The 'D' Word

Debt IR – The Same But Different

Debt is not a dirty word: most companies have a mix of debt and equity in their capital structure. In fact, there are a number of advantages of debt over equity for financing operations: for instance, the interest payments are tax deductible, and debt enhances management discipline. As well, the current low interest rate environment makes debt markets a more attractive option for many companies, especially because the focus of equity investors has largely been on securities that generate yield.

Most (especially smaller) companies rely solely on bank credit facilities for the debt portion of their financing activities, but borrowing from a bank can be more restrictive and expensive than issuing corporate debt instruments (typically bonds, notes, or debentures). However, companies that have both equity and debt securities outstanding tend to be reactive with respect to the debt side of the equation, leaving it largely in the hands of ‘the Treasury guys’ to serve the information needs of debt investors.

Corporate debt financing can be by private placement or public offering. Public debt offerings are similar to equity offerings. The private placement route is simpler, as it does not require a prospectus or a credit rating. Instead, a company works with its private placement investment banking syndicate (or sometimes directly with large institutional investors) and legal counsel to draft a note agreement, develop a debt investor presentation and conduct a debt road show. Private placement debt is rarely assigned or traded, so it is easier to build a long-term relationship with the holders.

As more and more companies diversify their financing activities, IROs definitely have a role to play in debt IR – building and managing relationships with bondholders and debt analysts in the same way we build relationships with shareholders and equity analysts. At a minimum, IROs should work closely with the folks in Treasury to ensure that disclosure rules are adhered to and that messages are consistent to all stakeholders.

Debt IR is the same…

Typical debt investors are pension funds, mutual funds, insurance companies, private wealth management funds, hedge funds, and sovereign wealth funds. Does this sound familiar? And there are fixed income analysts and fixed income investor conferences just as there are equity analysts and equity investment conferences.

…but different

The strategic messages are the same – but nuanced differently, with greater emphasis on creditworthiness (the ability to make the interest payments and repay debt as it comes due), whereas equity investors are typically looking for growth and the ability to increase earnings. Debt investors generally have a longer-term focus and are more risk-averse. And the two don’t always see eye-to-eye on the proposed financing of projects or acquisitions. Shareholders worry about dilution as additional shares are issued, and debt holders worry about an erosion in the debt-equity ratio and the company’s ability to service the interest payments.

Consider the needs of debt investors in facilitating proactive communications:

In quarterly reporting, proactively address issues of concern to debt investors and reach out to debt analysts in the quarterly conference call.
In developing the IR calendar, incorporate debt investors in non-deal road shows or organize a separate road show to visit current and prospective debt investors. Take along the CFO instead of the CEO. Consider whether the company should participate in debt investor conferences. Tailor the investor presentation to debt investors by addressing call risk and event risk. Be prepared to discuss the business model, strategy, strengths, target capital structure, financing strategy, the external landscape (regulation, competition), currency exposure, and risk mitigation.
On the website, for companies with publicly traded debt, consider a debt investor microsite that includes key metrics, credit ratings, debt facilities, outstanding bonds, maturity profile, debt investor presentations, FAQs and contact information.

Credit Rating Agencies

Institutional investors often use credit ratings to supplement their own credit analysis when making investment decisions about debt securities. Canadian securities legislation also includes a number of references to credit ratings, some of which permit different treatment based on the credit rating. For example, highly rated short-term debt securities can be distributed under an exemption from registration and prospectus requirements, can be distributed by short-form prospectus, are 'qualified securities' for mutual funds, and are eligible investments for money-market funds.

Following the financial crisis in 2008, Canada joined other member nations of the G20 in pledging to establish regulatory oversight of global credit rating agencies, which were blamed for failing to issue warnings related to the subprime mortgage market.

National Instrument 25-101 Designated Rating Organizations (NI 25-101) came into force in April 2012, establishing a regulatory framework for the oversight of credit rating organizations, by permitting them to apply for Designated Rating Organization (DRO) status. This framework is consistent with international regimes now applicable to credit rating agencies. For example, DROs must establish a code of conduct to ensure, among other things, the quality and integrity of the rating process and transparency and timeliness of ratings disclosure.

