Focusing on Fundamentals

If you are familiar with QV, then you are likely also familiar with our 7-test framework. It is the basis on which we analyze our holdings and how we on the fixed income strategy team make credit investment decisions. The 7 tests are financial record, capital allocation, balance sheet, management, franchise & outlook, valuation, and portfolio enhancement. They guide our process and help us to quantify our philosophy in an objective way.

Applying the 7-Tests to the Strategy

_{Source: QV Investors}

The above chart is a snapshot of our aggregate internal ratings across five of the seven tests for all of the corporate issuers in the QV Canadian Bond Strategy (representing 33% of the portfolio). We have excluded the portfolio enhancement test, which is constantly evolving, and the valuation test, which will be touched on later. We use an internal scorecard to rate our issuers on a scale from 1 (worst) to 5 (best) on each of these tests.

You may notice that our holdings rank average to above average on most of these tests, apart from the balance sheet test, where most of our holdings are rated as average to below average. This is partly due to the levered nature of some of our businesses, such as banks and REITs, which warrant a lower rating.

It’s also because some of our best opportunities come to us under stressed balance sheet conditions. In these cases, we have strong conviction in the overall fundamentals of the business, the strength of the franchise, and the track record of the management team, but the balance sheet may be temporarily stretched for an attractive M&A opportunity or a period of heightened capital expenditure.

But of course, as Howard Marks has written in the past, “Establishing a healthy relationship between fundamentals – value – and price is at the core of successful investing,” meaning valuation is the second key to establishing whether an investment is attractive. When balance sheets are temporarily stretched and valuations have deviated from the underlying fundamentals of the business, we are sometimes offered a window to invest in situations where we believe the credit trend will improve.

In Practice

This is the thought process we applied when adding to our position in Rogers Communications last year. In April of 2023, Rogers officially closed its acquisition of Shaw. Due to the high level of debt that it took on to fund the deal, Rogers’ credit rating was subsequently downgraded from BBB+ to BBB-, with a negative outlook. Management would have lost its investment grade credit rating if it did not materially decrease leverage by the end of 2024, from 5.4x to 4.5x net debt/EBITDA. As shown in the chart, the market reacted negatively to this news, causing Rogers’ spread to widen from that of BCE in April of 2023 (BCE is considered the benchmark with which to compare spreads in the telecommunications sector). This reaction wasn’t entirely unexpected, since this news suggested that its balance sheet was now in a weaker position.

_{Source: BMO Capital Markets}

However, we saw a path for Rogers to be able to pay down debt and achieve credit stability. We felt the purchase of Shaw fortified the strength of the franchise, and with a proven history of good debt management, we had strong conviction that management, with its back against the wall, would do what it needed to do to avoid a downgrade to high yield. This led us to add to our position in Rogers in September of 2023. Since that point, we have seen the management team execute on its deleveraging goals, sell its stake in Cogeco, implement a DRIP program, perform positively on the base business, and achieve its target synergies ahead of schedule. Concurrently, we have seen the spread tighten relative to BCE, which has been a benefit to our clients.

Picking our Moments

Our 7 tests are the foundation of how we analyze and form credit opinions. They can help us identify opportunities when we believe the market is pricing in more risk than we see. By having conviction in the rest of our tests, we can take opportunities to invest when the balance sheet is flexed, and valuations depart from our perception of risk. A key part of this analysis is knowing which moments to pick when applying this thinking. With corporate bond valuations at historically rich levels, we are using this strategy to augment our inventory list, maintaining a conservative bias until valuations move to open another window of opportunity.