What Drives Risk Premium in Corporate Bonds

Question 1

What causes some companies to have a higher cost of debt?

Answer 1

-probability of default
-loss given default

Question 2

expected loss

Answer 2

= probability of default * loss given default

Question 3

what would need to occur for the Company to generate insufficient cash to service its debt?

Answer 3

Reported EBITDA
Adjusted EBITDA

Question 4

Reported EBITDA

Answer 4

earnings before interest, tax, depreciation, and amortization

Question 5

Adjusted EBITDA

Answer 5

is meant to capture the core operating performance of the company

negative EBITDA is a problem- negative cash flow, burning cash

Question 6

EBITDA

Answer 6

revenue * gross margins - operating expenses

Question 7

risks to volume

Answer 7

-customer relationships
-contractual revenue
-macro risk
-competitive moat

Question 8

customer relationships

Answer 8

why do customers choose to work with this business over a competitor?

who are the company’s largest customers? how much volume do those customers represent?

how long have they had a relationship? how “sticky” is the relationship?

if the company lost a major customer, could management easily find replacement volume?

Question 9

contractual revenue

Answer 9

-average tenor, relative to the maturity of your debt
-minimum volume guarantees?

Question 10

macro risk

Answer 10

what macroeconomic factors impact demand for the company’s products?

where does the company sell its products? if its in one geographic area, how would the company manage through a downturn in that specific area?

Question 11

competitive moat

Answer 11

barriers to entry
switching costs

Question 12

barriers to entry

Answer 12

how difficult would it be for a new competitor to enter the market place?

Question 13

switching costs

Answer 13

how costly would it be for a customer to switch to an existing competitor

Question 14

three ways your market can decrease

Answer 14

1. aggregate market decreasing
2. people switching to an existing competitor
3. new competitor entrace

Question 15

risks to price

Answer 15

how important is price to the customer ?

what portion of the customer’s cost structure is our borrower’s product?

what would occur if the quality or timeliness declines? (airplane)

is the company’s product commodity or commoditized
(commoditized: customer’s main decision point is on price)

are prices volatile? if so, why?

Question 16

risks to gross margin

Answer 16

supplier relationship
margin by segment

Question 17

supplier relationship

Answer 17

what portion of the company’s purchases are from its largest supplier? largest 5?

if the company has a material concentration, how long has it worked with said supplier?

is the company the supplier’s largest customer? is the company able to pass raw material price increases on to customers?

Question 18

operating expense implications

Answer 18

aggregate spend
degree of operating leverage

Question 19

aggregate spend

Answer 19

what percent of revenue does the company spend on opex per annum?

Question 20

degree of operating leverage

Answer 20

what portion of the Company’s cost structure is fixed vs variable?

during a period of compressed demand what levers could the company pull to maintain profitability on a lower revenue base?

Question 21

financial policy

Answer 21

how likely is management to use leverage to seek shareholder returns?
-debt financed capital expenditures
-debt financed distributions
-debt financed acquisitions, depending on multiple

can be mitigated by covenants

Question 22

liquidity

Answer 22

cash on balance sheet and line of credit availability

Question 23

debt maturing profile

Answer 23

when are the largest pieces of the capital structure maturing?

if you are investing in a smaller tranche, you want it to mature inside of that maturity

Question 24

access to capital markets & bank financing

Answer 24

how likely is the company to be able to refinance

Question 25

Other key PD factors

Answer 25

size and scale
strategic importance to state & local governments

Question 26

size and scale

Answer 26

size intrinsically helps a company manage through negative operating trends

walmart vs cornerstore

Question 27

strategic important to state & local governments

Answer 27

likelihood of government support?

defects and war*

Question 28

loss given default

Answer 28

if a company defaults, what is the loss that the lender would expect on its specific transaction?

large driven by structure

Question 29

lending on specific assets

Answer 29

asset based lending
equipment finance

Question 30

asset based lending

Answer 30

working capital lending (AR & inventory)

advance 85% on AR and 60% on inventory

Question 31

equipment finance

Answer 31

lending for the express purpose of purchasing fixed assets

structure driven by useful life of the assets

Question 32

enterprise value lending

Answer 32

in a hypothetical default, senior creditors are paid out before stockholders
-if the business is worth more than outstanding debt at default, creditors are paid out in full