Fixed Income Securities

Fundamentals of Credit Analysis

Fundamentals of Credit Analysis
Contents

• Credit Risk
• Capital Structure, Seniority Ranking and Recovery Rates
• Rating Agencies, Credit Ratings, and their role in Debt Markets
• Traditional Credit analysis for Corporate Debt Securities
• Credit Risk vs Return : Yield and Spreads
Fundamentals of Credit Analysis
Credit Risk

• Credit risk is the risk of borrower not making timely and full
payments of interest or principal.

• Credit risk has two components :

• Default risk : Probability that the borrower fails to pay interest
or repay principal when due.

• Loss severity, or loss given default is the value a bond

investor loses if the issuer defaults.

• Expected loss = DefaultRisk * LossSeverity

• % LossSeverity = 1 − %RecoveryRate
 Fundamentals of Credit Analysis
Credit Risk

• Di erence in yield of a credit-risky bond and a credit-risk-free

bond of similar maturity is called its yield spread.

• Bond prices are inversely related to spreads.

• Size of the spread re ects creditworthiness of the issuer and
liquidity of the market for its bonds.

• Spread Risk is the probability that a bond’s spread will widen

due to :

• Credit Migration Risk or Downgrade Risk

• Market liquidity risk
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Fundamentals of Credit Analysis
Credit Risk

• Factors that a ect Market liquidity risk :

• Size of the Issuer
• Credit quality of the issuer.

• Less Debt means less trading and a higher liquidity risk.

• Lower the quality of issuer, higher will be the liquidity risk
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Concept Revision
Practice Questions

• Which of the following best de nes credit risk?

A. The probability of default times the severity of loss given default

B. The loss of principal and interest payments in the event of bankruptcy

C. The risk of not receiving full interest and principal payments on a

timely basis

• Which of the following is the best measure of credit risk?

A. The expected loss

B. The severity of loss

C. The probability of default

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Concept Revision
Practice Questions

• Which of the following is NOT credit or credit-related risk?

A. Default risk

B. Interest rate risk

C. Downgrade or credit migration risk

Fundamentals of Credit Analysis
Capital Structure, Seniority Ranking and Recovery Rates

• The composition and distribution across operating units, of a

company’s debt and equity is referred to as its Capital
Structure.

• Cross-border operations of Multinational corporations tend to

increase complexity of their capital structures.
Fundamentals of Credit Analysis
Capital Structure, Seniority Ranking and Recovery Rates

• Debt obligations of a given borrower will not necessarily all have

the same seniority ranking, or priority of payment.

• The most senior or highest-ranking debt will have the rst claim
on the cash ows and assets of the issuer.

• This a ects investor’s claim in the event of default and

restructuring.
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Fundamentals of Credit Analysis
Seniority Ranking

First Lien Loan - Senior Secured

Senior First Priority

Second Lien Loan - Secured

Senior Unsecured

Senior Subordinated

Subordinated

Junior Last Priority

Junior Subordinated
Fundamentals of Credit Analysis
Seniority Ranking

• All debt within same category is said to rank pari passu, or have
same priority of claims.

• Recovery rates are highest for debt with the highest priority.
• Recovery rates can vary widely by industry.
• Recovery rates can also vary depending on when they occur in
a credit cycle.

• Lower the seniority ranking of a bond, higher its credit risk.

Fundamentals of Credit Analysis
Recovery Rates

• In principle, in the event of bankruptcy or liquidation:

• Creditors with a secured claim have the right to property
before any other claim.

• If the value of the pledged property is less than the amount of

the claim, then the di erence becomes a senior unsecured
claim.

• Unsecured creditors have a right to be paid in full before

holders of equity interests.

• Senior unsecured creditors take priority over all subordinated

creditors
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Fundamentals of Credit Analysis
Recovery Rates

• In practice, however :
• Creditors with lower seniority and even shareholders may receive
some consideration without more senior creditors being paid in
full.

• Bankruptcies can be costly and take a long time, while legal

expenses increase.

