Fundamentals of credit analysis

Question 1

Credit risk is best measured by _____

Answer 1

by “expected loss”
- includes default risk and loss severity

expected loss = default prob * loss severity given default

loss severity = 1 - recovery rate

Question 2

Recovery rates vary based on:

Answer 2

• pari passu: creditors at the same level of capital structure will have the same recover rate; “on equal footing”
• vary by seniority ranking
• vary by industry
• vary by companies within the industry
• depends on where they occur in a credit cycle
• priority of claims is not always absolute

Question 3

Credit Rating grades by different agencies

Answer 3

• S&P and Fitch use the same symbols

High Qual
Moody's           S&P/Fitch 
Aaa                    AAA
Aa1                     AA+
Aa2                    AA
Aa3                    AA-
Upper-mid grades 
A1                       A+
A2                      A
A3                      A-
Low-mid grades
Baa1                  BBB+
Baa2                 BBB
Baa3                 BBB-
Low grade/spec
Ba1                    BB+
Ba2                   BB
Ba3                   BB-
B1                      B+
B2                     B
B3                      B-
Caa1                  CCC+
Caa2                 CCC
Caa3                  CCC-
Ca                      CC
C                        C
Default grade
C                        D

Question 4

The 4 Cs of credit analysis

Answer 4

• Capacity - ability to make payments
• Collateral - quality and value of the assets pledged against the debt
• Covenants - terms/conditions issuer must comply with
• Character - quality of the management

Question 5

Capacity

Answer 5

• the borrower’s ability to generate CF to service debt

uses a top-down approach to determine an issuer’s capacity in credit analysis

• industry structure (porter’s 5)
• industry fundamentals: cyclical/non-cyclical, growth prospects, published industry stats
• company fundamentals: track record/operating history, management’s strategy/execution, ratio analysis
• competitive position

Question 6

Key ratios used in credit analysis

Answer 6

• profitability ratios: higher is better
• cash flow measures: higher is better
• leverage ratios: lower is better
• coverage ratios: higher is better

Question 7

Affirmative covenants

Answer 7

• what the issuer is obligated to do

ie make interest and principal payments on time, comply with laws and regulations

Question 8

Negative covenants

Answer 8

• what the issuer must not do

ie: restrictions on debt, limits on maximum acceptable leverage ratios and min acceptable interest coverage ratios

Question 9

If a bond portfolio worth $100M, has a modified duration of 10, and convexity of 50, what will happen if spreads widen by 25bps.
Solve for a small change in yield and for a large change in yeild

Answer 9

small change in yield: (without convexity adjustment)
= -ModDur * ▲Spread
= -10 * .0025
= -2.5%
ie the portfolio will lose 2.5% of its value if spreads go up by 25bps

large change in yield: (with convexity adjustment)
= [ -ModDur * ▲Spread ] + [ 0.5 * convexity * ▲Spread^2 ]
= -2.5% + [ 25 * .00000625 ]

Question 10

The factors a credit analyst must focus on for a high-yield bond are:

Answer 10

• liquidity and CF
• detailed financial projections
• debt structure
  - leverage: Debt/EBITDA
• issuer’s corporate structure
• covenants
• equity-like approach to HY analysis
  
  • EV = equity market cap + total debt - cash
  • EV/EBITDA
  • debt/EBITDA

*there is a high corr. between returns on stocks and HY bonds