Tuesday, June 19, 2007

Who's scruffy looking?

Let me throw this out to the blogosphere.


There are two major reasons why a bond gets downgraded from investment grade to junk.

  • The firm's operations are performing poorly.
  • The firm chooses to increase leverage, for example through a LBO-type transaction.

So let's assume we have a firm currently rated A. They have $1.2 billion in operating profit and $300 million in annual debt service. The firm has $2.5 billion in expenses, $3.7 billion in revenue, and no non-debt liabilities. Let's say that if they increase leverage to 1.5x coverage, that would result in a junk rating. Obviously in real life, there is no magic interest coverage level that results in any given rating, so this is merely illustrative.

Let's consider two scenarios.

First, the company decides to increase leverage such that debt service is equal to $800 million, but operations are unchanged. That results in 1.5x coverage and a junk rating. But let's consider what's really happened here. The company took a look at its operations, and decided, by its own volition, that they could afford to be more aggressive with their financing. Sure, the margin of error is now much lower, and so the junk rating is justified, but given that the operating situation is stable, there is no imminent danger of default.

Contrast this with a second scenario, where revenue starts falling because of lackluster sales. If the company suffered a permanent decline in revenue of about 20% with no change in expenses, debt service would fall to 1.5x, and the firm loses its investment grade rating.

So what's the difference? In either case, a relatively small decline in revenue will result in net losses, and obviously continued net losses will lead to a default. But in one of the two scenarios, the company is failing to execute their basic strategy. In the other, they have simply chosen a more aggressive strategy. Which seems more dangerous to you?

So this begs the question, does the market go too far when repricing companies who are subject to sudden increases in leverage. Right now, Alltel bonds are trading cheaper than Ford Motor Credit, and I argue these two companies are good examples of each of the two scenarios described above. Ford is failing to execute. Alltel has made a strategic decision.

As many readers know, I own Alltel bonds, so I'm obviously biased. But forget about the specifics of the Alltel/Ford comparison. Conceptually, I'd rather own the LBO story than the fallen angel story. I'd always rather own the company that choose their situation than the one where the situation was trust upon them.

So I open it up to the blogosphere. Why does the market seemingly treat both these situations the same, when one sure seems more scruffy looking than the other? Why don't high yield buyers view LBO situations as superior to other firms? I'd love to hear the case for why the market acts as it does, either in the comments here or on other blogs. I've love for someone to prove me wrong here.

10 comments:

Vivek said...

Assuming data suggests they have an equal likelihood of default / similar recovery rates, I don't think it should matter. Are there any studies on this? I think the difference is sufficiently easily discernible to put any given junk rating in its appropriate camp (that is, risky leverage or declining fortunes).

Anonymous said...

I'm not a corporate finance expert, so it seems very possible that I'm missing something. What is the seniority of the new debt? If it's the same level of seniority as existing debt, then as a bondholder in the aggressive leverage case, management has impoverished me through a risky levered strategy. On the other hand, the fallen angel management has impoverished me through incompetence.

Presumably incompetence has its own negative consequences, but perhaps the market is signaling the agressive management that this is not the way to treat bondholders.

Anonymous said...

Wouldn't you want to look at the balance sheet in some detail? The aggressive growth story may not have much more than a sock puppet to sell off when it comes time to burn the furniture, but the stodgy old company with declining sales may have a ton of real estate carried at really old book value.

Anonymous said...

Am I missing something? On the LBO case the company actually got cash..and invested on something that at some stage will inpact positively on revenues....So unless the new debt has more seniority than old debt...the LBO case is far superior....

Anonymous said...

You asked am I missing something?
Well in the typical LBO the proceeds from the bond issue are used to buy the company from the previous owner so that by itself does not improve the company's EBITDA/cash flow.

However, proponents of LBOs would argue that higher debt service requirement forces managers to trim the fat and focus on cutting costs and generating sufficient cash flow to service the debt.

TDDG said...

Vivek:

I know that Altman did a study showing that companies that get downgraded once tend to get downgraded again. His conclusion was that ratings agencies lack the stones to downgrade as much as they should. Assuming that most downgrades are operations-related, that supports my theory.

The point it not that the LBO company doesn't deserve a junk rating, more than the LBO is better than the operational downgrade given the same rating.

Others:

Obviously the particulars of a case are imporant, such as the seniority of the old debt vs. new debt etc or balance sheet considerations. I'm more asking in theory, if all else is equal, wouldn't you rather the company with better operation situation.

Obviously the aggressive company is not acting bondholder friendly. But I'd rather the comptent management, even if they won't always be bondholder friendly, over the incompetent.

True that the LBO doesn't improve EBITDA, but it doesn't actually hurt either. The company with declining sales is seeing earnings fall.

RW said...

Isn't a portion of Alltel's debt going to be notes that allow the company to pay quarterly interest in issues of new debt? I know that's a specific rather than a more general risk (what if the new debt doesn't sell?) but it did make me think of fundamental differences between the concepts of uncertainty and risk so let me toss out that idea as a hypothesis.

This may be off base because I'm not sure how the bond market looks at things but perhaps the issue may be something like Ford and Alltel have different risk profiles since one is growing the other, apparently, not (although unlike GM I think Ford is making some good moves) but perhaps market uncertainty regarding the ability to sustain debt is essentially the same for both?

Stated another way, an LBO inevitably increases uncertainty in the same way aggressiveness can increase it (which can be perceived as risk depending upon circumstances) because, at least for a time, it may shake up the status quo but also increases the odds of positive and negative result alike (the outcome curve becomes more platykurtic, the peak falls and the tails fatten). Just a thought.

TDDG said...

RW: Nice use of platykurtic.

I think the question is less about Alltel/Ford, although I think I can make a good case why Alltel should be a lot tighter. I'm not here to prop up my positions. Its also not to say that a company which greatly increases leverage isn't worthy (?) of a junk rating. The question is more why aren't high-yield buyers putting on positions in Alltel right now. Given the universe of high-yield bonds, I argue that the company with strong operating results but high leverage is a better risk than a company with poor operating results and lower leverage.

venkateshbabu said...

It seems to be a very old blog, however I could not resist to comment on this interesting topic.

I think that what Tom said definitely holds i.e. superior management should allow Alltel a superior rating and I would hold an Alltel bond rather than a Ford bond if everything else between Alltel and Ford is same.

In the real word these two companies are not exactly identical and each has its own merits and disadvantages, which collectively contributed to their ratings. So we probably are not giving enough credit to Ford's debt by comparing the managements of the two companies as obviously Alltel has a superior mgmt. However, as anonymous indicated Ford could have valuable real estate as collateral which warrants similar rating for the two companies.

rw mentioned that LBO would result in a platykurtic distribution with fatter tails i.e. increased risk which implies that the benefits of increased leverage come with increased risk of default which warrnats a downgrade in rating.

TDDG said...

I'm not saying that the rating is wrong. Look, when Moody's says a bond is rated BB, they are saying there is a certain "expected loss" from that bond. But if you look at two companies with the same rating, one might have much better recovery and the other might have lower odds of default.

But management of a company is actively working to avoid default, they don't manage to recovery. In fact, what would happen if management of a company came out and said "Just in case we default, we're building up lots of attractive real estate assets that we can liquidate in bankruptcy."

So given that, say I'm looking at two BB-rated bonds, and both have balance sheets that justify that rating. If one has a better management team and/or more stable operations, I submit that there is a reasonable chance that management team will outperform what you'd expect just based on the balance sheet alone.