• To avoid unnecessary delays, negotiation and compromise

among various claim-holders may result in a reorganisation plan
that does not strictly conform to the original priority of claims.

• By such a vote or by order of the bankruptcy court, the nal plan

may di er from absolute priority.
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Concept Revision
Priority of Claims

• Under which circumstance is a subordinated bondholder most

likely to recover some value in a bankruptcy without a senior
creditor getting paid in full? When:

A. absolute priority rules are enforced.

B. the various classes of claimants agree to it.

C. the company is liquidated rather than reorganized.

Concept Revision
Priority of Claims

• In the event of bankruptcy, claims at the same level of the capital

structure are:

A. on an equal footing, regardless of size, maturity, or time

outstanding.

B. paid in the order of maturity from shortest to longest,

regardless of size or time outstanding.

C. paid on a rst-in, rst-out (FIFO) basis so that the longest-

standing
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Fundamental of Credit Analysis
Rating Agencies, Credit Ratings, and their role in Debt Markets

• Credit rating agencies assign ratings to categories of bonds with similar

credit risk.

• Rating agencies rate both the issuer and the debt issues.
• Issuer credit ratings are called corporate family ratings (CFR).
• Issue-speci c ratings are called corporate credit ratings (CCR).
• Three major global rating agencies are :
1. Moody’s

2. S&P

3. Fitch
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Fundamental of Credit Analysis
Credit Ratings

Investment Grade Ratings Noninvestment Grade Ratings

Standard & Standard &
Moody’s Moody’s
Poor’s, Fitch Poor’s, Fitch
Aaa AAA Ba1 BB+
Aa1 AA+ Ba2 BB
Aa2 AA Ba3 BB-
Aa3 AA- B1 B+
A1 A+ B2 B
A2 A B3 B-
A3 A- Caa1 CCC+
Baa1 BBB+ Caa2 CCC
Baa2 BBB Caa3 CCC-
Baa3 BBB- Ca CC
Fundamental of Credit Analysis
Credit Ratings

• Bonds rated triple-A (Aaa or AAA) are said to be “of the highest
quality, with minimal credit risk” and thus have extremely low
probabilities of default.

• Rating agencies will typically provide outlooks on their respective

ratings—positive, stable, or negative—and may provide other
indicators on the potential direction such as “On Review for a
Downgrade” or “On CreditWatch for an Upgrade.”

• Notching is the practice by rating agencies of assigning di erent

ratings to bonds of the same issuer.

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Fundamental of Credit Analysis
Issuer vs. Issue Ratings

• Notching is the practice by rating agencies of assigning di erent ratings

to bonds of the same issuer.

• It is a ratings adjustment methodology where speci c issues from the

same borrower may be assigned di erent credit ratings. Factors to
consider are

I. Default risk

II. Priority of payment in the event of a default (e.g., secured versus

senior unsecured versus subordinated)

III. Loss severity in the event of default

• Notching is less common for highly rated issuers than for lower-rated
issuers
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 Fundamental of Credit Analysis
Issuer vs. Issue Ratings

• Cross-default provisions:
• Provisions whereby non-payment of interest on one bond
trigger default on all outstanding debt.

• Structural subordination:
• Debt at the operating subsidiaries will get serviced by the cash
ow and assets of the subsidiaries before funds can be passed
(“up streamed”) to the holding company to service debt at that
level.
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Fundamental of Credit Analysis
Credit Ratings

• Several factors have led to the near universal use of credit ratings in the
bond markets are:

• Independent assessment of credit risk

• Ease of comparison across bond issuers, issues, and market segments
• Regulatory and statutory reliance and usage
• Issuer payment for ratings
• Huge growth of debt markets
• Development and expansion of bond portfolio management and the
accompanying bond indexes.
Fundamental of Credit Analysis
Credit Ratings

• Relying in ratings from credit rating agencies has some risks :

• Credit ratings are dynamic. Higher credit ratings tend to be
more stable than lower credit ratings.

