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Fundamentals of Credit Analysis Credit analysis has analysis has a crucial function in the debt capital markets–efficiently allocating capital by properly assessing credit risk, pricing it accordingly, and repricing it as risks change. Credit risk refers refers to the possibility that a borrower fails to make the schedu led interest payments or return of principal. Credit risk is composed of default risk , which is the probability of default, and loss severity (loss given default-LGD), default-LGD) , which is the portion of a bond's value (including unpaid interest or loan a lender or investor will lose if the borrower defaults. !he expect exp ected ed loss lo ss is the probability of default multiplied by the loss severity. "oss severity is often e#pressed as ($ – %ecov ery rate, where the recovery rate is the percentage of the principal amount recovered in the event of default. Spread risk is is the possibility that a bond loses value because its credit spread widens relative to its benchmark. &pread risk includes credit migration (or downgrade) risk (the (the risk that a bond issuer's creditworthiness declines or migrates migrates lower downgrades will cause bonds to trade at wider yields and thus lower prices and market liquidity risk (the (the risk that the price at which investors transact may be different from the price price indicated in the market due to a widening of the bidask spread on an issuer's bonds it is increased by less debt outstanding and)or a lower issue credit rating. !he composition of an issuer's debt and e*uity is referred to as its +capital +capital structure+. structure+. ebt ranks ahead of all forms of e*uity with respect to priority of payment. Corporate det is is ranked by seniority or priority of claims. Secured det is is a direct claim on specific firm assets and their associated cash flows and has p riority over unsecured det , the holders of which only have a general claim on the issuer's assets and cash flow. &ecured or unsecured debt may be further ranked as senior or subordinated. -n the typical case, all of an issuer's bonds have the same probability of default due to cross-default provisions (whereby events of default on one on e bond trigger default on all a ll outstanding debt in most indentures. riority of claims may be summari/ed as follows0 !irst follows0 !irst mortgage (pledge mortgage (pledge of a specific property, e.g., a power plant for a utility or a specific casino for a gaming company or first or first lien (pledge lien (pledge of certain assets that could include buildings but might also include property and e*uipment, licenses, patents, brands, and so on, &econd or subse*uent lien, &enior secured debt, &enior unsecured debt, &enior subordinated debt, &ubordinated debt and 1unior subordinated subo rdinated debt. !he highest priority of claims has the lowest credit risk. First lien loans and secured bonds are senior to any unsecured debt. All debt claims at the same level of capital structure is said to rank pari rank pari passu (+on an e*ual footing+, i.e., e*ual priority of claims for different debt issues in the same category. 2igh default rates and loss severity are indicators of potential lower recovery rates. -f the value of a pledged property is less than the amount of claim, then the difference becomes a senior unsecured claim. "solute claim. "solute priority of claims in claims in a (negotiated bankruptcy settlement might be violated because creditors negotiate)compromise a different outcome. !he three ma3or global credit rating agencies– agen cies– #oody$s, #oody$s, S%& , and !itc' and !itc' –play a central, if somewhat controversial, role in the credit markets and use similar, symbolbased ratings that are basically an assessment of a bond bo nd issue's risk of default. 4onds rated tripleA (Aaa or AAA are said to be +of the highest *uality, with minimal credit risk+. 4onds rated 4aa5)444 4a a5)444– – or higher highe r are called cal led +inv +investm estment ent grade gra de+. +. 4onds rated 4a$ or lower by 6oody's and 447 or lower by b y &8 and Fitch, respectively have speculative credit characteristics and increasingly higher default risk as a group, these bonds are referred to
as low grade, speculative grade, non-investment grade, elow investment grade, 'ig' yield or unk onds. !he rating is reserved for securities that are already in default in &8's and Fitch's scales. For 6oody's, bonds rated C are likely, but not necessarily, in default. 9ther not so well known rating agencies include Dominion ond *ating Service (D*S) in Canada and #ikuni % Co+ in 1apan. ,ssuer credit ratings, or corporate family ratings (C!*), reflect a debt issuer's overall creditworthiness. &enior unsecured debt is usually the basis for an issuer credit rating. ,ssue credit ratings, or corporate credit ratings (CC*) , reflect the credit risk of a specific debt issue. otc'ing of issue credit ratings can be upward or downward relative to an issuer credit rating to reflect the seniority and other provisions of a debt issue. As a general rule, the higher the senior unsecured rating, the smaller the notching ad3ustment will be. Structural suordination means that cash flows from a subsidiary are used to pay the subsidiary:s debt before these cash flows are upstreamed to the parent (holding company to service its debt. As a result, parent company debt is effectively subordinate to the subsidiary's debt. "enders and bond investors should not rely e#clusively on credit ratings from rating agencies for the following reasons0 $ Credit ratings can change during the life of a debt issue, ; %ating