While in a single name context ratings are often criticized for being lagging indicators of credit quality, classifying bonds by rating is one widely used method to reflect the behavior of different risk classes in credit markets.
Many market participants argue that spreads themselves and spread volatilities are more timely indicators of an issuer’s credit risk than ratings. They consequently prefer to split the universe in spread class buckets. The disadvantage of this method is that it leads to relatively unstable compositions of the individual buckets and is less convenient, because the major index providers do not calculate indices based on spread classes. Since the different rating buckets constitute the corporate bond market as a whole, there is clearly a correlation between overall market fluctuations and the spread changes of the different rating subportfolios.
The risk profile of a credit portfolio, in absolute terms as well as relative to a benchmark index, is largely determined by the weighting of different risk classes. Of course, the allocation of capital to riskier asset classes not only increases risk, but also offers ample opportunities for outperformance. From a top-down perspective there are various methods to split the corporate bond universe in different risk classes. Here the three most popular approaches are introduced: dividing the universe by rating classes, by degrees of subordination or by the degree of cyclicality of the different industries.
In the last 20 years there were two periods, when US companies substituted equity by debt, especially by issuing corporate bonds. Consequently, between 1984 and 1990 and in the second half of the 1990s leverage rose dramatically. It also stands out that there were various periods when banks’ lending standards were extremely restrictive and one period, namely since 2000, when activity in the commercial paper market slowed down. Both events spurred corporate bond issuance in the past. If the usual pattern of the credit cycle holds, equity buybacks remain subdued until the economic expansion gains ground. As long as companies are willing to repair their balance sheets, net corporate bond issuance is also expected to be low. The analysis of the maturity structure of outstanding US and Euro corporate bonds shows a massive amount of redemptions for 2004 and 2005. On the other hand, while supply should remain weak during this period, demand for US financial assets by foreign residents is expected to remain strong. It is primarily driven by European investors and Asian central banks that pour huge amounts of money into the US capital market. A potential shift in the balance of supply and demand, however, is an important technical factor for the outlook for corporate bond spreads.
This is a long-term process and you will be asked to repeat the steps outlined in Chapter 9 at least annually as your financial circumstances change over the years. However, if you have thoroughly worked the program outlined in this book and continue to be unhappy with your investments, do not be discouraged. The program in this book will teach you who you are in relation to investments, how to accept yourself as that person, and what investments work for that person. If nothing works for the person you discover yourself to be or if you cannot discover yourself in this process, then it is necessary to change yourself. Sometimes your investments are not wrong; instead, you need a new way to look at your investments and you need to give yourself the gift of getting those new glasses.
One of the untapped income sources for many companies is the trade discount offered for prompt payments. Many suppliers offer anywhere from a one percent to three percent discount if the invoice is paid within 10 days, as opposed the usual net 30 days and beyond. Use the following equation to predict your trade discount:
discount income = discount percent / (due date – discount date) x 360
Let’s assume our example company that receives a two percent discount on payments made within 10 days, rather than by the 45-day average established through weighted average invoice aging. That discount equation would be as follows:
2% / (45 – 10) x 360 = 20.5%
Unless the company’s cost of funds or interest earnings match or exceed 20.5 percent, the company gains more financial value if it pays within the trade discount period.
Many companies curry favor with suppliers by paying either prior to the due date or as an exception to their own weighted average. A company that does this should make sure the vendors know the company is making a policy exception and, if appropriate, why it’s doing so. If the company chooses to reward vendors with cash for some reason, the vendors should know why.
Reach an agreement with the debtor on the amount owed. One of the key things the collections person can do is help the debtor overcome his or her internal resistance. With the exception of a disputed amount, most debtors know they must pay and, more often than not, most want to pay. Getting them to verbally acknowledge their debt—recording what they said and when— may put the company ahead of another of that customer’s creditors. The more a company can work with a debtor, the more likely it is that the company will see its money.
The first thing to realize is probably the most important rule of bad debt collection: the collection effort begins before the sale is made.
If you wait until a debt goes bad and the debtor goes south, the likelihood of collection is low. But if the sales person takes time to qualify the account, check bank references, and otherwise ensure this person or firm is a quality company with a good record, then fear of bad debt down the road is greatly reduced.
Managers can help the effort by making sure that the sales person is financially respon-sible for that account, by limiting his or her ability to earn commission on any sale that goes bad. That type of incentive will make all the difference in the world.
Receivables tracking reports provide a system to determine which customers need to be reminded to pay, a process called dunning. It’s tough to nag customers for payment, but it may be necessary. The first approach is generally by letters—polite at first, then threatening if polite doesn’t work. These efforts are usually automated. The letters may be supplemented by phone calls or visits. In the worst cases, plan on collections efforts and/or legal action. Then take a look at the reserve for bad debts.
Receivables aging. This sort of report has two basic purposes. First, it allows managers to understand how old the receivables are; the older a receivable, the less likely it will be collected. Second, the report helps accountants calculate the amount of money to allow for uncollectible accounts.
Customer balance tracking. In preserving the asset value of the ACCOUNTS RECEIVABLE, keep a close eye on customer-related accounts. Pay special attention to accounts that have aged excessively, accounts for which the balance exceeds the credit limit, accounts with the longest-running balance, and accounts with the highest balance.
In the early stages, the bad debt accrual does not appear on the books, since we don’t know which accounts will go bad. To accommodate this need, some companies, espe-cially those that are audited, set up accounts based on aging categories or on a certain rate multiplied by sales. To set up such an account in the amount of $5,000, for example, the accountant debits Bad Debt Expense for $5,000, credits Reserve for Bad Debt Expense for $5,000, and notes this transaction as “Records accrual for bad debts.”
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