Many of you have likely read or heard about the huge growth in debt over the past few decades – be it the spectacular blow out of the Greek government in 2011 due to too much debt, or more recently, the huge build-up of private debt in China. New Zealand household borrowing, which is well above many of our global peers, is never far from the headlines these days either.
Given such headlines, it is timely to outline the factors we consider when we are investing in bonds; which is when we are effectively lending our clients money to a borrower. Ultimately this is important as we need to understand if a borrower’s debt is sustainable. I call our process the “5S's of debt sustainability”.
While the ideas below hopefully offer some insight into what debt sustainability means to me, in no way are they an exhaustive list. That is, debt sustainability depends on many variables that are a mixture of economics, social structures and market psychology.
To explain these concepts, I will relate this general framework to our credit investment process at Fisher Funds – a process that centres on investing in companies with strong balance sheets while offering attractive risk adjusted returns.
The “5S's of debt sustainability”
1. The Strength of the underwriting process
This basically means how much work the lender (us) puts into finding out about the ability and willingness of the borrower to repay their debts as they fall due.
Many readers no doubt recall the US housing market crisis and perhaps the associated term ‘ninja loans’ – an acronym for ‘no income, no job, no assets’. It should be obvious that lending money to households with limited income and assets isn’t likely to end well. And, as we know, it didn’t!
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. I think by really knowing these businesses, we greatly increase our chances of supporting companies that are responsible borrowers. As the saying goes, an ounce of prevention is worth a pound of cure.
2. Servicing capacity from current and future income
The stability of income is vital for servicing interest and principal repayments. A company that has an enduring competitive advantage and a strong balance sheet is much more likely to generate stable income and therefore, have a greater chance of returning our capital.
3. The Structure of terms and conditions
Debt agreements can be arranged in many ways (e.g. fixed or floating interest rates; domestic or foreign currency etc.). But the most important feature is the term or end date of the agreement. Companies that rely heavily on short term debt face the threat of ‘roll over’ risk which is the risk too many debts come due at an inopportune time for the business.
When we invest, we look for a staggered debt maturity profile to ensure the company in question never has too much debt due in any given year, allowing it to withstand the ups and downs of the business cycle.
If the money borrowed is backed by good quality assets (collateral) this can provide added protection for lenders in case the borrower falls on tough times. However, it’s important to recognise that taking control of a borrowers asset(s) is only ever a last-ditch option for a lender. Again, there is no substitute for lending against a steady stream of income.
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.
This is why 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.
When investing in corporate bonds on your behalf, we think about the “5S's of debt sustainability” and other factors to partner alongside companies that have sustainable balance sheets for the long term. In short, we believe fixed income investors are rewarded for prudence and diligence over time.