agencies cannot always 3udge credit risk accurately, 5 Firms are sub3ect to risk of unforeseen events (creditnegative outcomes that credit ratings do not reflect, like adverse litigation, and high severity even ts as earth*uake 8 hurricane, 8 < 6arket prices of bonds and credit spreads change much faster than credit ratings. Credit analysts tend to focus more on the downside risk given the asymmetry of risk)return whereas equity analysts focus more on upside opportunity from earnings growth, and so on. !he + four Cs+ of credit analysis are0 Capacity (the borrower's ability to make timely payments on its debt determined by analy/ing the growth prospects of the industry and assessing ratio analysis . Collateral (the value of assets pledged against a debt issue or available to creditors if the issuer defaults involves assessing the *uality and value of the assets in relation to the level of debt . Covenants (provisions of a bond issue that protect creditors by re*uiring or prohibiting actions by an issuer's management . 8 C'aracter (assessment of an issuer's management:s track record, soundness of strategy, accounting policies and ta# strategies, earnings *uality, fraud and malfeasance record, and prior treatment of bondholders. %egulated monopoly companies, such as utilities, generate strong and stable cash flows, enabling them to support high levels of debt. Credit analysts use profitability, cash flow, and leverage and coverage ratios to assess debt issuers: capacity. "ower leverage, higher interest coverage, and greater free cash flow imply lower credit risk and a higher credit rating for a firm. /,0D" = 9perating profit)income (>4-! 7 epreciation and amorti/ation !unds !rom 1perations (!!1) = ?- from continuing operations 7 epreciation and amorti/ation 7 eferred income ta#es 7 9ther noncash items !ree cas' flow = cash flow from operations (CF9 – capital e#p enditures @ dividends 0otal Capital = !otal debt 7 &hareholders' e*uity Credit analysts should add to a company:s total debt its obligations such as operating lease payments, offbalancesheet financing and underfunded pension plans hen
ad3usting for leases, analysts will typically add back the imputed interest or rent e#pense to various cash flow measures. For a specific debt issue, secured collateral implies lower credit risk compared to unsecured debt, and higher seniority implies lower credit risk compared to lower seniority. -f goodwill makes up a large percentage of a company's total assets, it indicates that a large percentage of the co mpany's assets are of low *uality since goodwill is viewed as a lower *uality asset compared with tangible assets that can be sold and more easily converted into cash. "ow capital e#penditures relative to depreciation e#pense could imply that management is insufficiently investing in its business, leading to lower*uality assets, potentially reduced future CF9, and high loss severity in the event of default. An analysis of the 'uman capital of a company is the purpose of assessing the strength of its balance sheets or, stated differently, the value and *uality of assets supporting the issuer's indebtedness (i.e., collateral. Covenants provide limited protection to investmentgrade bondholders and often only somewhat stronger protection to highyield investors. A re*uirement that a company offer security to a bond issue if it offers security to other creditors is referred to as a negative pledge. Few organised institutional investor groups focused on strengthening covenants include0 the Credit %oundtable in B& and the >uropean 6odel Covenant -nitiative in B. Corporate bond yields comprise the real riskfree rate, e#pected inflation rate, credit spread, maturity premium, and li*uidity premium. An issue:s yield spread to its benchmark includes its credit spread and li*uidity premium. !he level and volatility of yield spreads are affected by the credit and business cycles, the performance of financial markets as a whole, availability of capital from brokerdealers, and supply and demand for debt issues. Dield spreads tend to narrow when the credit cycle is improving, the economy is e#panding, and financial markets and investor demand for new debt issues are strong (as investors +reaching for yield+ increase their demand for bonds -f yield spreads narrow, the prices of corporate bonds increase relative to the prices of !reasuries. Dield spreads tend to widen when the credit cycle, the economy, and financial markets are weakening, higherthannormal li*uidity premium and in periods when the supply of new debt issues is heavy or roker-dealer capital is insufficient for market making &elling lowerrated bonds and buying higherrated bonds is an appropriate strategy if an economic contraction is anticipated. Analysts can use duration (6ur and conve#ity (Cv# to estimate the impact on return (the percentage change in bond price of a change in credit spread. For small spread changes0 return impact E @duration Gspread For larger spread changes0 return impact E @duration Gspread 7 $); conve#ity (Gspread; "onger duration bonds usually have longer maturities and carry more uncertainty of future creditworthiness, i.e., their prices and thus returns, are more volatile with respect to changes in spread. Credit curves (spread curves)@the plot of yield spreads for a given bond issuer across the yield [email protected] typically upward sloping, with the e#ception of high premiumpriced bonds and distressed bonds, where credit curves can be inverted because of the fear of default, when all creditors at a given ranking in the capital structure will receive the same recovery rate without regard to debt maturity.
