Credit Analysis

Question 1

What is the function of credit analysis?

Answer 1

Credit analysis has a crucial function- efficiently allocating capital by properly assessing the credit risk, pricing it accordingly and repricing it as risks change.

Question 2

What questions does credit analysis help to answer?

Answer 2

How do investors determine the riskiness of the the debt?

How do investors decide what they need to earn as compensation for that risk?

Question 3

What is credit risk? What are its two components?

Answer 3

It is the risk of loss resulting from the borrower failing to make full and timely payments of interest and/or principal. It is composed of two components, the default risk and loss severity. Default risk is the probability that the borrower fails to meet its obligations to make full and timely payments of interest and principal according to the terms of the debt security. Loss severity is the portion of the bond’s value an investor loses in the event of default.

Question 4

Spread Risk

why does yield spread widen?

Answer 4

Corporate bonds and other credit risky debt instruments typically trade at a yield premium over bonds that are considered “default free”. The default free debt includes US Treasury bonds or German government bonds. Yield spreads, in basis points, widen because of two reasons:
Deterioration of issuer’s creditworthiness, and /or increase in market liquidity risk.

Downgrade Risk: The risk that a bond issuer’s creditworthiness deteriorates.

Market liquidity risk: The risk that the price at which investors can actually transact may differ from the price indicated on the market.

Question 5

What is seniority ranking?

Answer 5

The seniority ranking refers tot he priority of payment when the issuer is insolvent. The bondholders with the most senior or highest-ranking will be the first in the queue to make a claim on the cash flows and assets of the issuer when the borrower is in default.
All creditors at the same seniority level of the capital structure are treated as one class. This provision is known as bonds ranking pari passu in right of payment.

Recovery rates vary by seniority of ranking in a company’s capital structure, under the priority of claims treatment in bankruptcy.

Question 6

Secured vs non secured debt

Answer 6

All debt can be separated into secured debt and unsecured debt. Secured debt refers that the debt holder has a direct claim- a pledge from the issuer- on certain assets and their associated cash flows. Unsecured debt refers the debt holder has only a general claim on an issuer’s assets and cash flow.

Question 7

What is the seniority ranking list?

Answer 7

First Lien Loan- Senior Secured
Second-Lien Loan- Secured
Senior Unsecured
Senior Subordinated
Subordinated
Junior Subordinated
Equity

Question 8

Why are credit rating agencies popular?

Answer 8

Independent assessment of credit risk
Easy of comparison across issuers and market segments
Regulatory and statutory rely on the ratings
Issuers pay for the service
Huge growth of debt markets
Bond portfolio management depend on the ratings

Question 9

What are issuer and issue ratings?

Answer 9

Issuer credit ratings address an obligor’s overall creditworthiness- its ability and willingness to make timely payments of interest and principal on its debt. The issuer credit rating usually applies to its senior unsecured debt.

Issue ratings refer to the specific financial obligations of an issuer and take into consideration such factors as ranking in the capital structure (secured v subordinated).

Question 10

Notching Process

Answer 10

For rating agencies, default risk is the primary factor in rating. This is followed by priority of payment in default and potential loss severity. Therefore there is the potential for higher or lower loss severity and so rating agencies employ a notching process where credit ratings on issues can be moved up or down from issuer rating, which is usually the rating applied to its senior unsecured debt.

Question 11

Limitations and risks of credit rating agencies

Answer 11

Credit rating can change over time
Credit ratings lag the market’s pricing of credit risk
Rating agencies rating may be based on fraudulent info
Some risks are difficult to capture in credit ratings.

Question 12

Traditional credit analysis of corporate debt securities

Answer 12

The goal of credit analysis is to assess issuer’s ability to satisfy debt obligations. Analysts perform 4C analysis:

Capacity- Ability of the borrower to make payments on time
Collateral- Refers to quality and value of the assets supporting the issuer’s indebtedness
Covenants- Refers tot he terms and conditions in lending agreements that the issuer must comply with
Character- Quality of management

Question 13

What is capacity?

Answer 13

The ability of borrower to service its debt.

Question 14

How do Analysts determine capacity?

