CFA 56: Fundamentals of Credit Analysis

Question 1

default risk (default probability)
Credit Risk

Answer 1

The probability that aborower defaults - that is , fails to meet its obligation to make full and timely payments of principal and interest, according to the terms of the debt security.

Question 2

loss severity

Credit Risk

Answer 2

Loss severity is the portion of abond’s value (including unpaid interest) an investor loses in the event of a default.

Question 3

expected loss

Credit Risk

Answer 3

Expected Loss = Default probability x Loss severity given default

Question 4

spread risk

Credit Risk

Answer 4

Spread risk is bond price risk arising from changes in the yield spread on credit-risky bonds; reflects changes in the market’s assessment and/or pricing of credit migration (or downgrade) risk and market liquidity risk.

Question 5

credit migration risk (downgrade risk)

Credit Risk

Answer 5

Credit migration risk is the risk that a bond issuer’s creditworthiness deteriorates, or migrates lower, leading investors to believe the risk of default is higher.

Question 6

market liquidity risk

Credit Risk

Answer 6

Market liquidity risk is is the risk that the price at which investors can actually transact - buying or selling - may differ from the price indicated in the market.

Question 7

seniority ranking

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 7

Seniority ranking means priority of payment.

Question 8

capital structure

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 8

Capital structure is the composition and distribution across operating units of a company’s debt and equity - including bank debt, bonds of all seniority rankings, preferred stock, and common equity.

Question 9

secured debt

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 9

Secured debt means the debtholder has a direct claim - a pledge from the issuer - on certain assets and their associated cash flows.

Question 10

unsecured debt

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 10

Unsecured debt is debt which gives the debtholder only a general claim on an issuer’s assets and cash flow.

Question 11

priority of claims

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 11

Priority of claims is priority of payment, with the most senior or highest ranking debt having the first claim on the cash flows and assets of the issuer.

Question 12

first mortgage debt

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 12

First mortgage debt refers to the pledge of a specific property (i.e. a power plant for a utility or a specific casino for a gaming company).

Question 13

first lien debt

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 13

First lien debt refers to a pledge of certain assets that could include buildings but might also include property and equiment, licenses, patents, brands, and so on.

Question 14

second lien (or third lien) debt
Capital Structure, Seniority Ranking, and Recovery Rates

Answer 14

second or third lien, secured debt, has a secured interest in the pledged assets but ranks below first lien debt in both collateral protection and priority of payment.

Question 15

subordinated debt

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 15

Subordinated debt is a class of unsecured debt taht ranks below a firm’s senior unsecured obligations.

Question 16

pari passu

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 16

pari passu means “On equal footing” duh

Question 17

The 4 important points on debt recovery

Capital Structure, Seniority Ranking, and Recovery Rates

Answer 17

1) Recovery rates can vary widely by industry. Companies that go bankrupt in secular decline (e.g. newspaper publishing) will most likely have lower recovery rates than those that go bankrupt in industries merely suffering from a cyclical economic downturn.
2) Recovery rates can also vary depending on when they occur in a credit cycle. Credit cycles describe the changing availability - and pricing - of credit. When the economy is strong or improving, the willingness of lenders to extend credit, and on favorable terms, is high. Credit cycles are almost always closely linked with the economy. At or near the bottom of a credit cycle, recoveries tend to be lower than at other times in the credit cycle. This is because there will be many companies closer to, or already in, bankruptcy, causing valuations to be depressed.
3) The recovery rates are averages. There can be large variability, both across industries, as well as across companies within a given industry. Factors might include composition and proportion of debt across an issuer’s capital structure. An abundance of secured debt will lead to smaller recovery rates on lower-ranked debt.
4) Priority of claims: not always absolute.

Question 18

cross-default provisions

Ratings Agencies, Credit Ratings, and Their Role in the Debt Markets

Answer 18

Cross-default provisions are provisions whereby events of default such as non-payment of interest on one bond trigger default on all outstanding debt; implies the same default probability for all issues.

Question 19

notching

Ratings Agencies, Credit Ratings, and Their Role in the Debt Markets

Answer 19

Notching is a ratings adjustment methodology where specific issues from the same borrower may be assigned different credit ratings.

Question 20

structural subordination

Ratings Agencies, Credit Ratings, and Their Role in the Debt Markets

Answer 20

Structural subordination arises in a holding company structure when the debt of operating subsidiaries is serviced by the cash flow and assets of the subsidiaries before funds can be passed to the holding company to service debt at the parent level.

Question 21

The 4 risks of relying on agency ratings

Ratings Agencies, Credit Ratings, and Their Role in the Debt Markets

Answer 21

1) Credit ratings can be very dynamic. Over a long period of time, they can move up or down significantly from the time of the bond issuance.
2) Rating agencies are not inffalible. Enron.
3) Other types of so-called idiosyncratic or event risk are difficult to capture in ratings. For example, litigation risk by tobacco companies, or environmental risk by chemical companies.
4) Ratings tend to lag market pricing of credit. Bond prices and relative valuations can move every day, whereas bond ratings, appropriately, don’t change that often.

Question 22

The Four Cs of Credit Analysis

Traditional Credit Analysis: Corporate Debt Securities

Answer 22

Capacity: The ability of the borrower to make its debt payments on time.

Collateral: The quality and value of the assets supporting the issuer’s indebtedness.

Covenants: The terms and conditions of lending agreements that the issuer must comply with.

Character: The quality of management.

