Part 17. Fundamentals of Credit Analysis

Question 1

Credit risk

Answer 1

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

Question 2

Default risk

Answer 2

The probability that a borrower (bond issuers) fails to pay interest or repay principal when due.

Question 3

Loss severity

Answer 3

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.

Question 4

Expected loss

Answer 4

This is equal to the default risk multiplied by loss severity; stated as a monetary value or percentage.

Question 5

Recovery rate

Answer 5

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.

Question 6

Yield spread

Answer 6

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.

Question 7

Spreads

Answer 7

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.

Question 8

Spread risk

Answer 8

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.

Question 9

Seniority ranking

Answer 9

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.

Question 10

Secured vs unsecured debt

Answer 10

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.

Question 11

Why seniority ranking is needed?

Answer 11

• 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.

Question 12

Cross default provision

Answer 12

When a company defaults on one of its several outstanding bonds, provisions in bond indentures may trigger default on the remaining issues as well.

Question 13

Notching

Answer 13

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.

Question 14

Structural subordination

Answer 14

• 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.

Question 15

4 risks relying on ratings from credit rating agencies:

Answer 15

1. Credit ratings are dynamic - they can change overtime.
2. Rating agencies are not perfect.
3. Event risk is difficult to assess - e.g. litigation risk, events such as natural disasters, acquisitions, equity buyback using debt.
4. 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.

Question 16

4 C’s of credit analysis:

Answer 16

1. Capacity - A corporate borrowers ability to repay its debt obligations on time.
2. Collateral
3. Covenants - the terms and conditions the borrowers and lenders agree to as part of a bond issue.
4. Character - refers to managements integrity and commitment to repay the loan.

Question 17

3 levels of assessment on capacity:

Answer 17

1. 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

3. Company fundamentals - a corporate borrower should be assessed on:

• Competitive position
• Operating history
• Managements strategy and execution
• Ratios and ratio analysis

Question 18

Collateral

Answer 18

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.

Question 19

Covenants

Answer 19

2 types:

1. 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.
2. 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.

Question 20

Character

Answer 20

Includes assessment of:

• Soundness of strategy
• Track record
• Accounting policies and tax strategies
• Fraud and malfeasance record
• Prior treatment of bondholders

Question 21

4 profit and cashflow metrics used in ratio analysis by credit analysis:

Answer 21

1. 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.

2. Funds from operation (FFO) - net income from continuing operations plus depreciation, amortisation, deferred taxes and noncash items.
3. Free cash flow before dividends - the net income plus depreciation and amortisation minus capital expenditures minus increase in working capital, excluding nonrecurring items.
4. 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.

Question 22

Leverage ratios:

Answer 22

1. 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.
2. 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.
3. FFO/debt ratio - this ratio divides a cash flow measure by value of debt, a higher ratio indicates lower credit risk.
4. FCF after dividends/debt - greater values indicate greater ability to service existing debt.

Question 23

Coverage ratio:

Answer 23

This measures the borrowers ability to generate cash flows to meet interest payments.

1. 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.
2. EBIT/interest expense - higher ratio indicates lower credit risk; a more conservative measure as depreciation and amortisation are subtracted from earnings.

Question 24

yield spread

Answer 24

yield spread = liquidity premium + credit spread

Question 25

Yield spreads on CB affected primarily by 5 interrelated factors:

Answer 25

1. Credit cycle - spread narrows then cycle improves, and spread widens the cycle deteriorates.
2. Economic conditions - spread narrows then economy strengthens, and investor expect firms credit metrics to improve.
3. Financial market performance - spread narrows in strong performing markets overall, including equity market, and widen in weak performing markets. Steady performing markets with low volatility of returns, spreads tend to narrow as investors reach for yield.
4. Broker-dealer capital - most bond trade OTC, broker deals provide market making capital for bond markets to function; spreads that are narrower when broker deals provide sufficient capital; and widen then become scare.
5. General market demand and supply - spread narrows in times of high demand for bonds, and widens in times of low demand for bonds.

