Fundamentals of Credit Analysis

In this reading, we introduced readers to the basic principles of credit analysis. We described the importance of the credit markets and credit and credit-related risks. We discussed the role and importance of credit ratings and the methodology associated with assigning ratings, as well as the risks of relying on credit ratings. The reading covered the key components of credit analysis and the financial measure used to help assess creditworthiness.

We also discussed risk versus return when investing in credit and how spread changes affect holding period returns. In addition, we addressed the special considerations to take into account when doing credit analysis of high-yield companies, sovereign borrowers, and non-sovereign government bonds.

• Credit risk is the risk of loss resulting from the borrower failing to make full and timely payments of interest and/or principal.

• The key components of credit risk are risk of default and loss severity in the event of default. The product of the two is expected loss. Investors in higher-quality bonds tend not to focus on loss severity because default risk for those securities is low.

• Loss severity equals (1 – Recovery rate).

• Credit-related risks include downgrade risk (also called credit migration risk) and market liquidity risk. Either of these can cause yield spreads—yield premiums—to rise and bond prices to fall.

• Downgrade risk refers to a decline in an issuer’s creditworthiness. Downgrades will cause its bonds to trade with wider yield spreads and thus lower prices.

• Market liquidity risk refers to a widening of the bid–ask spread on an issuer’s bonds. Lower-quality bonds tend to have greater market liquidity risk than higher-quality bonds, and during times of market or financial stress, market liquidity risk rises.

• The composition of an issuer’s debt and equity is referred to as its “capital structure.” Debt ranks ahead of all types of equity with respect to priority of payment, and within the debt component of the capital structure, there can be varying levels of seniority.

• With respect to priority of claims, secured debt ranks ahead of unsecured debt, and within unsecured debt, senior debt ranks ahead of subordinated debt. In the typical case, all of an issuer’s bonds have the same probability of default due to cross-default provisions in most indentures. Higher priority of claim implies higher recovery rate—lower loss severity—in the event of default.

• For issuers with more complex corporate structures—for example, a parent holding company that has operating subsidiaries—debt at the holding company is structurally subordinated to the subsidiary debt, although the possibility of more diverse assets and earnings streams from other sources could still result in the parent having higher effective credit quality than a particular subsidiary.

• Recovery rates can vary greatly by issuer and industry. They are influenced by the composition of an issuer’s capital structure, where in the economic and credit cycle the default occurred, and what the market’s view of the future prospects are for the issuer and its industry.

• The priority of claims in bankruptcy is not always absolute. It can be influenced by several factors, including some leeway accorded to bankruptcy judges, government involvement, or a desire on the part of the more senior creditors to settle with the more junior creditors and allow the issuer to emerge from bankruptcy as a going concern, rather than risking smaller and delayed recovery in the event of a liquidation of the borrower.

• Credit rating agencies, such as Moody’s, Standard & Poor’s, and Fitch, play a central role in the credit markets. Nearly every bond issued in the broad debt markets carries credit ratings, which are opinions about a bond issue’s creditworthiness. Credit ratings enable investors to compare the credit risk of debt issues and issuers within a given industry, across industries, and across geographic markets.

• Bonds rated Aaa to Baa3 by Moody’s and AAA to BBB– by Standard & Poor’s (S&P) and/or Fitch (higher to lower) are referred to as “investment grade.” Bonds rated lower than that—Ba1 or lower by Moody’s and BB+ or lower by S&P and/or Fitch—are referred to as “below investment grade” or “speculative grade.” Below-investment-grade bonds are also called “high-yield” or “junk” bonds.

• The rating agencies rate both issuers and issues. Issuer ratings are meant to address an issuer’s overall creditworthiness—its risk of default. Ratings for issues incorporate such factors as their rankings in the capital structure.

• The rating agencies will notch issue ratings up or down to account for such factors as capital structure ranking for secured or subordinated bonds, reflecting different recovery rates in the event of default. Ratings may also be notched due to structural subordination.

• There are risks in relying too much on credit agency ratings. Creditworthiness may change over time, and initial/current ratings do not necessarily reflect the creditworthiness of an issuer or bond over an investor’s holding period. Valuations often adjust before ratings change, and the notching process may not adequately reflect the price decline of a bond that is lower ranked in the capital structure. Because ratings primarily reflect the probability of default but not necessarily the severity of loss given default, bonds with the same rating may have significantly different expected losses (default probability times loss severity). And like analysts, credit rating agencies may have difficulty forecasting certain credit-negative outcomes, such as adverse litigation, leveraging corporate transactions, and such low probability/high severity events as earthquakes and hurricanes.

• The role of corporate credit analysis is to assess the company’s ability to make timely payments of interest and to repay principal at maturity.