• Rating agencies are not perfect. For example subprime

mortgage crisis.

• Event risk is di cult to assess. For example litigation risk to

tobacco companies.

• Credit ratings lag market pricing. Market prices and credit

spreads change much faster than credit ratings.
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Concept Revision
Practice Questions

• Using the S&P ratings scale, investment grade bonds carry which of the
following ratings?

A. AAA to EEE

B. BBB- to CCC

C. AAA to BBB-

• Using both Moody's and S&P ratings, which of the following pairs of ratings is
considered high yield, also known as "below investment grade,” "speculative
grade, or “junk”?

A. Baa1/BBB-

B. B3/CCC+

C. Baa3/BB+
Concept Revision
Practice Questions

• What is the di erence between an issuer rating and an issue

rating?

A. The issuer rating applies to all of an issuer's bonds, whereas

the issue rating considers a bond's seniority ranking.

B. The issuer rating is an assessment of an issuer's overall

creditworthiness, whereas the issue rating is always higher
than the issuer rating.

C. The issuer rating is an assessment of an issuer’s overall

creditworthiness, typically re ected as the senior unsecured
rating, whereas the issue rating considers a bond's seniority
ranking (e.g., secured or subordinated)
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 Concept Revision
Practice Questions

• Based on the practice of notching by the rating agencies, a subordinated bond from a
company with an issuer rating of BB would likely carry what rating?

A. B+

B. BB

C. BBB-

• The xed-income portfolio manager you work with asked you why a bond from an
issuer you cover didn't rise in price when it was upgraded by Fitch from B+ to BB.
Which of the following is the most likely explanation?

A. Bond prices never react to rating changes.

B. The bond doesn't trade often so the price hasn't adjusted to the rating change yet.

C. The market was expecting the rating change, and so it was already "priced in" to
the bond.
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Concept Revision
Practice Questions

• Amalgamated Corp. and Widget Corp. each have bonds outstanding with
similar coupons and maturity dates. Both bonds are rated B2, B-, and B
by Moody's, S&P, and Fitch, respectively. The bonds, however, trade at
very di erent prices-the Amalgamated bond trades at €89, whereas the
Widget bond trades at €62. What is the most likely explanation of the price
(and yield) di erence?

A. Widget's credit ratings are lagging the market's assessment of the

company's credit deterioration.

B. The bonds have similar risks of default (as re ected in the ratings), but
the market believes the Amalgamated bond has a higher expected
loss in the event of default.

C. The bonds have similar risks of default (as re ected in the ratings), but
the market believes the Widget bond has a higher expected recovery
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Fundamental of Credit Analysis
Traditional Credit analysis for Corporate Debt Securities

• The goal of credit analysis is to assess an issuer’s ability to

satisfy its debt obligations, including bonds and other
indebtedness, such as bank loans.

• Assumes an issuer’s willingness to pay and concentrates

instead on assessing its ability to pay.
Traditional Credit analysis for Corporate Debt Securities

Credit Analysis vs. Equity Analysis

Credit Analysis Equity Analysis

Bondholders do not share in the growth Shareholders have theoretically

in value of a company unlimited upside opportunity.

In the event of a default, investment is

Have some downside risk in the event
typically wiped out before the
of default.
bondholders su er a loss.

Credit analysts
Equity analysts will focus more on
tend to focus more on the balance sheet
income and cash ow statements.
and cash ow statements
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Fundamental of Credit Analysis
Traditional Credit analysis for Corporate Debt Securities

• Traditionally, analysts evaluate creditworthiness based on the

‘four Cs of credit analysis’ :

• Capacity.
• Collateral.
• Covenants.
• Character.
Traditional Credit analysis for Corporate Debt Securities

Capacity

• Borrower’s ability to generate cash ow or liquidate short term

assets to repay debt obligations.

• Firm’s liquidity position is key determinant factor.

• Assessment Stages
I. Industry Structure.

