Beyond Fundamentals: Taking A Deeper Look at Credit Risk

Why there is often more to the story than agency ratings suggest

Many people refer to high yield bonds as “junk,” which immediately makes the issuers sound like low-quality businesses. From our standpoint, that is true for some parts of the universe but certainly not all. The high yield market has evolved substantially over the past 25 years. It now includes many high-quality businesses willing to take on more debt to finance their operations and fund their future growth.

Credit rating agencies use standard risk measures for all companies, which allows regulators and investors to understand the risk profile of each bond quickly. The agencies assess traditional measures—like debt/EBITDA and interest coverage ratios—on an absolute basis. Practically speaking, this method tends to be backward-looking and therefore doesn’t always consider the growth or decline of enterprise value as it evolves. In our view, the agencies’ emphasis on the absolute level of leverage rather than the relative level provides opportunities in the market.

Looking at the oil & gas sector as an example, when oil prices are high, the agencies view oil & gas companies as not very risky because their earnings are so high at that point in time. As we go through a cycle and oil prices drop, the agencies quickly take the opposite view. Our analysts take a more nuanced, long-term approach by looking through the entire cycle to ascertain the underlying value of the companies through the peaks and valleys of oil prices.

We examine credit risk quite differently than traditional managers or ratings agencies do. We use a loan-to-value approach in our risk management. We look at what an overall business is worth and compare that to how much debt it has. For example, if two companies have the same amount of leverage, say 6 turns debt/EBITDA, the agencies would give them the same credit rating. That is a high amount of debt, but it’s not the same if a business is worth 8 or 15 turns. We take advantage of the fact that the agencies view the two companies as having the same level of risk, especially when we see a valuable business that we believe will grow and de-leverage over time.

In sum, we are not concerned about how the agencies issue their ratings because we do our own credit analysis. We aim to identify high-multiple businesses that have a quantum of debt that makes them lower-rated, but in our view, don’t represent nearly the same level of risk.

Important Disclosures

This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of May 2023 and may involve a number of assumptions and estimates which are not guaranteed and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness, or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction. Past performance does not guarantee future results and profitable results cannot be guaranteed.

Debt/EBITDA is a ratio measuring the amount of income generation available to pay down debt before deducting interest, taxes, depreciation, and amortization.

The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense during a given period.