Wednesday, January 11, 2012

Dumpster Diving In The Junk Bond Market – Part 2

How to start searching for the pearls among the squishy shellfish innards

In my last post I laid out a general framework to determine when to be in and out of the junk bond market.   The problem is that much of the time the junk market is neither a screaming buy nor is it grossly overvalued, leaving us without much of a clear signal much of the time.  So what is an investor with a risk appetite and an interest in yield to do?  Assuming you wish to own junk at all in the “in between” markets, there are two viable options:

1.      Select a junk bond fund run by a competent manager with a long track record of solid performance.

2.      Pick your own individual bonds.

The first option is beyond the scope of this discussion.  Instead, I will focus on how to pick individual bonds.

First, caveats are in order.  Picking bonds, just like picking individual stocks, is not for the faint of heart or suitable anyone that does not understand accounting, financial statement analysis, and the basics of finance.  It also probably represents an increase in investment risk, especially if you do not build a diversified portfolio with a significant number of individual issuers spread across numerous sectors.  Junk bonds frequently have significant market value volatility and can rise or fall large percentages in a short period of time.  A fair number of junk bond issuers go bankrupt or otherwise restructure every year, events which virtually always result in losses for investors in these companies’ bonds.  Finally, accounting is often less robust in junk-rated companies compared with large, investment grade firms.  As a result their financial statements may be less accurate, there is almost always more work to do to understand what is going on, and the risk of fraud is typically higher.  In sum, just because these are bonds does not mean they are low risk and you can lose money on this stuff (it is “junk,” remember?).

All that said, there will still be some (fool?) hardy souls who want to pick their own bonds.  The way to make money in high yield bonds over the long term is to try to avoid as many of the eventual defaults as possible.  Sounds simple, right?  To some extent it is simple.  Relatively high debt loads as featured on pretty much every junk-rated issuer’s balance sheet must be serviced with cash.  So the game is to determine which of the junk issuers out there have sufficient cashflow to pay their creditors interest, pay down debt and/or expand the business over time, and make sure that when debt matures they either have cash on hand to pay off the maturing principal or access to alternative sources of funding.

Consider American Axle (AXL) as a handy and relatively simple example.  This company is an automotive parts supplier specializing in all the parts of the drivetrain except the engine and the transmission.  Originally spun out of GM in the early 1990s, AXL has been all the way to investment grade (before the recession and implosion of the US auto industry) and is now rated as a “single B” bond issuer.  With at least three flavors (2014, 2017 and 2019 maturities) of registered bonds available to anyone who wishes to purchase them, AXL is a fairly liquid name whose bonds are bought and sold on just about every trading day of the year.  The first place to start our analysis is the amount of debt on the company’s balance sheet.  Conveniently, AXL gave an investor presentation (link here very recently in which the company computed net debt for us of $936MM.  Net debt is simply all of the company’s outstanding debt minus cash on hand.  This seems like a big number, but how do we put it into perspective?  Most analysts use earnings before interest, taxes, depreciation and amortization (EBITDA) as a proxy for the cashflow generation capacity of a company.  EBITDA is not an exact measure of cash generation, but it is close enough to serve our purpose.  You may also wish to adjust the raw reported EBITDA of a particular company for “one time” items, such as restructuring and impairment charges, gains on the sale of assets and other unusual items which obscure the true recurring cash generation capabilities of the company in question.  AXL computes “adjusted” EBITDA for us over the last twelve months to September 30, 2011 of $370MM.  So for our first ratio, debt to EBITDA is 936/370 = 2.53X.  Generally, I like to see debt to EBITDA of no more than 3 to 4X, depending upon the volatility of the issuer’s industry (auto parts is a highly cyclical industry so we want lower debt levels).  A reasonable debt load means that a company has a hope of keeping up with payments, maintaining and growing its business (which requires cash), and reducing its debt load over time.  An excessive debt load means that a company is struggling just to keep up with interest payments and at the first bump in the road may be in serious trouble.

Of course, the debt load does not tell us the entire story in the case of AXL.  As is the case with many automotive industry companies, AXL has pension and postretirement obligations to its unionized workers.  For the sake of simplicity, we will look only at the amounts reported on AXL’s balance sheet (more details are in the footnotes to the financial statements).  AXL reports a liability of $848MM (including “other” liabilities) and an asset of $240MM for a net liability of $608MM.  Added to the company’s funded debt load, AXL has total leverage of (608 + 936)/370 = 4.17X debt and pension liabilities to EBITDA.  This is somewhat on the high side, but it is manageable, especially since almost 40% of the total liabilities do not have a maturity date (the pension and postretirement obligations).

