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.
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.
The purpose of ACCOUNTS PAYABLE is to keep track of your company’s payables in an orderly fashion. But the advantage is that it enables a company to manage cash disbursement, allowing better control of cash flow and maximizing the value of funds to the organization.
As a rule of thumb, vendors meeting a company’s most critical needs—whether it’s raw materials or the retail items that are most popular or allow the highest markup—are paid first. Others follow as funds become available.
Sometimes cash flow is controlled out of necessity. There may be a snag in production or a liquidity problem that will require withholding or reducing some payments until the crisis is over. If that happens, the situation should be explained calmly and honestly to vendors. Chances are they’ve all been there and understand.
They will most probably want an estimated payment date. That’s where the ACCOUNTS PAYABLE system comes in handy.
Structured similarly to A/R, ACCOUNTS PAYABLE is another subledger that feeds the general ledger with summaries of more detailed information. Information about disbursements flows through the ACCOUNTS PAYABLE system from sources both within and outside the company and travels up to the general ledger to become part of your company’s overall financial picture.
A well-designed and well-managed accounts payable system will reliably track the amount owed each vendor and when to pay based on agreements with that vendor. The system keeps a running tally of amounts paid so it can be checked against budget. It also is the system that provides the necessary information for generating your company’s 1099 statements (for reporting amounts paid to suppliers).
Elicit a promise to pay by a certain date. Debtors, like everyone everywhere, work better with a deadline. If it’s a due date mutually agreed to by the company and the debtor, the joint ownership often will elicit greater allegiance toward the company than it will for others waiting for payment. If the debtor’s resources are limited, this becomes a very important strategy.
Follow up when payments aren’t made. All of this will be for naught if there’s no follow-up. No matter how cooperative the company may be, the debtor must understand that the bottom line is to recover the debt. Despite preliminary work, a few reminder calls may be necessary. They can be very effective.
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.
The three indicators based on balance—balance in excess of the credit limit, longest-running balance, and highest balance—represent elective risk based on sales decisions the company has made regarding specific customers. If the risk grows too great, a change in policy and procedure may be in order. The credit manager may be too lax in his or her
standards. (It may be good to stretch a little to meet new account needs, but too much stretch and the relationship will break.) The people responsible for collections may need to be more diligent in their efforts. Regular tracking in these four areas will help better control extremes in ACCOUNTS RECEIVABLE.
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