II. Industry Fundamental.

III. Company Fundamental.

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Capacity Assessment Stages
Industry Structure

• Can be described by porter’s ve forces

• Threat of Entry.
• Power of Suppliers.
• Power of buyers.
• Threat of substitution.
• Rivalry among existing competitors.
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Capacity Assessment Stages
Industry Fundamentals

• Industry Cyclicality
• Cyclical industries are sensitive to economic performance, tend
to have more volatile earnings, revenues and cash ows.

• Industry growth prospects

• Creditworthiness is most questionable for weaker companies in a
slow-growing or declining industry.

• Industry published statistics

• Industry statistics published by rating agencies, investment
banks, and government agencies can be a source for industry
performance and fundamentals.
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Capacity Assessment Stages
Company Fundamentals

• Competitive position
• Market share and cost structure relative to peers.
• Operating history
• Performance history over di erent phases of business cycle, trends in
margins and revenues, and current management tenure.

• Management’s strategy and execution

• Soundness of strategy, ability to execute the strategy, and e ect on
bondholders.

• Ratios and ratio analysis

• Leverage and Coverage ratios
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Concept Revision
Industry and Company Analysis

• Given a hotel company, a chemical company, and a consumer

products company, which is most likely to be able to support a
high debt load over an economic cycle?

A. The hotel company, because people need a place to stay

when they travel.

B. The chemical company, because chemicals are a key input

to many products.

C. The consumer products company, because consumer

products are typically resistant to recessions.
Concept Revision
Industry and Company Analysis

• Heavily regulated monopoly companies, such as utilities, often

carry high debt loads. Which of the following statements about
such companies is most accurate?

A. Regulators require them to carry high debt loads.

B. They generate strong and stable cash ows, enabling them

to support high levels of debt.

C. They are not very pro table and need to borrow heavily to
maintain their plant and equipment.
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Concept Revision
Industry and Company Analysis

• XYZ Corp. manufactures a commodity product in a highly

competitive industry in which no company has signi cant market
share and where there are low barriers to entry. Which of the
following best describes XYZ's ability to take on substantial debt?

A. Its ability is very limited because companies in industries with

those characteristics generally cannot support high debt
loads.

B. Its ability is high because companies in industries with those

characteristics generally have high margins and cash ows
that can support signi cant debt.

C. We don't have enough information to answer the question.

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Traditional Credit analysis for Corporate Debt Securities

Collateral

• Analyse value and quality of a company’s assets.

• Collateral analysis is more important for less creditworthy companies.
• Issues to consider when assessing collateral values include :
• Intangible assets
• Patents are considered to be high quality intangible assets.
• Goodwill is not considered a high-quality intangible asset.
• Depreciation
• Low capital expenditures relative to depreciation expense could
imply that management is insu ciently investing in its business.
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Traditional Credit analysis for Corporate Debt Securities

Collateral

• Issues to consider when assessing collateral values include :

• Equity Market Capitalisation
• A stock trading below book value may indicate that
company assets are of low quality.

• Human and Intellectual Capital

• These are di cult to value, but a company may have
intellectual property that can function as collateral.
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 Traditional Credit analysis for Corporate Debt Securities

Covenants

• Terms and conditions of bond issue.

• Protect creditors while also giving management su cient
exibility to operate its business on behalf of and for the bene t
of the shareholders.

• Put restriction on management’s ability to make operating and

nancial decisions.

• Analysis of covenants is important for high yield issues.

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 Traditional Credit analysis for Corporate Debt Securities

Covenants

Af rmative Covenants Negative Covenants

Prohibit borrowers from

Debtor to take certain action certain action like issue
like pay interest, principal, additional debt, dividends and
Taxes. require to maintain ratios,
cash ows.
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Traditional Credit analysis for Corporate Debt Securities

Character

• Character refers to management’s integrity and its commitment

to repay the loan.

