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. The expected loss is the probability of default multiplied by the loss
severity. Loss severity is often expressed as (1 Recovery 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. Spread 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).
The composition of an issuer's debt and equity is referred to as its "capital structure".
Debt ranks ahead of all forms of equity with respect to priority of payment. Corporate
debt is ranked by seniority or priority of claims. Secured debt is a direct claim on specific
firm assets and their associated cash flows and has priority over unsecured debt, the
holders of which only have a general claim on the issuer's assets and cash flow. Secured
or unsecured debt may be further ranked as senior or subordinated. In 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. Priority of claims may be summarized as follows: First 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 equipment, licenses, patents, brands, and so on), Second or
subsequent lien, Senior secured debt, Senior unsecured debt, Senior subordinated debt,
Subordinated debt and Junior subordinated debt. The 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 equal
footing"), i.e., equal priority of claims for different debt issues in the same category. High
default rates and loss severity are indicators of potential lower recovery rates. If the value
of a pledged property is less than the amount of claim, then the difference becomes a
senior unsecured claim. Absolute priority of claims in a (negotiated) bankruptcy
settlement might be violated because creditors negotiate/compromise a different outcome.
The three major global credit rating agenciesMoody's, S&P, and Fitchplay 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. Bonds rated triple-A
(Aaa or AAA) are said to be "of the highest quality, with minimal credit risk". Bonds
rated Baa3/BBB or higher are called "investment grade". Bonds rated Ba1 or lower by
Moody's and BB+ or lower by S&P 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, below investment grade, high
yield or junk bonds. The D rating is reserved for securities that are already in default in
S&P's and Fitch's scales. For Moody's, bonds rated C are likely, but not necessarily, in
default. Other not so well known rating agencies include Dominion Bond Rating Service
(DBRS) in Canada and Mikuni & Co. in Japan.
Issuer credit ratings, or
corporate family ratings (CFR), reflect a debt issuer's overall creditworthiness. Senior
unsecured debt is usually the basis for an issuer credit rating. Issue credit ratings, or
corporate credit ratings (CCR) , reflect the credit risk of a specific debt issue. Notching
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 adjustment will be. Structural
subordination means that cash flows from a subsidiary are used to pay the subsidiarys
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.
Lenders and bond investors should not rely exclusively on credit ratings from rating
agencies for the following reasons: 1) Credit ratings can change during the life of a debt
issue, 2) Rating agencies cannot always judge credit risk accurately, 3) Firms are subject
to risk of unforeseen events (credit-negative outcomes) that credit ratings do not reflect,
like adverse litigation, and high severity events as earthquake & hurricane, & 4) Market
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. The "four Cs" of credit analysis are: Capacity (the borrower's ability
to make timely payments on its debt; determined by analyzing 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 quality
and value of the assets in relation to the level of debt), Covenants (provisions of a bond
issue that protect creditors by requiring or prohibiting actions by an issuer's
management), & Character (assessment of an issuer's managements track record,
soundness of strategy, accounting policies and tax strategies, earnings quality, fraud and
malfeasance record, and prior treatment of bondholders). Regulated 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. Lower leverage, higher interest coverage, and greater free cash
flow imply lower credit risk and a higher credit rating for a firm.
EBITDA = Operating profit/income (EBIT) + Depreciation and amortization
Funds From Operations (FFO) = NI from continuing operations + Depreciation and
amortization + Deferred income taxes + Other non-cash items
Free cash flow = cash flow from operations (CFO) capital expenditures dividends
Total Capital = Total debt + Shareholders' equity
Credit analysts should add to a companys total debt its obligations such as operating
lease payments, off-balance-sheet financing and underfunded pension plans; When

adjusting for leases, analysts will typically add back the imputed interest or rent expense
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. If 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 quality
since goodwill is viewed as a lower quality asset compared with tangible assets that can
be sold and more easily converted into cash. Low capital expenditures relative to
depreciation expense could imply that management is insufficiently investing in its
business, leading to lower-quality assets, potentially reduced future CFO, and high loss
severity in the event of default. An analysis of the human capital of a company is the
purpose of assessing the strength of its balance sheets or, stated differently, the value and
quality 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 requirement 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 include: the
Credit Roundtable in US and the European Model Covenant Initiative in UK.
Corporate bond yields comprise the real risk-free rate, expected inflation rate, credit
spread, maturity premium, and liquidity premium. An issues yield spread to its
benchmark includes its credit spread and liquidity premium. The 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. Yield spreads tend to narrow when the credit cycle is improving, the
economy is expanding, and financial markets and investor demand for new debt issues
are strong (as investors "reaching for yield" increase their demand for bonds); If yield
spreads narrow, the prices of corporate bonds increase relative to the prices of Treasuries.
Yield spreads tend to widen when the credit cycle, the economy, and financial markets
are weakening, higher-than-normal liquidity premium and in periods when the supply of
new debt issues is heavy or broker-dealer capital is insufficient for market making;
Selling lower-rated bonds and buying higher-rated bonds is an appropriate strategy if an
economic contraction is anticipated.
