Fundamentals of Credit Analysis

Credit analysis has a crucial function in the debt capital marketsefficiently allocating
capital by properly assessing credit risk, pricing it accordingly, and repricing it as risks
change. Credit risk refers to the possibility that a borrower fails to make the scheduled
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), 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 expected loss is the probability of default multiplied by the loss
severity. "oss severity is often e#pressed as ($ %ecovery rate, where the recovery rate
is the percentage of the principal amount recovered in the event of default. Spread risk 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 risk that a
bond issuer's creditworthiness declines or migrates lower' downgrades will cause bonds
to trade at wider yields and thus lower prices and market liquidity risk (the risk that the
price at which investors transact may be different from the price indicated in the market
due to a widening of the bid(ask 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 structure+.
,ebt ranks ahead of all forms of e*uity with respect to priority of payment. Corporate
det is ranked by seniority or priority of claims. Secured det is a direct claim on specific
firm assets and their associated cash flows and has priority 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 bond trigger default on all outstanding debt in most
indentures. .riority of claims may be summari/ed as follows0 !irst mortgage (pledge of a
specific property, e.g., a power plant for a utility or a specific casino for a gaming
company or first 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 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 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 priority of claims in a (negotiated bankruptcy
settlement might be violated because creditors negotiate)compromise a different outcome.
!he three ma3or global credit rating agencies#oody$s, S%&, and !itc'play a central, if
somewhat controversial, role in the credit markets and use similar, symbol(based ratings
that are basically an assessment of a bond issue's risk of default. 4onds rated triple(A
(Aaa or AAA are said to be +of the highest *uality, with minimal credit risk+. 4onds
rated 4aa5)444 or higher are called + investment grade +. 4onds rated 4a$ or lower by
6oody's and 447 or lower by &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 (credit(negative outcomes that credit ratings do not reflect,
like adverse litigation, and high severity events 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 non(cash items
!ree cas' flow = cash flow from operations (CF9 capital e#penditures @ 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, off(balance(sheet financing and underfunded pension plans' Ahen
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 company'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 investment(grade bondholders and often only somewhat stronger
protection to high(yield 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 BC.
Corporate bond yields comprise the real risk(free 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 broker(dealers, 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, higher(than(normal 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 lower(rated bonds and buying higher(rated bonds is an appropriate strategy if an
economic contraction is anticipated.
Analysts can use duration (6,ur 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 F Gspread
For larger spread changes0 return impact E @duration F Gspread 7 $); F conve#ity F
(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 curve@are typically upward sloping, with the e#ception of high premium(priced
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, Aeak 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 off(balance 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 high(yield companies than
for investment grade companies as many high(yield companies are privately held and
thus don't have access to public e*uity markets' also there is no high(yield commercial
paper (C. market, and bank credit facilities often carry tighter restrictions for high(yield
companies. &ources of li*uidity (in order of reliability are0 4alance &heet cash, Aorking
capital, CF9, 4ank credit facilities, >*uity issuance 8 Asset sales. 2igh(yield 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 high(yield 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
investment(grade issuers, this covenant typically has a two(pronged test0 ac*uisition of
the borrower and a conse*uent downgrade to a high(yield 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 so(called 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
(investment(grade 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 beneath 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 surpluses+@i.e., 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 debt 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. A municipal 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 revenue(backed 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.