So AXL appears to have a moderately high but manageable debt load.  We next turn to the company’s ability to meet its interest payment obligations.  Interest expense over the last 4 quarters totaled $83MM, which shows us that EBITDA/interest was 370/83 = 4.45X, a strong coverage figure.  If AXL should hit an inevitable bump in the road, the company would have to see its cashflow generation drop by over 75% before it would not be able to cover interest payments.  Since we expect the company to maintain and expand its business over time, we also want to make sure that the company generates sufficient cash to reinvest in its business.  To ensure this is the case, we look at EBITDA/capital expenditures plus interest expense.  Cap Ex over the last 4 quarters was $146MM, so our ratio is 370/(83+146) = 1.62X.  This ratio shows us that AXL is generating cash well in excess of what it needs to pay interest and keep reinvesting in the business over time.  How much excess cash?  370 – 83 – 146 = $141MM over the past year, or enough to fully retire the outstanding net debt in about 6 and a half years.  Of course we would like to see AXL pay down its debt as quickly as possible, but cutting the company’s debt in half would likely push AXL to be an investment grade credit and this appears achievable within roughly 3 years.  This further reinforces the initial indications that AXL appears to have a reasonable debt load given its business.

Next, it is always wise to assess whether a junk issuer could have an imminent liquidity crisis.  The proximate cause of death for virtually every defaulting junk bond is a liquidity crisis occasioned by either an inability to generate enough cash to service debt, or an inability to refinance maturing debt.  As AXL appears to generate ample cash to service its debt, liquidity risk would chiefly come from maturing debt.  The company does not have debt that matures until 2014, with staggered maturities thereafter at 2017 and 2019.  As backup liquidity, AXL had over $100MM in cash at September 30, 2011 and $235MM of committed bank lines available through 2016.  AXL also recently issued $200MM its 2019 bonds, which gives some indication that the company can get bond investors to refinance existing debt as needed.  Considering all of these factors and the company’s apparent ability to generate excess cash that can be used to pay down debt, AXL does not obviously have an imminent liquidity problem.

Since the ratios appear in line for the company’s industry and AXL appears to have the ability to improve its credit profile as time goes on, we now turn to a consideration of the prospects for the company’s business.  Despite making efforts to diversify, AXL is heavily exposed to trucks, General Motors and the North American market.  Here is where things get a bit murky and one must ultimately make a judgment call.  The US auto market and the Big 3 automakers have been to hell and back in the last 5 years, to put it bluntly.  However, industry volumes grew about 11% in 2010 and about 10% in 2011, ending the year on a high note.  Most industry and analyst expectations are for US light vehicle volumes to increase again in 2012, underpinned by a very aged fleet of vehicles on the road in the US, reasonable flow of consumer credit for car loans, and a slowly improving US consumer.  I find the outlook to be reasonably positive, if not outstanding.  However, there is enough uncertainty in the environment that reasonable people might believe that the future is not all that bright for the US auto industry.  It is up to every investor to decide whether the yield offered by a particular issuer’s bonds is enough to compensate them for the risk those bonds pose.

Finally, we turn to that yield and considerations of value.  Should I buy this bond?  A few months ago when investors were a bit more worried, AXL’s 2017 bonds with a 7.875% coupon could be bought for about 95 cents on the dollar and a yield to maturity of about 9%.  More recently as confidence has come crawling back into the market, these bonds have traded at 102 cents on the dollar for a yield of 7.2%.  A significant decline in yields certainly makes this bond less attractive, but is it still a generous enough yield to consider buying the bonds?  The answer depends in large part on whether your outlook for the future of the US auto market is positive or negative and what your investment alternatives might be.  As a point of reference, a 5 year treasury is currently yielding .82%, so this bond is offering yield to maturity of another 6.4% over a treasury bond of similar maturity (or almost 9X the yield).  These bonds are callable in March 2012 at 103.9 cents on the dollar, declining to 100 cents on the dollar in 2015, so price appreciation of these bonds is limited to another penny or two on the dollar at most.  Personally, I like to buy junk that has the potential to deliver at least modest capital gains in addition to some nice coupons, so I would be inclined to wait and see if these bonds dipped in price at some point.

As presented here, the calculation of metrics and ratios is just a starting point for your due diligence if you plan to buy more than an iota of a company’s bonds.  At a minimum, I would strongly encourage you to read the latest 10-K, 10-Q and company investor presentation.  Some time spent looking at who runs the company and how reputable they are is also a good idea.  If you are spreadsheet-minded, it can also be helpful to build a model of how the company generates cash and what kind of shock has to happen to get a company into trouble.

In my next and final installment on junk, I will discuss the nuts and bolts of actually buying and selling junk bonds as a retail investor.

Disclosure: I am long AXL equity and options.

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