Thought Leadership

Fundamental Credit Analysis for Corporate Bond Portfolios

October 7, 2013

Samson’s objective in building conservative, separately managed corporate bond portfolios for small and intermediate-sized non-taxable entities, such as endowments and foundations, is to provide those investors with returns consistent with the broader corporate market by using the fewest number of positions in a focused portfolio of highly liquid credits. We believe that this can be accomplished by holding a basket of roughly 25 to 35 of the strongest-quality companies. We will discuss below that sufficient diversification can be achieved with this number of issuers. As a result, a corporate portfolio that is managed in this way can be customized for the risk/return profile desired by the client in a way that mutual funds cannot.

There are critical, practical reasons for designing focused corporate bond portfolios. A portfolio constructed using 25-35 prominent issuers typically has a cost advantage over an approach wherein a larger number of smaller lots are held. With fewer numbers of bonds in a portfolio, fewer transaction fees are incurred. Furthermore, when we build portfolios with corporate exposure, it is essential to maintain liquidity by investing in larger, more easily traded blocks. These concentrations enhance our ability to buy and sell securities for small to medium sized accounts opportunistically and at the best prices. Samson focuses on companies with credit ratings of A or better. We believe that the yield differential for securities below that level does not justify the additional risk. The universe is then limited by size, and very liquid bonds (greater than $750 million in issuance) are chosen to enhance the ease of trading. This results in a list of approximately 135 potential investable names. It is from this group of high quality, liquid securities that fundamental analysis commences, which is the focus of our strategy.

Samson’s macroeconomic view is blended with bottom-up research to identify industries that have the potential to outperform. Then, the best-in-class players in that sector are analyzed. To be considered for investment in the strategy, the company must have manageable debt levels, solid cash flow, and an attractive valuation. By client demand, additional consideration may also be given to exposure to environmental, social, or governance risk factors.

Traditional corporate strategies seek to diversify through the absolute number of securities they hold, but this can lead to hidden concentration by industry, geography, or economic drivers. For example, General Electric is widely viewed as a diversified conglomerate. However, when the layers of the onion are peeled back, significant EBITDA is clustered in financials (44%), energy infrastructure (26%), aviation (13%), and healthcare (11%). Thus, the true industry exposure of the portfolio is understated in those areas. Many other large industrial and financial names exhibit similar structural characteristics. Our objective through the analysis is to ensure that portfolios are not only diversified by name, but by cash flow source, and economic sensitivities.

Samson’s corporate credit process is built on information transparency, which is an essential characteristic in all names that we approve for purchase. Institutions with excellent corporate governance are identified, and management is evaluated through factors including strategic vision, market communication, and implications of company strategy for bondholders. Companies are favored that offer clear financial disclosure, so that the unique risks faced by each business can be better understood. This has led to our preference for industrial companies over financial institutions.

Industrials typically have simpler balance sheets, based on tangible products that have a hard asset value in times of extreme distress. As seen during the Great Recession, financial institutions held a wide variety of complex products, and investors were unaware of the deep underlying risks undertaken by those companies. Many of these financial instruments lost nearly all of their value. By focusing on transparency, we believe that downside potential can be minimized, and market returns may be realized by understanding the key financial drivers.

Let us take a closer look at the credit implications of the approach. Comparing the sector allocation of our model corporate portfolio to the S&P 500, we see a lower allocation to information technology, along with a higher concentration to financials. This is to be expected, as IT companies typically do not carry debt, while financial institutions rely on extensive leverage in their business model. However, this comparison merely highlights which sectors are more likely to issue equity rather than debt.

When sectors are compared with the Barclay’s Intermediate Corporate Index, seen on the prior page, we find our exposures are more closely aligned with debt market characteristics. To achieve diversification with 25-35 holdings, we select companies that broadly represent the sectors, such as IBM for technology. IBM offers a sizeable mix of diverse hardware components, complemented by a full suite of software offerings, as seen in the chart to the right.

Samson’s fundamental approach to managing our corporate credit holdings with sector, economic, and cash flow diversification as key factors provides a diverse portfolio more effectively than employing a large number of holdings that have not gone through this process. Our focused approach on best-in-class players with large issue size ensures liquidity while achieving broad bond market exposure. This conservative portfolio construction approach is ideal for small and intermediate-sized endowments and foundations who want separately managed accounts to meet their investment objectives.

 

Jeff Wimmer

Corporate Credit Analyst

 

October 7th, 2013

 

No representation or assurance is made that Samson High Grade Core Intermediate Strategy will or is likely to achieve its objectives, or will make a profit or will not sustain losses. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. Samson does not provide tax, accounting or regulatory advice. ANY TAX STATEMENT CONTAINED HEREIN IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY PERSON, FOR THE PURPOSE OF AVOIDING TAX PENALTIES.

Past performance is not indicative of future results. Performance reflects the reinvestment of income and other earnings. Any benchmarks or indices shown are for illustrative purposes only, are unmanaged, assume reinvestment of income, and have limitations when used for comparison or other purposes because they may have volatility, credit or other material characteristics (such as number and types of securities) that are different from (HGCI). Certain information is based on third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed. This information is confidential, is intended only for intended recipients and their authorized agents and may not be distributed to any other person without our prior written consent.