Part 17. Fundamentals of Credit Analysis Flashcards
Credit risk
The risk associated with losses stemming from the failure of a borrower to make a timely and full payments of interest or principal.
2 components:
- default risk
- loss severity
Default risk
The probability that a borrower (bond issuers) fails to pay interest or repay principal when due.
Loss severity
This refers to the value a bond investor will lose if issuer defaults; stated as a monetary amount or as a percentage of a bond’s value.
Expected loss
This is equal to the default risk multiplied by loss severity; stated as a monetary value or percentage.
Recovery rate
The percentage of a bond’s value an investor will receive if the issuer defaults.
Loss severity as a percentage is equal to 1 - recovery rate.
Yield spread
The difference in yield between a credit risky bond and credit risk free bond of similar maturity.
Bonds with credit risk trade at higher yields than bonds thought to be free of credit risk.
Spreads
Bonds are inversely related to spreads, the wider the spread implies lower bond price, and narrower spread implies higher price.
The size of spread reflects creditworthiness of issuer and liquidity of the market for its bonds.
Spread risk
The possibility that a bonds spread will widen due to 1 or both of these factors:
Credit mitigation/downgrade risk = the possibility that spreads will increase because the issuer has become less creditworthy.
Market liquidity risk = the risk of receiving less than market value when selling a bond reflected in size of bid-ask spreads.
- greater for bonds of less creditworthy issuers, and for bonds of smaller issuers with relatively little publicly traded debt.
Seniority ranking
A bonds priority of claims to issuers assets and cash flows.
For debt repayment priority:
- First lien/senior secured
- Second lien/secured
- Senior unsecured
- Senior subordinated
- Subordinated
- Junior subordinated
- all debt within same category is said to rank pari passu, or have same priority of claims.
- recovery rates highest for debt with highest priority of claims.
- lower seniority ranking of a bond, the higher its credit risk; with investors requiring a higher yield to accept lower ranks.
Secured vs unsecured debt
Secured debt = this is backed by collateral, distinguished as first lien, senior secured or junior secured debt.
Unsecured debt (debentures) represent a general claim to issuers assets and cash flows, further divided into senior, junior and subordinated graduations.
Why seniority ranking is needed?
- in event of default, senior leaders have claims on assets before junior lenders and equity holders.
- in many case, low priority debt holders may get paid even if senior debt holders are not paid in full.
- Bankruptcies can be costly, taking a long time to settle.
- Value of assets could deteriorate due to loss of customers, key employees, while legal expenses amount.
- to avoid delays, bankruptcy reorganisation plan may not strictly conform to original priority of claims.
Cross default provision
When a company defaults on one of its several outstanding bonds, provisions in bond indentures may trigger default on the remaining issues as well.
Notching
The assignment of individual issue ratings that are higher or lower than of the issuer.
For firms with high overall credit ratings, differences in expected recovery rates among firms individual bonds are less important, so bonds may not be notched at all.
Notching more likely for firm with higher probabilities of default (lower ratings) since difference in expected recovery rates among firms bonds are more significant.
Firm with speculative credit, its subordinated debt might be notched 2 ratings below its issuer rating.
Structural subordination
- In a holding company structure, parent company and subsidiaries may have outstanding debt; and subsidiary debt covenants may restrict transfer of cash or assets “upstream” to parent company before subsidiary debt is serviced.
Even though, parent company bonds are not junior to subsidiary bonds, the subsidiary bonds have priority claim to subsidiary cash flows; hence parent company bonds are effectively subordinated to subsidiary bonds.
4 risks relying on ratings from credit rating agencies:
- Credit ratings are dynamic - they can change overtime.
- Rating agencies are not perfect.
- Event risk is difficult to assess - e.g. litigation risk, events such as natural disasters, acquisitions, equity buyback using debt.
- Credit ratings lag market pricing - market price and credit spreads can change much faster than credit ratings, market prices reflect expected losses, while CR only assess default risk.
4 C’s of credit analysis:
- Capacity - A corporate borrowers ability to repay its debt obligations on time.
- Collateral
- Covenants - the terms and conditions the borrowers and lenders agree to as part of a bond issue.
- Character - refers to managements integrity and commitment to repay the loan.
3 levels of assessment on capacity:
- Industry structure - described by Porters 5 forces:
- Threat of entry
- Power of suppliers
- Power of buyers
- Threat of substitution
- Rivalry among existing competitors
2, Industry fundamentals - the influence of macroeconomic factors on industry growth prospects and profitability.
Focus on:
- Industry cyclicality
- Industry growth prospects
- Industry published statistics
- Company fundamentals - a corporate borrower should be assessed on:
- Competitive position
- Operating history
- Managements strategy and execution
- Ratios and ratio analysis
Collateral
Of greater importance for less creditworthy companies, things to consider include:
- Intangible assets - e.g. patents (HQ), goodwill (LQ).
- Depreciation - high depreciation expense relative to capital expenditures signal management is not investing sufficiently in company.
- Equity market capitalisation - stock that trades below book value may indicate capital assets of low quality.
- Human and intellectual capital - difficult to value; but company with IC can function as collateral.
Covenants
2 types:
- Affirmative covenants = require borrower to take certain actions, such as using the proceeds for the stated purpose; paying interest, principal and taxes; carrying insurance on pledged assets; continuing business activity and following relevant laws and regulations.
- Negative covenants = restrict borrower from taking certain actions that may reduce the value of the bondholders claims; constraining the issuers business activities and impose significant costs to issuer.
e. g. restrictions on payment of dividends and share repurchases, restrictions on amount of additional debt borrower can issue.
Character
Includes assessment of:
- Soundness of strategy
- Track record
- Accounting policies and tax strategies
- Fraud and malfeasance record
- Prior treatment of bondholders
4 profit and cashflow metrics used in ratio analysis by credit analysis:
- Earnings before interest, taxes, depreciation and amortisation (EBITDA)
Pro - used measure calculated as operating income plus depreciation and amortisation.
Con - it does not adjust for capital expenditure and changes in working capital, necessary uses of funds for a going concern; cash needed for these uses not available to debt holders.
- Funds from operation (FFO) - net income from continuing operations plus depreciation, amortisation, deferred taxes and noncash items.
- Free cash flow before dividends - the net income plus depreciation and amortisation minus capital expenditures minus increase in working capital, excluding nonrecurring items.
- Free cash flow after dividends - free cash flow before dividends minus dividends; if free cash flow after dividends > 0, this represents cash that could pay down debt or accumulate on balance sheet.
Leverage ratios:
- Debt/capital ratio - the percentage of capital structure financed by debt; lower ratio indicates less credit risk. If FS list high value for intangible assets such as good will, analyst should calculate 2nd debt to capital ratio adjusted for write down of assets after-tax value.
- Debt/EBITDA - a higher ratio indicates higher leverage and credit risk; the ratio more volatile for firms in cyclical industries or high operating leverage, because of high variability of EBITDA.
- FFO/debt ratio - this ratio divides a cash flow measure by value of debt, a higher ratio indicates lower credit risk.
- FCF after dividends/debt - greater values indicate greater ability to service existing debt.
Coverage ratio:
This measures the borrowers ability to generate cash flows to meet interest payments.
- EBITDA/interest expense - higher ratio indicates lower credit risk; used more often than EBIT/interest expense ratio as depreciation and amortisation are still included as part of cash flow measure; thus a higher value.
- EBIT/interest expense - higher ratio indicates lower credit risk; a more conservative measure as depreciation and amortisation are subtracted from earnings.
yield spread
yield spread = liquidity premium + credit spread