Reading 47: Fundamentals of Credit Analysis Flashcards
Explain how high-yield bonds can be viewed as a hybrid between investment-grade bonds and equity securities.
Movements in prices and spreads for high-yield bonds are less influenced by interest rate changes compared to investment-grade bonds.
Returns on high-yield bonds are highly correlated with movements in equity markets.
Describe notching.
In order to account for these different payment priorities, rating agencies have adopted the practice of notching, whereby they move credit ratings for specific issues up or down relative to the issuer rating (which applies to senior unsecured debt).
Define a general obligation (GO) bond, and identify the focus of the economic analysis of GO bonds.
GO bonds are unsecured bonds issued with the full faith and credit of the issuing entity, and are supported by the taxing authority of the issuer.
Economic Analysis of a GO Bond:
Employment
Per capita debt
Tax base
Demographics
Infrastructure and location for attracting and supporting new jobs
Volatility and variability of tax revenues during times of both economic strength and weakness
Unfunded pension and post-retirement obligations
The issuer’s ability to operate within its budget
What should analysts consider when evaluating management’s character?
Evaluate the suitability and reliability of management’s strategy.
Assess management’s track record in executing strategies successfully, while keeping the companies they run clear of bankruptcy, restructuring, and other distressed situations.
Identify the use of aggressive accounting policies and/or tax strategies.
Look for any history of fraud or malfeasance.
Look for instances of poor treatment of bondholders in the past.
Why do ratings tend to lag market pricing of credit?
Bond prices and credit spreads tend to change more quickly (to reflect changes in perceived creditworthiness) than credit ratings assigned to bonds. Most of the time, credit rating changes are already “priced in” by the market.
Why may a company issue subordinated debt?
Because (1) it is less expensive than issuing equity (and does not dilute existing shareholders’ holdings), (2) it is usually less restrictive than issuing senior debt, and (3) investors may be willing to buy it if they believe that the offered yield adequately compensates them for the associated risk.
Categorize the ratios analysts use to assess a company’s financial strength, and give the commonly used ratios.
Profitability and cash flow measures:
Earnings before interest, taxes, depreciation, and amortization (EBITDA)
Funds from operations (FFO)
Free cash flow before dividends and after dividends
Leverage ratios:
Debt/Capital
Debt/EBITDA
FFO/Debt
Coverage ratios:
EBITDA/Interest expense
EBIT/Interest expense
Why may companies issue secured debt?
It is required by investors given the company’s perceived riskiness or it is cheaper than unsecured debt due to its higher ranking in the priority of claims.
Name the aspects of company fundamentals.
Competitive position
Track record/operating history
Management’s strategy and execution
Ratios and ratio analysis
Explain the 2 components of credit risk.
- Default risk or default probability: This refers to the probability of a borrower failing to meet its obligations to make full and timely payments of principal and interest under the terms of the bond indenture.
- Loss severity or loss given default: This refers to the portion of the bond’s value that an investor would lose if a default actually occurred. A default does not necessarily mean that the investor will lose the entire amount invested.
Mathematically express the yield on a corporate bond.
Yield on a corporate bond = Real risk-free interest rate + Expected inflation rate + Maturity premium + Liquidity premium + Credit spread
Identify the factors that affect yield spreads on corporate bonds.
Credit cycle
Broader economic conditions
Financial market performance overall, including equities
Broker-dealers’ willingness to provide sufficient capital for market making
General market supply and demand
Distinguish between downgrade risk or credit migration risk and market liquidity risk.
Downgrade risk or credit migration risk: This is the risk that the issuer’s creditworthiness may deteriorate during the term of the bond, causing rating agencies to downgrade the credit rating of the issue.
Market liquidity risk: This is the risk that an investor may have to sell her investment at a price lower than its market value due to insufficient volumes (liquidity) in the market.
List the reasons why companies may be rated below investment grade.
Highly leveraged capital structure.
Weak or limited operating history.
Limited or negative free cash flow.
High sensitivity to business cycles.
Poor management.
Risky financial policies.
Lack of scale and/or competitive advantage.
Large off-balance-sheet liabilities.
Bleak industry outlook.
List the sources of liquidity for high-yield companies, from strongest to weakest.
Cash on the balance sheet
Working capital
Operating cash flow
Bank credit facilities
Equity issuance
Asset sales