• Analysis includes assessment of :

• Soundness of strategy.
• Track Record.
• Accounting policies and tax strategies.
• Fraud and malfeasance record.
• Prior treatment of bondholders.
Traditional Credit analysis for Corporate Debt Securities

Character Analysis

• Soundness of strategy
• Management’s ability to develop a sound strategy.
• Track Record
• Management’s past performance in executing its strategies.
• Company operation without bankruptcy, restructuring, or other
distress.
Traditional Credit analysis for Corporate Debt Securities

Character Analysis

• Accounting policies and tax strategies

• Use of accounting policies and tax strategies that may be
hiding problems.

• Revenue recognition issues.

• Frequent restatements.
• Frequently changing auditors.
• Fraud and malfeasance record
• Any record of fraud or other legal and regulatory problems.
Traditional Credit analysis for Corporate Debt Securities

Character Analysis

• Prior treatment of bondholders

• Bene ts given to equity holders at the expense of debt
holders.

• Debt nanced acquisitions and special dividends.

• Any intentional actions leading to credit rating downgrades.
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Concept Revision
Practice Questions

• The two components of credit risk are :

A. Default risk and yield spread.

B. Default risk and loss severity.

C. Loss severity and yield spread.

• Expected loss can decrease with an increase in a bond’s :

A. Default risk.

B. Loss severity.

C. Recovery rate.
Concept Revision
Practice Questions

• "Notching" is best described as a di erence between:

A. an issuer credit rating and an issue credit rating.

B. a company credit rating and an industry average credit rating.

C. an investment grade credit rating and a noninvestment grade credit

rating.

• Which of the following statements is least likely a limitation of relying on

ratings from credit rating agencies?

A. Credit ratings are dynamic.

B. Firm-speci c risks are di cult to rate.

C. Credit ratings adjust quickly to changes in bond prices.

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Concept Revision
Practice Questions

• Ratio analysis is most likely used to assess a borrower's:

A. capacity.

B. character.

C. collateral.
Evaluating Credit Quality
Credit analysis with ratios

• Ratio analysis is a part of capacity analysis.

• Two primary categories of ratios used are leverage ratios and
coverage ratios.

• Company ratios are used to :

• Assess viability of a company.
• Find trends over time.
• Compare companies to industry averages and peers.
Evaluating Credit Quality
Pro ts and Cash Flows

• Four pro t and cash ow metrics are commonly used in ratio analysis.
1. Earnings before interest, taxes, depreciation and amortization
(EBITDA)

• Commonly used measure.

• Calculated as operating income plus depreciation and amortization.
• A drawback is that it does not adjust for capex and changes in
working capital.

• Cash used in capex and working capital is not available to

bondholders.
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Evaluating Credit Quality
Pro ts and Cash Flows

2. Funds from Operations (FFO)

• Calculated as net income from continuing operations plus

depreciation, amortization, deferred taxes, and non-cash
items.

• Similar to cash ow from operations (CFO) except that FFO

excludes changes in working capital.
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Evaluating Credit Quality
Pro ts and Cash Flows

3. Free cash ow before dividends

• Net income plus depreciation and amortization minus capital

expenditures minus increase in working capital.

• Excludes non-recurring items.

4. Free cash ow after dividends

• Free cash ow before dividends minus the dividends.

• If greater than zero, it is a positive sign for creditworthiness.
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 Evaluating Credit Quality
Leverage Ratios

1. Debt/Capital

• Lower ratio indicates less credit risk.

• If nancial statements include a high value for intangible assets
like goodwill, a second debt/capital ratio adjusting for a write
down of these assets should be calculated.

2. Debt/EBITDA

• Higher ratio indicates higher leverage and higher credit risk.

• More volatile for rms in cyclical industries or with high
operating leverage.
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Evaluating Credit Quality
Leverage Ratios

3. FFO/Debt

• Higher ratio indicates lower credit risk.

4. FCF after dividends / Debt

• Greater values indicate greater ability to service existing debt.

Evaluating Credit Quality
Coverage Ratios

• Measure borrower’s ability to generate cash ows to meet

interest payments.

