Credit research is tough enough without trying to do it with one arm tied behind your back. Back in the day, credit analysts would diligently put together massive spreadsheets with all kinds of metrics that explained all aspects of a company’s financial performance and credit strength. These days, however, you have quant geeks trying to boil everything down to one number that “explains it all” so that picking relative value is somehow “easier.” The most common relative-value graph produced by the Street these days is a plot of leverage versus yields. Well, in our view, easy isn’t the best in the world of high yield credit. We’ve seen numerous “credit pickers” out there focused entirely on leverage, who have totally forgotten the rest of the important credit metrics, particularly, coverage.
Let’s Define Our Terms
First, two definitions. 1: Leverage – In credit analysis, the most common measure of leverage is to take a company’s total balance sheet debt and divide that total by EBITDA (earnings before interest, taxes, depreciation, and amortization – a rough measure of cash earnings that could be available to service debt payments). The higher the result, the higher the leverage and, all else being equal, the more risky the credit. 2: Coverage - This figure gauges the number of times an earnings measure covers an expense measure, for instance, EBITDA divided by interest expense tells us how “safe” a credit is by looking at how much cushion there is, or how many times earnings could “cover” the interest payments – hence coverage. When rates were at much higher levels, i.e. more normal, credit analysts would talk about leverage and coverage at the same time and a common understanding developed on what the pair of numbers meant. So it was perhaps natural to try and boil the research down to a single measure – leverage.
Back to the Point
So we often talk about the leverage and the coverage of the companies in our high yield portfolios. Other analyst teams do the same thing, but over the years they’ve increasingly dropped coverage from the discussion and just focused on leverage, as if that measure alone told you everything you needed to know about a company’s risk profile. However, with high yield rates down around 6% versus the average over the past 20 years of around 10% (Source: J.P. Morgan, Credit Strategy Weekly Update, October 18, 2013), the relationship between leverage and coverage has changed. A company with 5-times leverage issuing debt at 6% will have much better coverage now, compared with that same company issuing the same amount of debt in a 10% environment. The cash flow for a given company can support more debt than it could in a higher-rate environment.
So how much more leverage can a company carry at the current low rates and keep its coverage the same? To have the same amount of coverage, a company could carry two-thirds more debt, or leverage. To illustrate, here’s a quick example: Today “Average High Yield Company X” issues $150 million of debt at 6%, and has $25 million of EBITDA. With $9.0 million per year of interest expense (6% times $150 million), we would have these metrics: Interest Coverage of 2.77 times and Leverage of 6 times. With rates at 10%, this same company would have only be able to “afford” $90 million of debt if it wanted to maintain 2.77 times coverage, but their leverage would have to be much lower – around 3.6 times.
This is why we look at a myriad of credit metrics, their trends, and, most importantly, future expected metrics, when judging overall credit quality. Managers who are showing you pretty graphs of leverage versus yield may have the wrong portfolio of future outperformers! Credit research isn’t an easy or a simple job, and “dumbing it down” to one metric could prove to be a huge oversimplification and a big mistake.
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