Fundamental Analysis of Credit Markets: The Quest for Value and Income

The CFA Institute Fixed-Income Management Conference is an annual event focused on global debt markets, fixed-income sectors, security selection, and portfolio construction. The Fixed-Income Management 2019 Conference will bring together researchers, analysts, portfolio managers, and top strategists in Boston, Massachusetts, on 17–18 October.

Mutual funds typically keep their analysis regimens close to their vest, but at the CFA Institute Fixed-Income Management 2012 Conference, the co-president of Dodge & Cox Funds, Dana M. Emery, CFA, described in detail how she and the members of her famed research team conduct fundamental analysis of credit markets. Importantly, the firm insists that each analyst act as if they are owners of the business when reviewing securities. This philosophy tends to focus analyst work on important business-related, cash-flow-impacting issues.

Emery also noted that several factors made the environment a particularly fertile time to conduct fundamental analysis of credit markets, including:

• The rapidly growing size and complexity of credit markets in recent years.
• Increasing sector diversification.
• All-time low yields.
• Nearly all investment grade sectors, such as banking, at multiyear tight (i.e., narrow) credit spreads; though, 10-year senior unsecured bond spreads are wider than historical averages.
• Strong industrial balance sheets in the United States, which led Dodge & Cox to feel that companies will eventually start spending.
• Improving bank capital ratios.
• Significant default risk compensation as measured by the size of average credit spreads relative to historical average default rates.

Fundamental analysis focuses on economic and industry factors, as well as company-specific facts and expectations. Additionally, Dodge & Cox assesses issuer liquidity in a deep-dive way by evaluating sources of liquidity and calls on liquidity, such as contingent liabilities, as well as anticipated strategic transactions (i.e., mergers and acquisitions) that are likely to require additional debt to finance.

When it comes time for analysis of a specific issue, Emery’s analysts do a recovery value assessment. While typical default recoveries average 40%, each recovery situation is different. Therefore Dodge & Cox evaluate the quality of a company’s assets and the ability of a company to generate cash flow over an entire economic cycle.

For each security a full valuation analysis is conducted and a full research report written. Emery’s team begins by considering a starting valuation based on option adjusted spreads (OAS). It is the firm’s view that you have a higher chance of outperforming treasuries — assuming there are no credit issues identified — the higher the OAS is at the outset.

Despite this rigor, Emery’s analysts also uses credit ratings to supplement individual analyst models, because they think that credit ratings provide a good source of independent judgment separate from their own. Similarly, the firm studies ratings agency bankruptcy reports, categorizing what caused bankruptcies so they can learn from the past. For example, in the last cycle, the worst bankruptcies had similar criteria, such as: being thinly capitalized; having significant asset growth; having a high cost basis; and being wholesale funding reliant.

Thinking like an owner also tends to lead to more rigorous risk management because it forces analysts to consider the nuances of individual credits and issues. After all, as Emery points out, in bonds you typically have limited upside, but a possible downside of 100%. Consequently, Emery’s team evaluates the risk of permanent loss.

Beyond managing risk through security selection, Dodge & Cox also manages risk via portfolio diversification and by running total return simulations under various scenarios in which they look at excess return over Treasuries adjusted for default-risk. Each portfolio is also protected for future purchasing-power loss by controlling interest rate risk in portfolios. Last, the firm fully acknowledges that price volatility is a part of investing.

The Dodge & Cox team also believes that there are advantages to having what they describe as a “very long-term” investment time horizon of 3–5 years. Each analyst is asked to answer an important question: Would you buy a credit if you had to hold it for the next 3–5 years? Answering “no” helps analysts to recognize underlying assumptions in their investment thesis. Additionally, the firm believes that having long-term fortitude has certain advantages, including  taking advantage of interest compounding to increase total return and a dampening of short-term volatility.

Another important layer in the Dodge & Cox process is their use of teams to vigorously debate investment ideas for their soundness. One very interesting choice is that the firm advocates both equity and credit analysts evaluating the same ideas and providing them to portfolio managers. I have often thought that the divide between credit analysis and equity analysis is silly, as both consider the ability of an issuer to pay cash flows required by an issue. A full issuer analysis requires thorough credit and equity analysis.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.