Analysts can use duration (MDur) and convexity (Cvx) to estimate the impact on return
(the percentage change in bond price) of a change in credit spread.
For small spread changes: return impact duration spread
For larger spread changes: return impact duration spread + 1/2 convexity
(spread)2
Longer 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 curveare typically upward sloping, with the exception 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.

High yield (junk) bonds are more likely to default than investment grade bonds, which
increases the importance of estimating loss severity. Reasons for below investment grade
ratings include: High leverage, Weak or limited operating history, Low or negative free
cash flow, Highly cyclical business, Poor management, Risky financial policies, Lack of
scale and/or competitive advantages, Large off-balance sheet liabilities & Declining
industry (e.g., newspaper publishing). Analysis of high yield debt should focus on
liquidity, projected financial performance, the issuer's corporate and debt structures, &
debt covenants. Issuer 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 equity markets; also there is no high-yield commercial
paper (CP) market, and bank credit facilities often carry tighter restrictions for high-yield
companies. Sources of liquidity (in order of reliability) are: Balance Sheet cash, Working
capital, CFO, Bank credit facilities, Equity issuance & Asset sales. High-yield companies
that have a lot of secured debt (typically bank debt) relative to unsecured debt are said to
have a "top heavy" capital structure. In a holding company structure, the parent owns
stock in its subsidiaries; The parent's reliance on cash flow (via dividends or an
intercompany loan) from its subsidiaries means the parent's debt is structurally
subordinated 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 change of control put
covenant requires a company/issuer to redeem (buy back) their debt (a "put option") in
the event of the company being acquired, often at par or some premium to par value; For
investment-grade issuers, this covenant typically has a two-pronged test: acquisition of
the borrower and a consequent 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 equity holders. The limitations on liens covenant is meant to put limits on
how much secured debt an issuer can have. Restricted subsidiaries favor the parent
holding company by making its debt pari passu with a subsidiarys debt, rather than being
structurally subordinated to the subsidiarys debt. Bank 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/EBITDA may not exceed "x" times.
High-yield bonds are sometimes thought of as a "hybrid" between higher quality
(investment-grade corporate) bonds and equity securities. Their more volatile price and
spread movements are less influenced by interest rate changes than are higher-quality
bonds, and they show greater correlation with movements in equity markets. An equitylike approach to high-yield analysis can be helpful. Calculating and comparing enterprise
value (Equity market capitalization + Total debt Excess cash) with EBITDA and
debt/EBITDA can show a level of equity "cushion" or support beneath an issuer's debt.
EV is a measure of what a business is worth (before any takeover premium) since an
acquirer would either have to pay off or assume the debt. Narrow differences between the
EV/EBITDA and debt/EBITDA ratios for a given issuer indicate a small equity cushion
and, therefore, higher risk for bond investors.
All sovereigns are best able to service both external (denominated in hard currency, often
the US dollar) and local debt if they run "twin surpluses"i.e., a govt. budget surplus as
well as a current account surplus (net exporter of capital to the world). Sovereign credit
analysis includes assessing both an issuer's ability and willingness to pay. Ability 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 sovereigns ability to repay its debts by increasing tax
revenue. Willingness refers to the possibility that a country refuses to repay its debts; It is
important because due to the principle of sovereign immunity, a sovereign government
cannot be forced to pay its debts. The five key areas for evaluating and assigning a credit
rating for sovereign bonds are: 1) Institutional effectiveness and political risks, 2)
Economic structure and growth prospects, 3) International investment position (includes
analysis of the country's foreign exchange supply (external debt), its external debt, and
the status of its currency, 4) Fiscal performance, flexibility, and debt birden, & 5)
Monetary flexibility
Historically, municipal bonds usually have lower default rates than corporate bonds of the
same credit ratings. General obligation (GO) bonds are unsecured municipal bonds
backed by the full faith, credit and taxing power of the issuing government, typically a
city, county, or state, and thus tend to have lower yields than revenue bonds. Analysis of
GO bonds is similar to analysis of sovereign debt, focusing on the strength of the local
economy and its effect on tax revenues. A municipal bond guarantee is a form of
insurance provided by a third party other than the issuer; Bonds with municipal bond
guarantees are more liquid in the secondary market and generally have lower required
yields. GO bonds' creditworthiness is affected by economic downturns. Revenue bonds
are serviced by the income generated from specific projects, e.g., toll roads, bridge, etc.
Analysis of municipal revenue bonds is similar to analysis of corporate debt, focusing on
the ability of a project to generate sufficient revenue to service the bonds. A key credit
metric for revenue-backed municipal bonds is the debt service coverage ratio (DSCR),
which measures how much revenue is available to cover debt payments after operating
expenses; Many revenue bonds have a minimum DSCR covenant; the higher the DSCR,
the stronger the creditworthiness, which comes from the revenues generated by usage
fees and tolls levied.