2igh yield (3unk bonds are more likely to default than investment grade bonds, which increases the importance of estimating loss severity. %easons for below investment grade ratings include0 2igh leverage, eak or limited operating history, "ow or negative free cash flow, 2ighly cyclical business, oor management, %isky financial policies, "ack of scale and)or competitive advantages, "arge offbalance sheet liabilities 8 eclining industry (e.g., newspaper publishing. Analysis of high yield debt should focus on li*uidity, pro3ected financial performance, the issuer's corporate and debt structures, 8 debt covenants. ,ssuer liquidity is a bigger consideration for highyield companies than for investment grade companies as many highyield companies are privately held and thus don't have access to public e*uity markets also there is no highyield co mmercial paper (C market, and bank credit facilities often carry tighter restrictions for highyield companies. &ources of li*uidity (in order of reliability are0 4alance &heet cash, orking capital, CF9, 4ank credit facilities, >*uity issuance 8 Asset sales. 2ighyield companies that have a lot of secured debt (typically bank debt relative to unsecured debt are said to have a +top 'eavy+ capital structure. -n a 'olding company structure, the parent owns stock in its subsidiaries !he parent's reliance on cash flow (via dividends or an intercompany loan from its subsidiaries means the parent's debt is structurally suordinated to the subsidiaries' debt and thus will usually have a lower recovery rating in default. Covenant analysis is especially important for highyield bonds. A c'ange of control put covenant re*uires a company)issuer to redeem (buy back their debt (a +put option+ in the event of the company being ac*uired, often at par or some premium to par value For investmentgrade issuers, this covenant typically has a twopronged test0 ac*uisition of the borrower and a conse*uent downgrade to a highyield rating. A restricted payments covenant provides some protection to the bondholder)creditors by limiting the amount of cash paid to e*uity holders. !he limitations on liens covenant is meant to put limits on how much secured debt an issuer can have. *estricted susidiaries favor the parent holding company by making its debt pari passu with a subsidiary:s debt, rather than being structurally subordinated to the subsidiary:s debt. 4ank covenants can be more restrictive than bond covenants and may include socalled maintenance covenants, such as leverage tests, whereby the ratio of , say, debt)>4-!A may not e#ceed +#+ times. 2ig'-yield onds are sometimes thought of as a +hybrid+ between higher *uality (investmentgrade corporate bonds and e*uity securities. !heir more volatile price and spread movements are less influenced by interest rate changes than are higher*uality bonds, and they show greater correlation with movements in e*uity markets. An e*uity like approach to 'ig'-yield analysis can be helpful. Calculating and comparing enterprise value (>*uity market capitali/ation 7 !otal debt @ >#cess cash with >4-!A and debt)>4-!A can show a level of e*uity +cushion+ or support ben eath an issuer's debt. /3 is a measure of what a business is worth (before any takeover premium since an ac*uirer would either have to pay off or assume the debt. ?arrow differences between the >H)>4-!A and debt)>4-!A ratios for a given issuer indicate a small e*uity cushion and, therefore, higher risk for bond investors. All sovereigns are best able to service both external (denominated in hard currency, often the B& dollar and local debt if they run +twin [email protected], a govt. budget surplus as well as a current account surplus (net e#porter of capital to the world. Sovereign credit analysis includes assessing both an issuer's ability and willingness to pay. "ility to pay
is greater for debt issued in the country's own currency than for debt issued in a foreign currency as sovereigns can print money to repay debt, but municipalities cannot if a sovereign were to rely heavily on printing money to repay debt, it would fuel high inflation or hyperinflation and increase default risk on local d ebt as well. An increase in income per capita improves a sovereign:s ability to repay its debts by increasing ta# revenue. 4illingness refers to the possibility that a country refuses to repay its debts -t is important because due to the principle of sovereign immunity, a sovereign government cannot be forced to pay its debts. !he five key areas for evaluating and assigning a credit rating for sovereign bonds are0 $ -nstitutional effectiveness and political risks, ; >conomic structure and growth prospects, 5 -nternational investment position (includes analysis of the country's foreign e#change supply (e#ternal debt, its e#ternal debt, and the status of its currency, < Fiscal performance, fle#ibility, and debt birden, 8 I 6onetary fle#ibility 2istorically, municipal onds usually have lower default rates than corporate bonds of the same credit ratings. General oligation (G1) onds are unsecured municipal bonds backed by the full faith, credit and ta#ing power of the issuing government, typically a city, county, or state, and thus tend to have lower yields than revenue bonds. Analysis of J9 bonds is similar to analysis of sovereign debt, focusing on the strength of the local economy and its effect on ta# revenues. Amunicipal ond guarantee is a form of insurance provided by a third party other than the issuer 4onds with municipal bond guarantees are more li*uid in the secondary market and generally have lower re*uired yields. J9 bonds' creditworthiness is affected by economic downturns. *evenue onds are serviced by the income generated from specific pro3ects, e.g., toll roads, bridge, etc. Analysis of municipal revenue bonds is similar to analysis of corporate debt, focusing on the ability of a pro3ect to generate sufficient revenue to service the bonds. A key credit metric for revenuebacked municipal bonds is the det service coverage ratio (DSC*), which measures how much revenue is available to cover debt payments after operating e#penses 6any revenue bonds have a minimum &C% covenant the higher the &C%, the stronger the creditworthiness, which comes from the revenues generated by usage fees and tolls levied.