By Michael M. Terry, CFA – Founder Rubicon Associates

One often overlooked aspect of credit investing is the contract between the company and the investor. The formal name of the contract is the Indenture.

The indenture contains the description of the bonds (generally) and what the company can and cannot do. What the company can and cannot do are spelled out in the indenture’s covenants. A covenant is defined as an agreement, usually formal, between two or more persons to do or not do something specified. Is covenant analysis a thing of the past? Are old school credit guys like me dinosaurs? In good times, it may seem so as investors don’t have to worry about covenants as companies are healthy and the risk of being effectively subordinated are low. But what about when the market is not so healthy and/or liquidity dries up?

We went through such a market no more than four years ago and chances are, we will go through one again. When this occurs, covenants will be important and those that took the covenants into consideration when investing will be better off.

Having been involved in fixed income investing, analysis and portfolio management for two decades, I have learned a couple things: it will happen again, it is not different this time and downside is the biggest risk to fixed income investors (an asymmetric risk profile – lots of downside, a little upside).

Having realized these three facts, I have boiled the credit investment process down to a three stage decision tree: Many investors focus on the first and third steps of the process – the credit analysis and the relative value. While these are very important steps in the process, and carry a large amount of the weight towards an investment decision, they are complemented with covenant analysis. Within the investment grade

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