Question 23

5 industry structure components

The Four Cs of Credit Analysis: Capacity

Answer 23

1) Power of suppliers: An industry that realies on just a few suppliers has a greater credit risk than an industry that has multiple suppliers.
2) Power of buyers/ customers: Industries that rely heavily on jsust a few main customers have greater risk because the negotiating power lies with the buyers.
3) Barriers to entry: Industries with high barriers to entry tend to have lower risk than industries with low entry barriers because competition may not be as fierce and pricing power is strong or at least sufficient.
4) Substitution risk: Industries (and companies) that offer products and services that provide great value to their customers, and for which there are not good or cost-competitive substitutes, typically have strong pricing power, generate substantial cash flows, and represent less credit risk than other industries or companies.
5) Level of Competition: Industries with heavy competition - characterized by a large number of participants, none of whom has significant market share - tend to have less cash flow predictability and, therefore, represent higher credit risk than industries with less competition.

Question 24

3 industry fundamentals

The Four Cs of Credit Analysis: Capacity

Answer 24

1) Cyclical or non-cyclical: This is a crucial assessment because industries that are cyclical - that is, have greater sensitivity to broader economic performance - have more volatile revenues, margins, and cash flows and thus are inherently riskier than non-cyclical industries.
2) Growth prospects: Industries that have little or no growth tend to conolidate via mergers and acquisitions. Weaker competitors in slow growth industries may begin to struggle financially, adversely affecting their creditworthiness.
3) Published industry statistics: Analysts can get a strong sense of an industry’s fundamentals and performance by researching published statistics.

Question 25

4 company fundamentals

The Four Cs of Credit Analysis: Capacity

Answer 25

1 ) competitive position

2) track record/operating history
3) management’s strategy and execution
4) ratios and ratio analysis

Question 26

prospectus

Traditional Credit Analysis: Corporate Debt Securities

Answer 26

The bond prospectus is the document that is part of a new bond issue. It describes the terms of the bond issue, as well as supporting financial statements, to help investors perform their analyses and make investment decisions as to whether or not to submit orders to buy the new bonds.

Question 27

bond indenture

Traditional Credit Analysis: Corporate Debt Securities

Answer 27

The bond indenture is the governing legal credit agreement and is typically incorporated by reference in the prospectus.

Question 28

5 biggest factors affecting spreads on corporate bonds

Credit Risk vs Return: Yields and Spreads

Answer 28

1) Credit cycle: As the credit cycle improves, credit spreads will narrow. A deteriorating credit cycle will cause credit spreads to widen.
2) Broader economic conditions: Weakening economic conditions will push investors to desire a greater risk premium and drive overall credit spreads wider. A strengthening economy will cause spreads to narrow.
3) Financial market performance overall, including equities. In weak financial markets, credit spreads will widen, where as in strong markets, credit spreads will narrow. In a steady, low -volatility environment, credit spreads will typically also narrow, as investors tend to “reach for yield”.
4) Broker-dealers’ willingness to provide sufficient capital for market making: Bonds trade primarily over the counter, so investors need broker-dealers to commit capital for market-making purposes. For example the financial and regulatory stresses faced by broker-dealers from the 2008-2009 financial crisis greatly reduced the total capital available for making markets and the willingness to buy/sell credit-risky bonds.
5) General market supply and demand: In periods of heavy new issue supply, credit spreads will widen if there is insufficient demand. In period of high demand for bonds, spread will move tighter.

Question 29

credit curves

Credit Risk vs Return: Yields and Spreads

Answer 29

Credit curves show the relationship between time to maturity and yield spread for an issuer with comparable bonds of various maturities outstanding, usually upward sloping.

Note: bid-ask spreads (in yield terms) translate into higher transaction costs for longer-duration bonds; investors want to be compensated for that as well. For these reasons, spread curves (credit curves), like yield curves, are typically upward sloping. That is, longer-maturity bonds of a given issuer typically trade at wider spreads than shorter-maturity to their respective comparable-maturity government bonds.

Question 30

restricted payments

Special Considerations of High-Yield, Sovereign, and Municipal Credit Analysis

Answer 30

The restricted payments covenant is meant to protect creditors by limiting how much cash can be paid out to shareholders over time. The restricted payments “basket” is typically sized relative to an issuer’s cash flow and debt outstanding - or is being raised - and is an amount that can grow with retained earnings or cash flow, giving management more flexibility to make pay-outs.

Question 31

limitations on liens

Special Considerations of High-Yield, Sovereign, and Municipal Credit Analysis

Answer 31

The limitations on liens covenant is meant to put limits on how much secured debt an issuer can have. This covenant is important to unsecured creditors who are structurally subordinated to secured creditors; the higher the amount of debt that is layered ahead of them, the less they stand to recover in the event of default.

Question 32

restricted vs unrestricted subsidiaries

Special Considerations of High-Yield, Sovereign, and Municipal Credit Analysis

Answer 32

Issuers may classify certain of their subsidiaries as restricted and others as unrestricted as it pertains to offering guarantees for their holding company debt. These subsidiary guarantees they be very useful to holding company creditors because they put their debt on equal standing (pari pass) with debt at the subsidiaries instead of with structurally subordinated debt.

Question 33

maintenance covenants

Special Considerations of High-Yield, Sovereign, and Municipal Credit Analysis

Answer 33

Maintenace covenants are provisions such as leverage tests, whereby the ratio of, say, debt/EBITDA may not exceed “x” times. In the event a covenant is breached, the bank is likely to block further loans under the agreement until the covenant is cured. If not cured, the bank may accelerate full payment of the facility, triggering a default.