Question 26

High yield (non investment grade)

Answer 26

Due to higher perceived risk; corporate bonds are rated below Baa3/BBB by credit agencies.

reason for non investment grade ratings:

• high leverage
• unproven operating history
• low or negative free cash flow
• high sensitivity to business cycles
• low confidence in management
• unclear competitive advantages
• large off balance sheet liabilities
• industry in decline

Question 27

Special considerations for high yield bonds:

Answer 27

• Liquidity
• Financial projections
• Debt structure
• Corporate structure
• Covenants

Question 28

6 sources of liquidity (in order of reliability):

Answer 28

1. Balance sheet cash
2. Working capital
3. Operating cash flow (CFO)
4. Bank credit
5. Equity issued
6. Sales of assets

Question 28

6 sources of liquidity (in order of reliability):

Answer 28

1. Balance sheet cash
2. Working capital
3. Operating cash flow (CFO)
4. Bank credit
5. Equity issued
6. Sales of assets

Question 29

Financial projections

Answer 29

This is important in highlighting potential vulnerabilities to inability to meet debt payments, through stress scenarios, accounting for changes in capital expenditures and working capital.

Question 30

Debt structure

Answer 30

This includes different types of debt with several levels of seniority; hence varying levels of potential loss severity.

Credit analyst will calculate leverage for each level of debt structure when issuer has multiple layers of debt with variety of expected recovery rates.

Companies with top heavy capital structures (secured bank debt is high proportion of capital structure) are more likely to default and have lower recovery rates for unsecured debt issues.

Question 31

Corporate structure

Answer 31

High yield companies use holding company structure; where parent company receives dividends from earnings of subsidiaries at its primary source of operating income.

Structural subordination, where subsidiaries dividends paid upstream to parent company are subordinate to interest payments; but dividends can be insufficient to pay debt obligations of parent, reducing recovery rate for debt holders of parent company.

Question 32

Important covenants for high yield debt include:

Answer 32

1. Change of control put
2. Restricted payments
3. Limitations on lien
4. Restricted vs unrestricted subsidaries

Question 32

Important covenants for high yield debt include:

Answer 32

1. Change of control put:
   - give debt holders the right to require issuer to buy back debt in event of an acquisition; for investment grade bonds this applies only if acquisition of borrower results in rating downgrade to below investment grade.
2. Restricted payments:
   - protects lenders by limiting the amount of cash may be paid to equity holders.
3. Limitations on lien:
   - limits amount of secured debt that borrower can carry; where unsecured debt holders prefer issuer to have less secured debt, which increases recovery amount available in event of default.
4. Restricted vs unrestricted subsidiaries:

• restricted = cash flows and assets can be used to service debt of parent holding company; benefiting creditor of holing companies as their debt is pari passu with debt of restricted subsidiaries than structurally subordinated.
• restricted - holding company’s larger subsidiaries that have significant assets
• bank covenants are more restrictive than bond covenants; when violated, banks can block additional loans until violation is corrected.
• if violation is not remedied, banks can trigger default by accelerating full repayment of loan.

Question 33

Enterprise value

Answer 33

The equity market capitalisation plus total debt minus excess cash.

• for high yield companies, not publically traded, comparable public equity data can be used to estimate EV.
• EV analysis can indicate firms potential for additional leverage, or potential credit damage might result from leveraged buyout.
• analyst can compare firms based on difference between EV/EBITDA and debt/EBITDA ratios.
• firms with wider difference between these ratios have greater equity relative to their debt; hence less credit risk.

Question 34

Sovereign debt

Answer 34

This is issued by national governments; where analysis must assess both governments ability to service debt and willingness to do so.

5 key areas:

1. Institutional assessment
2. Economic assessment
3. External assessment
4. Fiscal assessment
5. Monetary assessment

Question 35

Local vs foreign currency debt rating

Answer 35

• ratings are assigned separately as defaults on foreign currency denominated debt have historically exceeded local currency debt.
• foreign currency has higher default rate, and lower credit rating as gov must purchase foreign currency in open market to make interest and principal payments; exposing it to risk of significant local currency depreciation.
• access to debt markets can be difficult for sovereigns in bad economic times.

Question 36

Non sovereign gov debt

Answer 36

This is issued by local governments, and quasi governmental entities.

Question 37

Municipal bonds

Answer 37

• A general obligation bonds or revenue bonds.
• Most often exempt from national income taxes.
• Default rates are very low relative to general corporate bonds.

Question 38

General obligation (GO) bonds

Answer 38

These are unsecured bonds backed by full faith credit of issuing governmental entity, supported by its taxing power.

• cannot use monetary policy to service debt, just balance their operating budgets.
• servicing GO by municipalities depends on local economy; where economic factors such as employment, trends in per capita income etc, evaluate creditworthiness of GO bonds.
• must also observe revenue variability through economic cycles; as relying on highly variable taxes can signal higher credit risk.

Question 39

Revenue bonds

Answer 39

They are issued to finance specific projects such as airports, toll bridges, hospitals and power generation facilities.

Often have higher credit risk than GO bonds as project is sole source of funds to service debt.