Answer 14

Industry analysis is the first step. Porters 5 forces. THen the fundamentals of the industry is assessed, including sensitivity of macro factors, growth prospects, profitability and business needs of high credit quality.
Ie. cyclical? Growth prospects? Industry stats

Analysts can understand industry fundamentals through researching stats.

Then the fundamentals of the company is analysed. This includes:
Competitive position, track record, management strategy and execution , ratio and ratio analysis.

Competitive position- market share over time and against peers. How does it compare to cost structure?

Track record- Performance over time? Trends in revenue, profit and cashflow? Trends on balance sheet, debt vs equity. Current management team?

Management strategy- What strategy to compete and grow? Riskiness? Differentiated? Confidence in ability to execute? Management track record? Balance sheet plans?

Question 15

Cyclical Industries

Answer 15

greater sensitivity to macroeconomics- more volatile revenues, margins and cash flows. Inherently riskier than non-cyclical industries.

Question 16

Little growth industries

Answer 16

Consolidate via mergers and acquisitions. Depends on how they are financed may not be favorable to bond investors.

Question 17

Ratio and Ratio analysis

Answer 17

Is to provide context tot he analysis and understanding of company fundamentals based on industry, competitive position, strategy and execution. Financial measures derived from company’s principal financial statements are examined.

Key credit analysis measures:
Profitability & cash flow- Profitability and cash flow allows for debt servicing. Credit analysts look at operating profit margins and operating income for company’s profitability over time.
Leverage - measure of financial risk
Coverage- Measure ability to “cover” interest payments

Question 18

Profitability and cash flow measures

Answer 18

EBITDA : is equal to operating income plus depreciation and amortisation expense.
FFO = net income from continuing operations + depreciation+ amortisation+ deferred income taxes + other non-cash items
FCF (BD) : (revenues-costs-depreciation)*(1-tax rate)+ depreciation - capex - change in WC

FCF (AD) = FCF (BD) - dividend payments

EBITDA is a crude measure of cash flow because it excludes certain cash-related expenses such as capital expenditures and changes in non-cash working capital.

FCF measures excess cash flow generated by company before payments to shareholders or that could be used to pay down debt or pay dividends.

Question 19

Leverage Ratios

Answer 19

Debt/capital - Shows % of company’s capital base that is financed with debt.
Debt/EBITDA - Higher ratio indicates more leverage and higher credit risk. can be volatile for cyclical companies
FFO/Debt - Higher ratio indicates greater ability to pay debt by funds from operations
FCF(AD)/Debt- Higher ratio indicates that a greater amount of debt can be paid off from free cash flow after dividend payments.

Question 20

Coverage Ratios

Answer 20

EBITDA/Interest Expense- More liberal than EBIT. Higher ratio- higher credit quality

EBIT/Interest Expense- More conservative. less used

Question 21

Capacity- Liquidty

Answer 21

Issuer’s access to liquidity is also important consideration in credit analysis.
Cash on balance sheet
Net working capital
Operating cash flow
Committed bank lines
Debt coming due and committed capital expenditures in the next one to two years.

Question 22

Collateral in 4C

Answer 22

Collateral analysis is typical more prominent in lower credit quality companies. Only when default probability rises to sufficient level do analysts typically consider asset or collateral value in loss severity.

Question 23

Covenants in 4C

Answer 23

Meant to protect creditors while also giving management sufficient flexibility to operate its business in behalf and for the benefit of the shareholders. Define what issuer’s management is obligated to do (affirmative) and limited in doing (negative).

Question 24

Character in 4C

Answer 24

Analysts can make judgement about management’s character in the following ways:

• An assessment of the soundness of management’s strategy
• Management’s track record in executing past strategies, particularly if led to bankruptcy or restructuring.

Use of aggressive accounting policies and/or tax strategies

History of fraud or malfeasance

Previous poor treatment of bondholders

Question 25

The yield on the bond can be decomposed as:

Answer 25

yield= RFR + E + LP +CS +MP

where the yield spread LP+CS

Question 26

Factors that affect the spread on corp bonds

Answer 26

Credit cycle
Broader economic conditions
Financial market performance overall, including equities
Broker/dealers willingness to provide sufficient capital for marketing making
General market supply and demand

Question 27

Factors that impact the Price Impact(volatility) from spread changes

Answer 27

Modified duration and the magnitude of spread change.