(47) Fundamentals of Credit Analysis Flashcards
LOS 47. a: Describe credit risk and credit-related risks affecting corporate bonds
Credit risk is the risk of not receiving full interest and principal payments on a timely basis Credit risk is made up of two components: Default risk and loss severity Credit-related risks include spread risk, liquidity risk and credit migration (downgrade) risk
LOS 47. b: Describe default probability and loss severity as components of credit risk
Default risk (probability): risk that the issuer or company doesn’t pay Loss severity: The size of the loss given the event of default Multiplying these two factors together = expected loss which is the best measure of credit risk
LOS 47. c: Describe seniority rankings of corporate debt
Two broad categories include secured and unsecured.
Secured has higher credit rating and lower coupon then unsecured. Secured includes: first lien/mortgage debt, 2nd lien, 3rd lien, senior secured.
Unsecured includes: senior unsecured (most common type of corporate debt) through junior subordinated
All claims at the same level of the capital structure are on equal footing
LOS 47. d: Distinguish between corporate issuer credit ratings and issue credit ratings and describe the rating agency practice of “notching”
Issuer credit rating is also called corporate family rating (CFR) - Addresses the obligor’s overall creditworthiness (applies to senior unsecured debt).
Issue credit rating is also called corporate credit rating (CCR) - refers to specific financial obligations of an issuer
Issuer rating will only equal issue rating when debt is rated AAA
LOS 47. d: Distinguish between corporate issuer credit ratings and issue credit ratings and describe the rating agency practice of “notching”
Explain the primary focus of investment grade and non-investment grade rated bonds
Notching: ratings adjustment methodolgy where specific issues from the same borrower may be assigned different credit ratings
Investment grade: Issue is 1 notch +/- issuer (primary focus is the probability of default
Non-investment grade: issue is 2 notches below issue (primary focus is on the recovery rate
LOS 47. e: Explain risks in relying on ratings from credit rating analysis
Risks include:
- Ratings do not stay static over time
- Agencies can and have been wrong
- Ratings can’t incorporate unpredictable events
- Ratings tend to lag mark pricing of risk
- Bonds with equal ratings may have very different prices
LOS 47. f: Explain the four C’s of traditional credit analysis
- Capacity - Ability to pay on time
- to determine this, credit analysis looks at the industry analysis/structure (porters framework), industry fundamentals, and company fundamentals
- Collateral - focus is on the estimated loss (1 - recovery rate) and involves estimates of market value
- Covenants - affirmative (mgmt. is obligated to do) vs. negative (mgmt. limited in doing)
- Character - track record, poor strategy and policies, poor treatment of bond holders
LOS 47. h: Evaluate the credit quality of a corporate bond issuer and a bond of that issuer, given key financial ratios of the issuer and the industry
Bondholders look at profitability and cash flow, leverage ratios, and coverage ratios of bond issuers
Leverage:
Debt/capital ratio - lower ratio = lower risk
Debt/EBITDA - lower ratio = lower risk
Funds from operations (FFO)/Debt - higher ratio = lower risk
Coverage:
EBITDA/interest exp. - higher ratio = lower risk
LOS 47. i: Describe factors that influence the level and volatility of yield spreads
Yield on corporate bond = benchmark rate (gov’t) + spread (corporation)
Benchmark rate includes maturity premium, inflation premium, real rate
Spread includes liquidity premium and credit spread
Factors that affect spread include: credit cycle, broader economic conditions, financial market performance, market making willingness, supply and demand (these are all functions of the business cycle)
Lower rated bonds have greater spread volatility
LOS 47. j: Explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues
High yield corporate bonds are considered non-investment grade and are those rated below Baa3/BBB.
Special considerations:
Liquidity (Having cash/ability to raise cash) is very important for high yield bonds
Debt structure - many layers of debt with varying levels of seniority; lower debt/EBITDA the better
Corporate structure - evaluate how cash moves from parent to subsidiary and vice versa; look for structural subordination
Covenant analysis
LOS 47. j: Explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues
For sovereign debt you must look at the ability to pay and willigness to pay (Sovereign governments have immunity and don’t have to pay investors
Sovereign debt has external offerings (issued in USD) and internal offerings (issued in local currency)
Special considerations include political and economic factors
LOS 47. j: Explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues
Things to consider - municipalities must balance their budgets
LOS 47. j: Explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues. Describe the key convenants for high-yield issuers
Change of control put - in the event of acquisition, bond holders can require full payment at par
Restricted payments - limits amount of cash that can be paid to shareholders
Limitations on liens - limits amount of secured debt
Restricted subsidiaries - those that are designated to help service parent-level debt, typically through guarantees
Unrestricted subsidiaries
What is credit migration risk?
Refers to the risk that a bond issuer’s creditworthiness may deteriorate or migrate lower. Risk of default is higher, causing the spread on the bond to widen
(AKA - downgrade risk)
When a company has less debt outstanding, what type of risk will increase?
Market liquidity risk (Price at which investors can actually transact differs from the quoted price in the market)
