FI: Fundamentals of Credit Analysis

Question 1

2 components of credit risk =

Answer 1

default risk

loss severity = 1 - recovery rate (%)

expected loss = default risk x loss severity

Question 2

Spread risk =

x2 factors

Answer 2

the possibility that a bond’s spread will widen due to:

credit migration risk/downgrade risk

Market liquidity risk: receiving less than market value when selling a bond - large bid/ask spread.

greater for smaller issues w/ little debt

Question 3

Seniority ranking =

Answer 3

1. FIRST LIEN (MORTGAGE)
2. SENIOR SECURED DEBT
3. JUNIOR SECURED DEBT
4. SENIOR UNSECURED DEBT
5. SENIOR SUBORDINGATED DEBT
6. SUBORDINATED DEBT
7. JUNIOR SUBORDINGATED DEBT

Question 4

CFR VS CCR =

Answer 4

ratings agencies rate both issuers and issues

Corporate family rating: rating of the issuer - based on senior unsecured debt

Corporate credit rating: issue specific.

Question 5

Notching =

Answer 5

assigning different ratings to debt of the same issuer, considering seniority of bonds and impact on potential loss severity

less commnon for highly rated issuers

rating agencies will consider structural subordination: *sometimes subsidiaries and covenants will make cash flows prioritized for certain parts of the firm/lenders *

Question 6

4x risks of relying on credit ratings FROM AGENCIES =

Answer 6

• Credit ratings are DYNAMIC
• RATING AGENCIES ARE NOT PERFECT
• EVENT RISK is DIFFICULT TO ASSESS
• credit ratings LAG market prices

Question 7

4x key components of credit analysis =

THE 4 ‘C’S’

Answer 7

1. CAPACITY
2. COLLATERAL
3. COVENANTS
4. CHARACTER

Question 8

4x key components of credit analysis: 1 =

Answer 8

CAPACITY - borrowers ability to repay debt obligations on time

JUDGE CAPACITY BY LOOKING AT A, B, C

A) INDUSTRY STRUCTURE - described by porter’s five forces -

• rivalry among competitors
• threat of new entrants
• threat of substitute products
• bargaining power of buyers
• bargaining power of suppliers

B) INDUSTRY FUNDAMENTALS - incl macro factors relevant to growth prospect + profitability

• industry cyclicality
• industry growth prospects
• industry published statistics

C) COMPANY FUNDAMENTALS

• competitive position
• operating history
• management strategy and execution
• ratios

Question 9

4x key components of credit analysis: 2 =

Answer 9

COLLATERAL

• intangible assets - patents are a high quality intangible asset, good will is not (often written down when performance is poor)
• depreciation - high depreciation expense to capital may signal lack of investment. If asset quality is bad operating cash flow and profitability may suffer
• equity market cap - a stock trading below book value may indicate company assets are low quality
• human and intellectual capital - difficult to value but can function as collateral

Question 10

4x key components of credit analysis: 3 =

Answer 10

COVENANTS

can be NEGATIVE or AFFIRMATIVE

strict covenants can make it more difficult for borrowers to pay

but give lenders more uncertainty - covenants provide a legally binding framework

Question 11

4x key components of credit analysis: 4 =

Answer 11

CHARACTER

management’s integrity and commitment to repay a loan

• soundness of strategy
• track record
• accounting policies and tax strategies
• fraud and malfeasance record
• prior treatment of bond holders

Question 12

Profit & cash flow measures: EBITDA =

Answer 12

OPERATING INCOME + D + A

note: does not adjust for capital expenditures and changes in working capital, which are not available to bond holders

I’M NOT QUITE SURE WHETHER THAT MEANS THEY ARE INCLUDED OR NOT…

Question 13

Profit & cash flow measures: FFO =

Answer 13

NET INCOME + D + A + deferred taxes + noncash items

similar to CFO but EXCLUDES CHANGES IN WORKING CAPITAL

tigher measure than both EBITDA and CFO

Question 14

Profit & cash flow measures: FCF BEFORE DIVIDENDS =

Answer 14

NET INCOME + D + A - CAPEX - INCREASE IN WORKING CAPITAL

EXCLUDES NON RECURRING ITEMS

Question 15

Profit & cash flow measures: FCF AFTER DIVIDENDS =

Answer 15

NET INCOME + D + A - CAPEX - CHANGE IN WORKING CAPITAL - DIVIDENDS

(fcf before dividends, minus the dividends!)

if FCF AFTER DIV is positive, this represents cash that could pay down debt or accumulate on the balance sheet.

