STRATEGY INSIGHT
January 2014
The Quest For Credit Value:
Expected Compensation and Valuation
Our investment process is built on the selection of
individual securities capitalizing on market inefficiencies.
We are fortunate to invest at a time when the availability
of data and computational power help us calculate the
attractiveness of thousands of securities simultaneously. A
security’s expected compensation, however, should not be
confused with its valuation. We use the former to
systematically review market opportunities, whereas the
latter requires insights that only fundamental analysis and
deep experience can provide. The integration of systematic
and fundamental disciplines is at the center of our
valuation framework and defines our bottom-up fixed
income investment process.
In this article we provide an in-depth discussion of the
ways in which we combine the work of credit and
quantitative research into a single process whose ultimate
goal is to maximize the absolute return of our clients’
capital. This process rests on three pillars: credit criteria,
fundamental outlook, and expected compensation.
an issuer’s level and variability of cash flow
comfortably supports its operations and capital
structure. Leverage should not be excessive
relative to cash flow variability, nor should debt
maturity profiles result in an excessive reliance on
financial markets for capital structure viability.
3. Well-Managed – We select credits supported
by a management team that has a proven track
record of execution and is an effective steward of
capital, aligned appropriately with creditors’ and
shareholders’ interests.
4. Transparent – We demand the necessary visibility
into critical business activities and credit
Durable
Transparent
Credit Criteria
We seek credits or issues in which we invest to be durable,
appropriately-structured, well-managed, and transparent.
These four requirements define our credit criteria:
1. Durable – Companies must have the ability
to withstand a wide variety of economic and
regulatory outcomes. It is important that they
demonstrate sustainable competitive advantages
and execute on an effective growth strategy based
on being providers of essential products and
services and leadership in attractive markets.
2. Appropriately-Structured – We assess whether
Appropriately
Structured
Well-Managed
For illustrave purposes only
agreements to evaluate the risks inherent in
issuers and securities. We are particularly careful
about structural considerations and protections
that might be accorded to the securities under
consideration.
Strategy Insight / january 2014
Fundamental Outlook
After passing our basic credit criteria, we then consider
the fundamental outlook for any issuer. We avoid
situations where the credit metrics are likely to decline or
might be subject to a high degree of event risk. We also
subject our investments to rigorous, proprietary stress
tests. This stress analysis determines the resilience of
investment candidates to a prolonged period of adverse
business and financial conditions.
Expected Compensation
For each investment under consideration, we calculate its
expected compensation or return in excess of a similar
maturity U.S. Treasury security. In order to estimate this
excess compensation, we study the spread dynamics of
the industry and rating cohort to which the security
belongs. From this analysis, we determine a fair longterm spread range for the security and use it as a
reference to determine potential for purchase.
Furthermore, each industry and rating cohort is subject
to a default penalty and a liquidity charge. When the
security offers just enough compensation to cover these
default and liquidity costs, we designate it a hold. A
security is designated a buy when the compensation it
offers exceeds default and liquidity costs plus a margin
of safety1. Finally, when a security’s offered compensation
is not enough to cover default and liquidity costs, it is
designated a sell.
Adherence to this strict buy, hold, and sell discipline is
a central component of our investment process. We do
not buy securities unless the spread is above our
minimum required compensation plus a margin of
safety, and we do not hold a position that has exhausted
its excess return potential.
Expected Compensation and Valuation:
Identifying Credit Value opportunities
All the securities we own must clear all of the three
hurdles discussed above. There are times when a company
comes to the new issue market and our credit analysts
1 With respect to fixed income investments, a margin of safety exists when
the additional yield offers, in BBH’s view, compensation for the potential
credit, liquidity and inherent price volatility of that type of security and
it is therefore more likely to outperform an equivalent maturity Treasury
instrument over a 3-5 year horizon.
are often already familiar with the entity from a credit
criteria and fundamentals perspective. Thus, only an
expected compensation analysis is needed. At other times
when screening the vast secondary market, we may
identify potential buys from unfamiliar issuers. Our
credit research team subsequently scrutinizes these
issuers, filtering out all the names that do not clear the
credit criteria or fundamentals thresholds.
In both instances, it is important to arrive at an accurate
assessment of valuation that incorporates both credit
analysts’ knowledge of the industry and the issuer, and
our systematic calculations of potential expected
compensation.
A few examples will highlight our process at work. In each
case, we have adjusted the calculated expected
compensation to represent the characteristics of the
securities under evaluation more accurately. It is important
to note that our views are independent of stated ratings,
or other external perceptions of business models and
fundamentals.
1. Adjustments to agency-assigned ratings
We sometimes disagree with agency ratings. On occasion,
we may argue against the high-yield designation in favor
of an investment-grade designation. For example, in
February 2011 we analyzed Expedia (EXPE), a crossover
agency-rated consumer-services company, and thought
that its real credit risk corresponded to that of mid-tohigh BBB. At the time, its expected compensation was
between 250-300 basis points. These levels were not
particularly attractive for a high-yield crossover credit,
but compensation was quite attractive for a BBB-rated
investment grade security.
