19 November 2020

    Assessing debt sustainability

    Choosing quality fixed income investments

    Quin Casey (CFA)

    Credit Portfolio Manager

    Email Quin
    Quin Casey (CFA)

    Credit Portfolio Manager

    Email Quin

    At Fisher Funds, we invest into equities, but we also invest into fixed income securities. These securities are debt obligations and we make sure that when we invest into them, the debt burden for the borrower is sustainable. By doing this, we can invest with conviction and can enhance returns to our clients despite the currently low level of interest rates.  

    Indeed, many of you have likely read or heard about the growth of various debt obligations over the past few decades – be it Greek government debt, private debt in China, or more recently, concerns over the future increase in New Zealand public debt reflecting the large fiscal response to the coronavirus outbreak.   

    Given such headlines, I thought it would be timely to outline a simple framework of factors I consider when trying to understand if a borrower’s debt is sustainable. I call them the “5Ss of debt sustainability”.

    To explain these factors, I will relate them to our corporate credit investment process which centres on investing in companies with robust business models and strong balance sheets. Examples of such companies include TR Group, Summerset Group Holdings, Port of Tauranga and Spark - businesses with corporate bonds that we have been hand-picked on your behalf.   

    So, let’s begin. The first factor to consider when assessing debt sustainability is

    1.Strength of the underwriting process.

    This basically means how much work or effort the lender puts into finding out about the ability and willingness of the borrower to repay debts as they fall due.

    At Fisher Funds, our credit assessment process is built on a thorough understanding of the business and financial risk profiles of the companies we lend or invest into. By really getting to grips with underlying business dynamics, our team increases the likelihood of supporting companies that are responsible borrowers. As the saying goes, an ounce of prevention is worth a pound of cure!

    2. Servicing from current and future income

    The stability of income or cash flow is vital for servicing interest and principal repayments. For companies, debt servicing capacity is captured by the free cash flow generated by the business, which is greatly enhanced if the company has an enduring competitive advantage and a strong balance sheet.

    A thorough analysis of a company’s cash flow is a necessary requirement when investing in corporate bonds and our team takes the time to understand where cash comes into a business and where it flows out.      

    3. Structure of terms and conditions

    Also influences debt sustainability. Debt agreements can be arranged in many ways (e.g. fixed or floating interest rates; domestic or foreign currency etc.) but the term or end date of the debt is important. Companies that rely heavily on short term debt face the threat of ‘roll over’ risk which is the risk of too many debts coming due for repayment at an inopportune time for the business.

    When investing in corporate bonds, it makes sense to seek out companies with staggered debt maturity profiles as this contributes toward balance sheet strength and improves a company’s ability to withstand the ups and downs of the business cycle.     

    4. Security

    Good quality collateral can provide downside protection for lenders in case the future turns out differently from initial expectations. But enforcement of security by creditors should be considered the last repayment source for a lender. To reiterate, there is no substitute for lending against a steady stream of cash flow and as above, analysis of free cash flow is at the heart of our credit research process.

    5. Stability of the legal framework

    After all, debt is a contract between a lender and a borrower. Though often in the background, legal details contribute to the confidence lenders have in their rights to receive repayment. For this reason, we focus on investing in parts of the world with a strong rule of law, rather than veering into territories where the rule book can be changed overnight.     

    We keep the above factors in mind when looking for companies with robust business models and strong balance sheets that can pay back their debts as promised.

    By doing this, we enhance our commitment to you: expect greater lifetime savings.