Now is an important time to be diligent with your clients’ credit portfolios. The health of the U.S. economy, previously on a solid growth path, is coming into question and a hawkish Federal Reserve has now become dovish and has taken any rate hikes off the table for the year.
Just as economic concerns started to develop at the tail end of 2018, so did an increase in idiosyncratic credit risks. General Electric and Anheuser Busch’s downgrades to BBB were first to dominate the headlines and were followed closely by PG&E, which faced concerns over legal liabilities following the deadly California wildfires. We call idiosyncratic stories like these—signified by uncertain events that cause an immediate deterioration in a borrower’s credit quality—“landmines.”
Landmines can inflict significant damage on a credit portfolio, especially if they lead to credit events like defaults or downgrades. I believe diversification is crucial for defending against them, but alone may not be enough in a world where idiosyncratic credit risk is potentially on the rise. No manager can afford to scrimp on the fundamentals and diligent and thorough bottom-up credit analysis will always be the most important line of defense.
Here are six of the most important behaviors, factors and red flags that advisors should continually monitor with investors:
1) Liquidity. Defaults can often be borne of a lack of liquidity. If a company is currently unable to access enough liquidity to meet its next two years’ of obligations (without any additional borrowing), it could find itself in a vulnerable position if circumstances turn against it.
2) Contingent liabilities. Some liabilities are not immediately obvious when first analyzing a company’s balance sheet. An example could be a large corporate pension plan. All may seem well at first glance if the plan is fully funded; however, if it suddenly runs into a deficit due to market movements in the value of its pension assets or changes in the discount rate of its liabilities, it could require unexpected contributions.
3) Regulatory risk. Different industries are subject to varying degrees of regulatory attention. Those under greater scrutiny (tobacco or financials, for example) could be at higher risk of adverse regulatory rulings. Therefore, besides an in-depth understanding of the company and its industry, credit analysts also need an appreciation of the evolving regulatory environment to judge the risk.
4) Event risk. Unexpected events can be almost impossible to predict with any kind of accuracy or timing. For example, a political or ecological event could cause a sudden share price reaction. However, investors can evaluate a credit’s potential vulnerability to such an event. Perhaps the most common type of event risk is the public announcement of debt-funded mergers and acquisitions (M&A) activity. The key here is for an investor to consider, in advance, the potential motivations for management to engage in future M&A. For instance, there may be pressure on management to add shareholder value in an economic environment in which organic growth is difficult to achieve. Rising costs in certain industries may also motivate consolidation to increase economies of scale and maintain competitiveness.
5) Leveraged buy-out (LBO) risk. Certain companies may be attractive targets for private equity firms looking to carry out LBOs. Such an event has the potential to leave the investor with a far more leveraged borrower than before. Investors should consider these risks with each borrower and price the risk accordingly.
6) Environmental, social and governance (ESG) factors. Most investors seem to view responsible investing factors as entirely separate to credit analysis. But in my experience, mismanagement of environment, social or governance factors can be one the greatest sources of risk. I believe that investors should continually monitor, evaluate and score how a company is managing ESG risks as an integral part of their credit analysis. Furthermore, engaging with the company to encourage it to improve its practices where required could help add further material value to a portfolio.