The Canadian Securities Administrators (CSA) have designated DBRS Limited, Fitch, Inc., Moody’s Canada Inc., and Standard & Poor’s Ratings Services (Canada) as DROs. Visit their websites to better understand their ratings.

Managing Rating Agencies

While it is important to keep the messaging consistent to all investors, the disclosure of confidential information to a rating agency creates a different dynamic. Typically, the rating agency relationship is managed by Treasury although IR should participate in conference calls and meetings to remain informed.

Key Terms

Commercial paper generally refers to an unsecured, short-term (less than 270 days) debt instrument issued by a company to finance its short-term liabilities (i.e. accounts receivable, inventory).

Covenants are rules placed on the company by the lender, which are designed to stabilize performance and reduce the likelihood of default. Once a covenant is broken, the lender will typically have the right to call in the debt if not cured within a specified period of time. Covenants can be both financial and operational in nature. Operational covenants often require that companies maintain their physical assets to certain standards, meet minimum disclosure requirements, engage only in permissible business lines, or maintain a certain level of insurance. Financial covenants often limit the use of proceeds, the company’s ability to purchase or sell assets, the payment of dividends, and changes in control. Some may also limit compensation packages for officers. Financial covenants are frequently ratios that the company is required to stay above or below, such as a maximum debt to asset or debt to equity ratio, or minimum working capital levels or interest coverage ratios. It is important to note that many of these ratios do not conform to generally accepted accounting principles (GAAP).

Credit spread represents the investor’s payoff for assuming credit risk. It is typically calculated as the spread between the yield on a corporate bond and a government bond.

Financial leverage ratios are capital structure ratios used by credit and equity analysts to determine whether a company has the optimum mix of debt and equity in its capital structure. Ratios can be based on long-term debt, total debt, or net debt (total debt less working capital) and can be based on book value or market value.

Debt to equity ratio = debt divided by equity, expressed as, for example, 0.33:1 indicating the company has one third as much debt as equity.
Debt to capital ratio = debt divided by debt plus equity, expressed as, for example, 25:75 in which the company has debt and equity comprising 25% and 75%, respectively, of total capitalization.
Debt to cash flow ratio = debt divided by annualized cash flow from operations. This ratio provides an indication of how many years it will take a company to pay down all its debt from internally generated cash flow. (Sometime the inverse ratio – cash flow to total debt – is used).

Financial Liquidity gives an indication of how quickly current assets can be converted into cash to meet current liabilities.

Interest coverage ratios give an indication of how much cash the company generates each year to fund the annual interest on its debt. A common interest coverage ratio is earnings before interest and taxes (EBIT) divided by annual interest expense.

Investment grade is a rating that indicates that a municipal or corporate bond has a relatively low risk of default. Rating agencies use different designations; typically ‘AAA’ is the highest rating, and ‘BBB’ is medium quality. Ratings below ‘BBB’ are considered speculative, non-investment grade, and are commonly referred to as 'junk bonds'.

Shelf prospectus is a regulatory document that may pertain to different types of securities and can be used to distribute any combination of debt securities, preferred shares, derivatives, asset-backed securities and equity securities (i.e. an unallocated base shelf prospectus), for which the issuer is eligible to participate in the short-form prospectus distributions system. The required disclosure is essentially the same as for a short-form prospectus, modified in accordance with National Instrument 44-102 Shelf Distributions. Certain information relating to the details of a particular offering may be omitted from a base shelf prospectus, provided it is included in a supplementary document (referred to as a shelf supplement) that is filed and delivered when the actual distribution of securities occurs. Once approved, the base shelf prospectus allows companies to access the capital markets quickly. They do so by filing a shelf supplement for a specific offering of securities, which is typically not reviewed by regulators.

Solvency: measures a company’s ability to maintain operations and meet its long-term fixed obligations.