and the latter is saved for the weaker.

    Within each of these two categories there are different levels of financial strength to help investors distinguish between the strong and the stronger, as well as the weak and the weaker firms. There are a very large number firms that are on the fence between investment-grade and junk. There are investor concerns that today’s investment-grade companies can very well end up being tomorrow’s junk bonds.

    [JENNIFER FOX] Do you believe that that concern is valid?

    [JIM BARNES] I do think that we will see more firms downgraded from investment-grade to junk, but simply because there are more of them. There are many firms that appear weaker based on credit rating, but have been very successful in managing their cash flow. And of course, you have those firms that may have borrowed beyond their means and will have difficulty servicing their debt going forward.

    In general, there will be more downgrades during periods of economic distress. I believe that the economy takes a turn for the worse, credit quality will deteriorate. And given the number of firms that have increased their leverage over the years, this downturn may be felt by a larger group of firms relative to prior years. It is difficult to predict the severity. However, it brings me back to the importance of doing your homework prior to making any fixed income investment.

    [JENNIFER FOX] Jim, thank you very much for joining me today. Your comments and insights are very helpful.

    [JIM BARNES] You’re very welcome, Jen. Very happy to help.

    [AUDIO CONCLUSION/CLOSE]  This has been a production of Bryn Mawr Trust, copyright 2019, all rights reserved. Visit us online at BMT.com/Wealth.

    [MUSIC PLAYING]

    The views expressed herein are those of Bryn Mawr Trust as of the date recorded, and are subject to change without notice. Guest opinions are their own, and may differ from those of Bryn Mawr Trust, its affiliates and subsidiaries. This podcast is for informational purposes only, and should not be construed as a recommendation for any product or service.

    BMT Wealth Management provides products and services through Bryn Mawr Bank Corporation and its various affiliates and subsidiaries, which do not provide legal, tax, or accounting advice. Please consult your legal, tax, or accounting advisors to determine how this information may apply to your own situation. Investments and insurance products are not bank deposits, are not FDIC-insured, are not backed by any bank or government guarantee, and may lose value. Past performance is no guarantee of future results. Insurance products not available in all states.

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