1. EBITDA/Interest Expense

• Higher ratio indicates lower credit risk.

• Used more often than EBIT-to-Interest expense ratio.
• Higher than the EBIT Version.
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Evaluating Credit Quality
Coverage Ratios

2. EBIT/Interest Expense

• Higher ratio indicates lower credit risk.

• A more conservative measure because depreciation and
amortization are subtracted from earnings.

• Ratings agencies publish benchmark values for nancial ratios that

are associated with each ratings classi cation.

• Credit analysts can evaluate the potential for upgrades and

downgrades based on subject company ratios relative to
benchmarks.
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Concept Revision
The four Cs

1. Which of the following would not be a bond covenant?

A. The issuer must le nancial statements with the bond

trustee on a timely basis.

B. The company can buy back as much stock as it likes.

C. If the company o ers security to any creditors, it must o er

security to this bond issue.
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Concept Revision
The four Cs

2. Why should credit analysts be concerned if a company's stock

trades below book value?

A. It means the company is probably going bankrupt.

B. It means the company will probably incur lots of debt to buy

back its undervalued stock.

C. It's a signal that the company's asset value on its balance

sheet may be impaired and have to be written down,
suggesting less collateral protection for creditors.
Concept Revision
The four Cs

3. If management is of questionable character, how can investors

incorporate this assessment into their credit analysis and
investment decisions?

A. They can choose not to invest based on the increased credit

risk.

B. They can insist on getting collateral (security) and/or demand

a higher return.

C. They can choose not to invest or insist on additional security

and/or higher return.
Example
Credit analysis based on ratios

Yape, Inc. Zuari, Inc. Industry Average

EBIT $ 5,50,000 $ 22,50,000 $ 14,00,000

FFO $ 3,00,000 $ 8,50,000 $ 6,00,000
Interest
$ 40,000 $ 1,60,000 $ 1,00,000
expense
Total Debt $ 10,00,000 $ 25,00,000 $ 24,00,000
Total
$ 40,00,000 $ 65,00,000 $ 60,00,000
Capital
• Yape, Inc has goodwill of $500,000 and operating lease obligations with a present value of
$900,000.

• Zuari, Inc has net pension liability of $200,000.

• Appropriate industry averages are goodwill of $200,000, operating leases with a present value
of $200,000, and no net pension asset or liability.
Example
Credit analysis based on ratios

• Results after analyst adjustments :

Yape, Inc. Zuari, Inc. Industry Average

EBIT $ 5,50,000 $ 22,50,000 $ 14,00,000

FFO $ 3,00,000 $ 8,50,000 $ 6,00,000
Interest
$ 40,000 $ 1,60,000 $ 1,00,000
expense
Total Debt $ 19,00,000 $ 27,00,000 $ 26,00,000

Total Capital
excluding $ 35,00,000 $ 65,00,000 $ 58,00,000
goodwill
Example - Credit analysis based on ratios
Leverage and Coverage ratios

EBIT
• Interest :

$550000
Yape : = 13.8x
$40000
$2250000
Zuari : = 14.1x
$160000
$140000
Industry Average : = 14.0x
$100000
Both Yape and Zuari have interest coverage in line with their industry
average.
Example - Credit analysis based on ratios
Leverage and Coverage ratios

FFO
• TotalDebt :

$300000
Yape : = 15.8 %
$1900000
$850000
Zuari : = 31.5 %
$2700000
$600000
Industry Average : = 23.1 %
$2600000
Zuari’s FFO relative to its debt level are greater than the industry average.
Example - Credit analysis based on ratios
Leverage and Coverage ratios

TotalDebt
(Including Goodwill) :
• TotalCapital

$1900000
Yape : = 47.5 %
$4000000
$2700000
Zuari : = 41.5 %
$6500000
$2600000
Industry Average : = 43.3 %
$6000000
Example - Credit analysis based on ratios
Leverage and Coverage ratios