2. Alternative industry cohort classifications
Companies can be inappropriately classified in industry
cohorts that may not accurately reflect their actual
business models. This can lead to misleading perceptions
of required spread compensation that does not accurately
reflect the risk of the credit. A good illustration is
Western Union (WU), regarded as a consumer cyclical
services company in the Barclays Corporate Index. Upon
closer inspection, WU’s consumer orientation, high
degree of recurring revenue, loyal customers, global
presence, and stable credit metrics maintained even
during the 2008-09 financial crisis, led us to believe that
the business model was better aligned with the nonbrown brothers harriman www.bbh.com
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Strategy Insight / january 2014
4. Secular industry change
Financial credits have historically traded at lower spreads
than industrial credits. The financial crisis of 2008
changed that, perhaps permanently. Indeed, financial
spreads widened the most during the crisis, and as credit
markets normalized, they remained higher than
industrials. Furthermore, financial issuers remained
highly vulnerable to exogenous fluctuations such as the
sovereign crisis in Europe. Finally, given the legislative
and regulatory uncertainties introduced by the DoddFrank bill and Basel III regulations, we adjusted our
compensation requirements and stress-testing parameters
to reflect these new realities. As a result, we were able to
express our conviction on the attractiveness of the
5. Expanding investment opportunities
The flexibility of the investment process allows us to
both accurately assess credit risk and adapt to changing
market conditions and opportunities. The composition
of credit indices changed rapidly as the share of issuers
domiciled outside the U.S. grew over the last couple of
Barclays Capital Investment Grade
Corporate Bond Index
%
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40
35
Share of Yankee Issuance
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3. Differences in fundamental business models
Companies in the same industry may have different
fundamental trajectories. A tale of two such investmentgrade healthcare real estate investment trusts (REITs),
HCP Inc. and Health Care REIT Inc. (HCN), is an
interesting one. At the time, both companies showed the
same rating and had comparable leverage levels. Both
companies had similar healthcare property portfolios,
possessed strong liquidity profiles, and benefited from
favorable long-term demographics and secular healthcare
industry tailwinds. On the face of it, this would appear
to justify similar spread compensation for the two
credits. However, upon closer examination of their lease
structures, it became clear to us that whereas HCP
typically structures fixed-price leases with annual
escalators (low volatility cash flow), HCN enters into
profit-sharing lease structures where its cash flows
experience volatility associated with operating risk.
With more than a third of HCN’s pre-interest, pre-tax
earnings derived from these variable lease structures, its
future cash flows were likely to be more volatile than
HCP’s. We felt this material difference required a
corresponding extra compensation when purchasing
HCN.
banking sector more confidently and we built an
allocation to banks.
Feb - 08
cyclical sector, or even a generic global industrial
company of the same rating. When viewed as a consumer
non-cyclical or generic global industrial company, WU
appeared very attractive at the then-prevailing spread
levels, whereas our framework would have rejected the
purchase of a similarly-rated consumer cyclical services
company.
Source: Barclays Capital and BBH Analysis
years. The Barclays Investment Grade Corporate Index
has been growing steadily and currently has over 40% of
its market value in securities from non-U.S. issuers. To
evaluate a security domiciled overseas, we make
adjustments to properly assess each security within the
investment process.
When evaluating credit risk, we added a layer to our
analysis that assesses the quality of the country where the
issuer is domiciled. In addition to the quality of the
sovereign, we evaluate the efficiency of the legal systems
to solve disputes and challenge regulations, the
independence of the judicial system, and the strength of
investor protections. Once the domicile meets our
country eligibility restrictions and the issuer meets our
credit criteria and requirements on fundamentals, we
proceed to assess the attractiveness of the security within
our expected compensation framework. To enhance our
framework, we add a margin of safety premium to the
spread dynamics describing the industry and ratings
cohort to determine whether the security is a buy or not.
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Strategy Insight / january 2014
Conclusion
Finding securities at attractive yields that provide required compensation plus a margin of safety is often challenging,
no matter what rate environment. Global economic growth ebbs and flows, as do inevitable exogenous uncertainties,
but our bottom-up investment process and its disciplines remain constant, consistently asking the question: are we
getting sufficient compensation to buy or hold a security? We believe a distinctive feature of our investment process
is the complementary work of credit and quantitative research. The ability to map our collective views on individual
credits into a unified framework that translates expected compensation into valuation has allowed us to focus on
choosing the most attractive opportunities regardless of sector or asset class concentration. As we navigate the capital
markets, we are confident that selecting securities with a substantial margin of safety will increase our ability to
absorb a wider range of outcomes for continued outperformance.
Jorge G. Aseff, PhD
Vice President
Head of Quantitative Research
Rishi Sadarangani, CFA
Vice President
Corporate Credit Research
This publication is a general guide to the views of Brown Brothers Harriman & Co. and is provided to recipients who are classified as Professional Clients and Eligible Counterparties if
in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation
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All rights reserved. 01/2014.
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