Justin McGowan - Opening Credit: A practitioners guide to credit investment

T his book has its genesis in three important problems in the world of investing in credit. It is written to help solve them, and to that end brings to bear our experience in investment in general, and in the credit markets in particular.

The first problem is that much of the work available on investment in both credit and equity is quantitative in its focus. Without in any way seeking to diminish the importance of quantitative analysis, it strikes us that success in selecting investments that yield above-market returns and in avoiding investments that materially underperform and possibly default, depends on understanding the strategies that led to the quantitative output. Those strategies do not emerge from the ether but are the product of individual decisions. The focus of the investor should therefore be on identifying the persons responsible for the decisions and understanding their motives and the factors underlying their decision-making. Our goal, then, is to return the analysis of human factors to the centre stage of investment evaluation.

The second problem is that any analysis that focuses on the human elements of the corporation must also evaluate the rules that regulate how those humans interact and relate to their investors (i.e. corporate governance). However, for most investors this has been reduced to a box-ticking exercise. We champion a more holistic approach to finding the holes in the corporate structure, something we believe is of paramount importance for credit investors, since while they may rarely use it shareholders at least have the nuclear trigger of being able to fire the managers that steward their assets. Credit investors can only fall back on the contractual rights that they have been able to negotiate; they are stuck with the management and, hence, need to understand at the most fundamental level how managements actions are regulated.

The third and final problem is that much work on credit analysis seems to treat it as simply an adjunct to equity analysis. This is both misleading and simplistic. Often the desires of equity and credit investors and the strategies they pursue are in conflict. Whereas the equity market is, we would argue, more or less efficient and most equities of an individual corporation are fungible, the same is simply not true of credit. The credit market is far from efficient in the generally accepted sense of the term it has increasingly patchy liquidity, multiple traded asset classes with widely differing claims on the assets of the corporation in the event of a bankruptcy and highly idiosyncratic characteristics affecting their relative pricing. In addition to differences in claims, differences in maturity also ensure that credit instruments of the same entity are rarely fungible. These variances affect the valuation of the underlying securities to a profound degree and must be clearly identified in order to determine where, if anywhere, value exists. Thus, while investors might have a solid grasp of fundamental corporate analysis, they will be unlikely to succeed in credit investing without an equally robust understanding of the technical issues pertaining to credit. We will attempt to outline some of the factors that matter.

The ratings agencies have published their own methodologies for assessing credit risk, and publications of an academic nature detail the more quantitative side of the discipline, along with the mathematical aspects of portfolio risk. However, there are few options available when setting out into a field which remains, relative to other investment options, somewhat obscure. We hope to address this in the coming chapters, tying the thematic and theoretical elements of the book into a selection of factual case studies from the recent past.

This book, then, is intended for readers who already have some awareness of corporate credit as an asset class but are not themselves seasoned credit practitioners. In our view, this group is fairly wide-ranging and diverse, and includes: