Morningstar Advisor - June/July 2010 - 40

Spotlight

How We Determine if a Bond Is a Buy
Morningstar’s credit rating serves as the foundation for determining whether a bond is attractively priced or not. Once we have a credit rating in place, we look at the yield offered on the company’s bonds. If the bonds trade at a higher yield than they should—as implied by the Morningstar credit rating—they’re potentially attractive investments. Consider a company that we rate A. The typical A rated company yields roughly 100 basis points above Treasuries. If our hypothetical company trades at a 200-basis-point spread, investors are getting a good return relative to other investments of similar risk. Now let’s suppose our hypothetical company has two bonds outstanding, one due in 10 years and one due in 20 years. If the two bonds both trade at 200 basis points over Treasuries of similar maturities and 100 basis points over other corporate bonds of similar credit quality, are they both attractive? Here, we lean on our economic moat rating. If our hypothetical company owns a wide moat—a capability to maintain high profitability for 20-plus years—we’d probably be comfortable recommending both the 10-year bonds and 20-year bonds. But if it’s a no-moat or narrow-moat firm, we’d likely recommend sticking with the shorter- maturity bonds. We’d be more worried that competitive pressures will drive down profitability within this time horizon. We’d need to see an extra margin of safety— a higher yield spread—to recommend something beyond 10 years. This example glides over quite a bit of nuance, of course. Each bond is a contract, and these contracts can differ in ways large and small as we move from bond to bond. Maturities, call and put provisions, and financial covenants all can vary across bond issues. Morningstar’s credit ratings apply at the company, or issuer, level. For a company with a simple capital structure— just senior unsecured debt outstanding, for example—applying this overall credit rating to individual bonds of the company is straightforward. For firms with both senior and junior debt, or companies with debt secured by specific assets like a piece of property, the individual bond might carry better or worse credit quality than the company overall. Another wrinkle is that we focus on relative value. Our bond trading at 200 basis points above Treasuries is attractive relative to similar bonds. Even if we’re correct in this assessment, the bond could still be a horrible investment. If interest rates rocket up, the bond would get crushed along with others. Until we figure out how to forecast rates, we’ll stick to relative value. Finally, the yield spread we’d demand for a given bond depends on factors like the Morningstar Uncertainty Rating we attach to the company’s equity. For bond investors to get paid back their principal, a company’s assets need to exceed liabilities from now until the maturity of the bond. Because assets minus liabilities equals equity, the equity value of a company can be thought of as the cushion a company’s creditors have before losing all or part of their loan. The uncertainty rating captures the level of uncertainty in that cushion for bondholders. Bondholders need an extra margin of safety, measured in a higher yield, to compensate for higher uncertainty.

should the stock price stay above the strike price, and deleveraging as the company recovers from the depths of the recession. If there are no negative earnings surprises or corporate actions, we think the worst for the stock may be past and the convertibles have a reasonable chance of conversion in November. Also, as the company generates earnings over the coming quarters, the balance sheet will naturally deleverage. We believe the bonds offer excess value for their risk and could realize spread tightening toward investment grade over time.

Pride International PDE BBB2
Business Risk Cash-Flow Cushion Solvency Score Distance to Default

Fair

Poor

Good

Background

Pride is a deep-water rig contractor with a fleet of 24 offshore vessels that drill thousands of feet below the ocean. Pride’s substantial cash balance and sizable backlog of work mean the firm is well positioned to survive the downturn.
Credit Rating Rationale

While we expect the company to be free-cashflow negative in 2010 and 2011 because of heavy investment outlays, we view it as a borderline investment-grade credit because of the ample cash flows that it is likely to reap in subsequent years. Pride’s contract profile over the next five years ranks among the strongest in the industry in terms of rig days under contract, providing us with a degree of comfort that expected cash flows will materialize.
Investment Rationale

at a lower cost than others in the industry. This cost advantage, and a broad diversification across customers, product lines, and geographies, has allowed Actuant to grow in the face of competition and market cycles.
Credit Rating Rationale

Risk rating captures this positioning, but the firm’s small size within the broader industry and inherent cyclicality weigh on this score.
Investment Rationale

Actuant’s credit rating of BBB2 reflects the firm’s solid positioning in niche markets and relatively sound financial metrics. Our Business

Actuant’s senior note trades firmly in junk territory, with spreads substantially wider than our BBB2 rating would imply. We believe that two catalysts could drive spreads tighter: the conversion of the convertible bond to equity,

Pride’s 2014 and 2019 senior notes trade firmly in junk territory, with spreads substantially wider than our BBB2 rating would imply. While we think both issues offer good value, we prefer the 2014 issue, given the relatively high cash-flow visibility we have on Pride over the next several years: 100% of its available deep-water rig days are under contract for 2010, 80% in 2011, 67% in 2012,

40 Morningstar Advisor June/July 2010

Morningstar Advisor - June/July 2010

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