TotalDebt
(Excluding Goodwill) :
• TotalCapital

$1900000
Yape : = 54.3 %
$3500000
$2700000
Zuari : = 41.5 %
$6500000
$2600000
Industry Average : = 44.8 %
$5800000
Yape is more leveraged than Zuari and the industry average, especially after
adjusting for goodwill.
Example
Credit analysis based on ratios

• Conclusion
• Based on ratio calculations, Zuari Inc. appears to be more
creditworthy than Yape Inc.
 Fundamentals of Credit Analysis
Credit Risk vs Return : Yields and Spreads

• YieldSpread = LiquidityPremium + CreditSpread

Taxation

Spread Risk Premium Liquidity

Credit Risk

Expected
“Risk-Free” In ation Rate
Benchmark Rate of
Return Expected
Real Rate
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Fundamentals of Credit Analysis
Credit Risk vs Return : Yields and Spreads

• Yield spreads on corporate bonds are a ected by ve

interrelated factors :

1. Credit Cycle

• As the credit cycle improves, credit spreads will narrow.

Conversely, a deteriorating credit cycle will cause credit
spreads to widen.

• Spreads are tightest at or near the top of the credit cycle,

when nancial markets believe risk is low.
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 Fundamentals of Credit Analysis
Credit Risk vs Return : Yields and Spreads

2. Broader Economic Conditions

• Weakening economic conditions will push investors to desire a

greater risk premium and drive overall credit spreads wider.

• A strengthening economy will cause credit spreads to narrow.

3. Broker-Dealer Capital

• Yield spreads are narrower when broker-dealers provide

su cient capital.

• Yield spreads widen when market-making capital becomes

scarce.
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Fundamentals of Credit Analysis
Credit Risk vs Return : Yields and Spreads

4. Financial Market Performance

• Credit spreads narrow in strong performing markets overall,

including equity market.

• Spreads widen in weak performing markets.

5. General market demand and supply

• In periods of heavy new issue supply, credit spreads will widen

if there is insu cient demand.

• In periods of high demand for bonds, spreads will move tighter.

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Credit Risk vs Return : Yields and Spreads
US Investment Grade and High Yield Corporate Spreads

Sources: Bloomberg Barclays Indices and Loomis, Sayles & Company.

Credit Risk vs Return : Yields and Spreads
US Investment Grade and High Yield Corporate Spreads

Sources: Bloomberg Barclays Indices and Loomis, Sayles & Company.

Concept Revision
Yield Spreads

1. Which bonds are likely to exhibit the greatest Spread Volatility ?

A. Bonds from issuers rated AA.

B. Bonds from issuers rated BB.

C. Bonds from issuers rated A.

 Concept Revision
Yield Spreads

2. If investors become increasingly worried about the economy-

say as shown by declining stock prices-what is the most likely
impact on credit spreads ?

A. There will be no change in credit spreads. They aren't

a ected by equity markets.

B. Narrower spreads will occur. Investors will move out of

equities into debt securities.

C. Wider spreads will occur. Investors are concerned about

weaker creditworthiness.
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Fundamentals of Credit Analysis
Evaluating High-Yield Bond

• A bond may be rated non-investment grade or junk, because of :

I. Highly leveraged capital structure

II. Weak or limited operating history

III. Limited or negative free cash ow

IV. Highly cyclical business

V. Poor management

VI. Risky nancial policies

VII.Lack of scale and/or competitive advantages

VIII.Large o -balance-sheet liabilities

IX. Declining industry (e.g., newspaper publishing)

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Fundamentals of Credit Analysis
Evaluating High-Yield Bond

• High-Yield bond analysis is more in-depth than investment grade

bond analysis. It requires special considerations.

I. Greater focus on issuer liquidity and cash ow.

II. Detailed nancial projections.

III. Detailed understanding and analysis of the debt structure.

IV. Understanding of an issuer’s corporate structure.

V. Covenants.

VI. Equity-like approach to high yield analysis.

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 Fundamentals of Credit Analysis
Evaluating High-Yield Bond

• The lower the ranking in the debt structure, the lower the credit
rating and the lower the expected recovery in the event of
default.

