Credit Analysis Flashcards
What is the function of credit analysis?
Credit analysis has a crucial function- efficiently allocating capital by properly assessing the credit risk, pricing it accordingly and repricing it as risks change.
What questions does credit analysis help to answer?
How do investors determine the riskiness of the the debt?
How do investors decide what they need to earn as compensation for that risk?
What is credit risk? What are its two components?
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.
Spread Risk
why does yield spread widen?
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.
What is seniority ranking?
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.
Secured vs non secured debt
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.
What is the seniority ranking list?
First Lien Loan- Senior Secured Second-Lien Loan- Secured Senior Unsecured Senior Subordinated Subordinated Junior Subordinated Equity
Why are credit rating agencies popular?
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
What are issuer and issue ratings?
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).
Notching Process
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.
Limitations and risks of credit rating agencies
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.
Traditional credit analysis of corporate debt securities
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
What is capacity?
The ability of borrower to service its debt.
How do Analysts determine capacity?
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?
Cyclical Industries
greater sensitivity to macroeconomics- more volatile revenues, margins and cash flows. Inherently riskier than non-cyclical industries.
Little growth industries
Consolidate via mergers and acquisitions. Depends on how they are financed may not be favorable to bond investors.
Ratio and Ratio analysis
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
Profitability and cash flow measures
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.
Leverage Ratios
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.
Coverage Ratios
EBITDA/Interest Expense- More liberal than EBIT. Higher ratio- higher credit quality
EBIT/Interest Expense- More conservative. less used
Capacity- Liquidty
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.
Collateral in 4C
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.
Covenants in 4C
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).
Character in 4C
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
The yield on the bond can be decomposed as:
yield= RFR + E + LP +CS +MP
where the yield spread LP+CS
Factors that affect the spread on corp bonds
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
Factors that impact the Price Impact(volatility) from spread changes
Modified duration and the magnitude of spread change.