Question 16

Leverage Ratios: Debt/Capital =

Answer 16

THE PERCENtAGE OF THE CAPITAL STRUCTURE FINANCED BY DEBT

denominator = the capital structure, debt + equity

lower value equals less credit risk ie less debt financing

Question 17

Leverage Ratios: Debt/EBITDA =

Answer 17

higher ratio = higher risk/leverage

note: more variable for firms in cyclical industries or with high operating leverage, as this causes variability of EBITDA

Question 18

Leverage Ratios: FFO/Debt =

Answer 18

as with debt/ebitda, higher ratio = more risk

(cash flow measure/value of debt)

Question 19

Coverage Ratios: EBIT/interest and EBITDA/interest =

Answer 19

measure theborrower’s ability to generate cash flow to meet interest payments

higher ratio indicates LOWER CREDIT RISK

EBITDA/interest is used more often, which is a greater value than EBIT/interest (obviously a more conservative measure of interest coverage)

Question 20

5x factors influencing yield spreads =

with yield spreads being the liquidity and credit portion of the yield (excluding compensation for interest rate/inflation/maturity risk)

Answer 20

1. credit cycle
2. economic conditions
3. financial market performance
4. broker-dealer capital
5. general market demand & supply

yield spreads on higher quality issues are less volatile than lower quality issues

Question 21

Return impact from a change in spread =

small spread change

Answer 21

sidenote: credit curves/spread curves show spread vs maturity, and are typically upward sloping (as maturity increases so does spread)

Question 22

Return impact from a LARGE change in spreads =

Answer 22

use 1/2 times convexity.

“check that the convexity value is the same order of magnitude (# decimal places?) as modified duration squared”

Question 23

HY Factors: Liquidity =

Answer 23

availability of cash is critical for HY issuers

Analysts focus on 6 sources of liquidity, in order of reliability:

1. balance sheet cash
2. working capital
3. operating cash flow (CFO)
4. bank credit
5. equity issued (many HY issuers dont have access to public equity markets)
6. sales of assets

Liquidity is critical - companies may have to fund long term assets with short term liabilities and rely on these sources.

Question 24

HY Factors: Financial Projections =

Answer 24

projections of future earnings and cash flows, including stress tested scenarios and accounting for changes in capex and working capital, is crucial to understand potential vulnerabilities.

Question 25

HY Factors: Debt Structure = + 'top heavy capital structure'

Answer 25

analyst will need to calculate leverage for each level of the capital structure - multiple levels will mean different risk/recovery rates. A top heavy capital structure is when a company has a high proportion of secured bank debt - reducing their potential/ability to borrow from banks if a stressful period arises --\> more likely to default and have lower recovery rate for unsecured debt issues

Question 26

HY Factors: Corporate Structure =

Answer 26

**Hold co's:** parent company is paid dividends from its subsidiaries. For subsidiaries, these dividends are subordinate to interest payments - which can reduce the recovery rate of the hold co/parent company debt. However, the parent's rating may be higher as it has multiple/diverse cash flow streams MBOs/M&A can result in complicated structures and intermediate hold co's If one subsidiary defaults, there is not necessarily a cross default --\> you need to calculate leverage ratios at each level as well as on a consolidated basis

Question 27

HY Factors: Covenants = x4

Answer 27

* **Change of control put** - can put back the bond if an acquisition takes place * **Restricted payments -** protects lenders by restricting the amount of cash that may be paid to equity holders * **Limitations on liens -** limits the amount of secured debt an issuer can have * **Restructed versus unrestricted subsidiaries -** restricted subsidiaries' assets can be used to cover obligations of the parent company - better for bond holders of the parent company Loan covenants are generally more restrictive than bond covenants

Question 28

HY and Equity =

Answer 28

HY is considered to be more like Equity than IG - greater prces and spread volatility.

Question 29

EV - enterprise value =

Answer 29

market cap + total debt - excess cash can be estimated for non public HY companies by looking at a comparable company. allows analysis of potential for leverage and damage from a leveraged buyout. greater difference between EV/EBITDA and debt/EBITDA shows more equity relative to debt and less credit risk and more potential for increased leverage.

Question 30

Sovereign Debt = Assigning ratings

Answer 30

rating based on ability and willingess to pay - willingness is important as there is normally no legal recourse in the case of default. ratings are assigned to 1. Local currency debt 2. Foreign currency debt default rates on foreign currency debt are typically higher - it involves currency risk for the issuer.

Question 31

Sovereign Debt = 5x evaluation factors

Answer 31

1. Institutional effectiveness 2. Economic prospects - growth, demographic etc 3. International investment position incl reserves, external debt, status of currency 4. Fiscal flexibility 5. Monetary flexibility

Question 32

Muni debt = GO

Answer 32

usually have lower default rates than corporates of the same rating. factors to assess include * employment * trends in per capita income and debt * demographics * ability to attract new jobs * revenue variablity due to tax/economic cycles * long term obligations ie pension plans/post-retirement benefits, possibly underfunded

Question 33

Muni debt = Revenue bonds

Answer 33

higher credit risk than GO bonds as the project is the sole source of funds. Analysis focuses on the project, with similar techniquest to analyzing corporate bonds. *key metric: DSCR* **debt service coverage ratio:** net revenue/required interest and principal payments (higher ratio is better) many rev bonds have a minimum debt service coverage ratio to protect the lenders' interest.