• In exchange for these associated higher risks, investors will

normally demand higher yields.

• Sources of liquidity (Strongest to weakest) :

Cash on the balance sheet→Working capital→Operating cash
ow→Bank credit facilities→Equity issuance→Asset sales
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Evaluating High-Yield Bond
Covenant Analysis

1. Change of control put

• In the event of an acquisition (a “change of control”), bondholders

have the right to require the issuer to buy back their debt (a “put
option”), often at par or at some small premium to par value

• This covenant is intended to protect creditors from being

exposed to a weaker, more indebted borrower as a result of
acquisition.

2. Restricted payment

• Bond covenant meant to protect creditors by limiting how much

cash can be paid out to shareholders over time.
Evaluating High-Yield Bond
Covenant Analysis

3. Limitations on liens

• This covenant is meant to put limits on how much secured debt an issuer
can have.

• Important to unsecured creditors who are structurally subordinated to

secured creditors

4. Restricted versus unrestricted subsidiaries

• Issuers may classify certain of their subsidiaries as restricted and others

as unrestricted as it pertains to o ering guarantees for their holding
company debt

• These subsidiary guarantees can be very useful to holding company

creditors because they put their debt on equal standing (pari passu) with
debt at the subsidiaries instead of with structurally subordinated debt.
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Fundamentals of Credit Analysis
Sovereign Debt Analysis

• Two key issues for sovereign analysis are

1. a government’s ability to pay and

2. its willingness to pay.

Fundamentals of Credit Analysis
Sovereign Debt Analysis

• A basic framework for evaluating Sovereign debt includes ve key areas :

1. Institutional e ectiveness

• includes successful policymaking, absence of corruption, and

commitment to honor debts.

2. Economic prospects

• include growth trends, demographics, income per capita, and size of

government relative to the private economy.

3. International investment position

• includes the country’s foreign reserves, its external debt, and the
status of its currency in international markets.
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Fundamentals of Credit Analysis
Sovereign Debt Analysis

• A basic framework
4. Fiscal exibility

• includes the government’s willingness and ability to increase

revenue or cut expenditures to ensure debt service, as well as
trends in debt as a percentage of GDP.

5. Monetary exibility

• includes the ability to use monetary policy for domestic

economic objectives (this might be lacking with exchange rate
targeting or membership in a monetary union) and

• the credibility and e ectiveness of monetary policy.

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Concept Revision
Practice Questions

1. In order to analyze the collateral of a company a credit analyst should

assess the:

A. cash ows of the company.

B. soundness of management’s strategy.

C. value of the company’s assets in relation to the level of debt.

2. In order to determine the capacity of a company, it would be most

appropriate to analyze the:

A. company’s strategy.

B. growth prospects of the industry.

C. aggressiveness of the company’s accounting policies.

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Concept Revision
Practice Questions

3. A credit analyst is evaluating the credit worthiness of three

companies: a construction company, a travel and tourism
company, and a beverage company. Both the construction and
travel and tourism companies are cyclical, whereas the
beverage company is non-cyclical. The construction company
has the highest debt level of the three companies. The highest
credit risk is most likely exhibited by the:

A. construction company.

B. beverage company.

C. travel and tourism company

Concept Revision
Practice Questions

4. In the event of default, which of the following is most likely to have the
highest recovery rate?

A. Second lien

B. Senior unsecured

C. Senior subordinated

5. The process of moving credit ratings of di erent issues up or down from the
issuer rating in response to di erent payment priorities is best described as:

A. notching.

B. structural subordination.

C. cross-default provisions.
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Concept Revision
Practice Questions

6. The factor considered by rating agencies when a corporation

has debt at both its parent holding company and operating
subsidiaries is best referred to as:

A. credit migration risk.

B. corporate family rating.

C. structural subordination.
Thank You