• Credit analysis is similar to equity analysis. It is important to understand, however, that bonds are contracts and that management’s duty to bondholders and other creditors is limited to the terms of the contract. In contrast, management’s duty to shareholders is to act in their best interest by trying to maximize the value of the company—perhaps even at the expense of bondholders at times.

• 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 “4 Cs” of credit—capacity, collateral, covenants, and character—provide a useful framework for evaluating credit risk.

• Credit analysis focuses on an issuer’s ability to generate cash flow. The analysis starts with an industry assessment—structure and fundamentals—and continues with an analysis of an issuer’s competitive position, management strategy, and track record.

• Credit measures are used to calculate an issuer’s creditworthiness, as well as to compare its credit quality with peer companies. Key credit ratios focus on leverage and interest coverage and use such measures as EBITDA, free cash flow, funds from operations, interest expense and balance sheet debt.

• An issuer’s ability to access liquidity is also an important consideration in credit analysis.

• The higher the credit risk, the greater the offered/required yield and potential return demanded by investors. Over time, bonds with more credit risk offer higher returns but with greater volatility of return than bonds with lower credit risk.

• The yield on a credit-risky bond comprises the yield on a default risk–free bond with a comparable maturity plus a yield premium, or “spread,” that comprises a credit spread and a liquidity premium. That spread is intended to compensate investors for credit risk—risk of default and loss severity in the event of default—and the credit-related risks that can cause spreads to widen and prices to decline—downgrade or credit migration risk and market liquidity risk.

  Yield spread = Liquidity premium + Credit spread.

• In times of financial market stress, the liquidity premium can increase sharply, causing spreads to widen on all credit-risky bonds, with lower-quality issuers most affected. In times of credit improvement or stability, however, credit spreads can narrow sharply as well, providing attractive investment returns.

• Credit curves—the plot of yield spreads for a given bond issuer across the yield curve—are 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.

• The impact of spread changes on holding period returns for credit-risky bonds are a product of two primary factors: the basis point spread change and the sensitivity of price to yield as reflected by (end-of-period) modified duration and convexity. Spread narrowing enhances holding period returns, whereas spread widening has a negative impact on holding period returns. Longer-duration bonds have greater price and return sensitivity to changes in spread than shorter-duration bonds. 

Price impact ≈ –(MDur × ∆Spread) + ½Cvx × (∆Spread)²

• For high-yield bonds, with their greater risk of default, more emphasis should be placed on an issuer’s sources of liquidity, as well as on its debt structure and corporate structure. Credit risk can vary greatly across an issuer’s debt structure depending on the seniority ranking. Many high-yield companies have complex capital structures, resulting in different levels of credit risk depending on where the debt resides.

• Covenant analysis is especially important for high-yield bonds. Key covenants include payment restrictions, limitation on liens, change of control, coverage maintenance tests (often limited to bank loans), and any guarantees from restricted subsidiaries. Covenant language can be very technical and legalistic, so it may help to seek legal or expert assistance.

• An equity-like approach to high-yield analysis can be helpful. Calculating and comparing enterprise value with EBITDA and debt/EBITDA can show a level of equity “cushion” or support beneath an issuer’s debt.

• Sovereign credit analysis includes assessing both an issuer’s ability and willingness to pay its debt obligations. Willingness to pay is important because, due to sovereign immunity, a sovereign government cannot be forced to pay its debts.

• In assessing sovereign credit risk, a helpful framework is to focus on five broad areas: (1) institutional effectiveness and political risks, (2) economic structure and growth prospects, (3) external liquidity and international investment position, (4) fiscal performance, flexibility, and debt burden, and (5) monetary flexibility.

• Among the characteristics of a high-quality sovereign credit are the absence of corruption and/or challenges to political framework; governmental checks and balances; respect for rule of law and property rights; commitment to honor debts; high per capita income with stable, broad-based growth prospects; control of a reserve or actively traded currency; currency flexibility; low foreign debt and foreign financing needs relative to receipts in foreign currencies; stable or declining ratio of debt to GDP; low debt service as a percent of revenue; low ratio of net debt to GDP; operationally independent central bank; track record of low and stable inflation; and a well-developed banking system and active money market.

• Non-sovereign or local government bonds, including municipal bonds, are typically either general obligation bonds or revenue bonds.

• General obligation (GO) bonds are backed by the taxing authority of the issuing non-sovereign government. The credit analysis of GO bonds has some similarities to sovereign analysis—debt burden per capita versus income per capita, tax burden, demographics, and economic diversity. Underfunded and “off-balance-sheet” liabilities, such as pensions for public employees and retirees, are debt-like in nature.

• Revenue-backed bonds support specific projects, such as toll roads, bridges, airports, and other infrastructure. The creditworthiness comes from the revenues generated by usage fees and tolls levied.