Why the Debt/EBITDA Ratio is Crucial to Junk Bonds

A company’s debt/EBITDA ratio measures its ability to pay off its incurred debt. It’s a useful tool to investors trying to estimate a baseline of just exactly how long an issuer will require to pay off what it owes without taking into account variables like amortization, depreciation, taxes and interest.

Debt/EBITDA is one of the more common financial metrics credit ratings agencies like Standard & Poor’s, Moody’s and Fitch Ratings use to appraise an issuer’s risk of default. When an issuer’s debt/EBITDA ratio is high, agencies tend to downgrade a company’s ratings as this is typically an indicator they may indeed have difficulty making good on their financial obligations and debts. On the other hand, a low debt/EBITDA ratio indicates the opposite: that a firm should indeed be able to make good on what it owes and therefore is more likely to receive a higher credit rating. (For related reading, see: A Brief History of Credit Ratings.)

This helps to illustrate just how direct the link is between an issuer’s debt load and its credit rating. High yield, or junk bonds, are fixed income securities from issuers with a credit rating of “BB” or lower (S&P), or “Ba” or lower (Moody’s). It’s because of this lower credit rating which generally results in an inherent higher-risk that the name junk bond has been attached to such debt instruments. This higher default risk stands in direct correlation with the level of debt as well as the corporation’s earnings before interest, taxes, depreciation and amortization.

The higher a company’s debt/EBITDA ratio, the more indebted it is. This of course means it’s not only more unlikely to be able to pay off that debt, but should it wish to attract more investors, it will have to offer even higher yields. A debt/EBITDA ratio of 4 to 5 is typically considered too high by most ratings agencies to consider a corporate bond investment grade. Typically, agencies look for companies with a debt/EBITDA ratio of less than 2 to be considered investment grade. Those companies receiving 3s, 4s and 5s, therefore, must compensate for their higher ratio with higher yields in order to encourage investors to take on the added risk. However, please note these underlying ratios may change significantly from industry to industry.

It’s clear that debt/EBITDA is one of the central financial criteria ratings agencies use to assess the credit worthiness of an issuer. The ratio is also used to assess a company’s credit in the event of a debt-financed takeover, as well as in order to assess if the issuer can service the debt it currently holds. For investors buying junk or high yield bonds, this ratio along with other measurements is extremely critical to assess whether or not the added risk is worth taking on. Both an issuer’s ability to make coupon payments and make good on the principal at maturation are assessed by its debt/EBITDA ratio among other things. (For more, see: Junk Bonds: Everything You Need to Know.)

The net debt/EBITDA ratio is considered to be even more significant for investors in higher yielding corporate bonds. This measures leverage, that is, the issuer’s liabilities minus assets (cash and equivalents), divided by their EBITDA. This net debt to debt/EBITDA ratio indicates the number of years it would take an issuer to pay off all debt assuming both its EBITDA and net debt remain constant. When a company has more on-hand cash than it does debt, its ratio can even be negative.

This figure is also a popular measurement with analysts who want to determine if a company can increase its debt and still be able to make good on a bond’s coupon and principal at maturity. Anything higher than a 4 to 5 is typically avoided by investors because such scores indicate the issuer may indeed be unlikely to handle the burden and thus have no ability to grow its business if it takes on more debt obligation. 

No doubt, both debt/EBITDA ratios mentioned above have a significant importance to investors in and analysts of corporate high yield bonds or so-called junk bond issues. It should be made clear that despite common misconceptions, EBITDA does not represent cash earnings. It is a great tool for evaluating profitability, but is not designed to do so for a company’s cash flow. One reason is that it leaves out potential costs that can be significant like working capital or replacing broken and/ or dated (depreciated) tangible assets. Because it doesn’t take into account such things, EBITDA can also be used to ‘dress up’ a company’s earnings. Therefore, investors are best advised to rely on EBITDA in accordance with other performance metrics to ensure that an issuer is not trying to keep something hidden.