2015, Study Session # 16, Reading # 56

FUNDAMENTALS OF CREDIT ANALYSIS

MV
NOI
TV
RC
DSCR

= Market Value
= Net Operating Income
= Terminal Value
= Replacement Cost
= Debt Service Coverage
Ratio

CR
Y.S
GO
RE
REITS

1. INTRODUCTION

2. CREDIT RISK

Credit risk risk of loss resulting from the issuer of debt failing to make full &
timely payments of interest &/or principal.

Components of CR

Default Risk

Loss Given Default

Probability that a borrower defaults.

As an issuers default risk rises, investors will
focus more on what the recovery rate might
be in the event of default.

Portion of a bonds value an investor lose.

Expected loss = default probability loss
severity given default

Spread Risk

Risk that yield spread will widen & bond will underperform.

Factors Affecting Y.S

Credit Migration (Downgrade) Risk

Market Liquidity Risk

Risk that a bond issuers credit worthiness
.

Default risk, yield spreads widen, bond
price
.

Risk that transaction price may differ from

market price.

A liquidity premium in addition to credit
premium to compensate the liquidity risk.

Size of the issuer & credit quality of the issuer
are main factors that affect market liquidity
risk.

3. CAPITAL STRUCTURE, SENIORITY RANKING, AND RECOVERY RATES

3.1 Capital Structure

Capital structure the composition & distribution of a

companys debt & equity.

Some companies have straightforward while others have
very complex capital structures.

Copyright FinQuiz.com. All rights reserved.

= Credit Risk
= Yield Spread
= General Obligation
= Real Estate
= Real Estate Investment
Trusts

2015, Study Session # 16, Reading # 56

3.2 Seniority Ranking

Seniority ranking refers to the priority of payments.

Level of seniority can affect the value of an investors claim in the event of default
& restructuring.

Unsecured debt often referred to as debentures.

Secured debt debt-holder has a direct claim.

First mortgage debt pledge of a specific property.

First lien debt pledge of a certain assets.

Reason for different seniority rankings to optimize cost of capital.

3.3 Recovery Rates

Pari-Passu equal footing in the right of payment.

Recovery rates can vary widely by industry or depending on when they occur in a
credit cycle.

Recovery rates are average & key components of credit analysis & risk.

4. RATINGS AGENCIES, CREDIT RATINGS, AND THEIR ROLE IN THE DEBT MARKETS

Major credit agencies (Moodys, S&P, Fitch) play a central role in the credit market.

Some factors that led to the universal use of credit ratings include:

Independent credit risk assessment.

Regulatory & statutory reliance & usage.

Huge growth of debt market & issuer payment for ratings.

Ease of comparison across bond issuers, issues & market segments.

4.1 Credit Ratings

Long-Term Ratings Matrix: Investment Grade vs. Non-Investment Grade
Investment Grade
High-Quality
Grade

Upper-Medium
Grade
Low-Medium
Grade

Non-Investment
Grade Junk or
High Yield

Low Grade or
Speculative
Grade

Default

Moodys
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3

S&P
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBB-

Fitch
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBB-

Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Ca
C
C

BB+
BB
BBB+
B
BCCC+
CCC
CCCCC
C
D

BB+
BB
BBB+
B
BCCC+
CCC
CCCCC
C
D

Reference: Level I Curriculum, Volume 5, Reading 56, Exhibit 4.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 16, Reading # 56

4.2 Issuer vs. Issue Ratings

Rating agencies provide both issuer (corporate family) & Issue (corporate credit) rating.

Cross default provisions whereby events of default on one bond trigger default on all
outstanding debt.

Structural subordination when a corporation with a holding company structure has
debt at both its parent & subsidiaries level.

Notching process credit ratings on issues can be moved up or down from the issuer
rating.

 The senior unsecured rating, the smaller the notching adjustment will be.

4.3 Risks in Relying on Agency Ratings

Limitations & risks to relying on credit rating agency ratings include:

Credit ratings can be very dynamic.

Rating agencies are not infallible.

Other types of so-called idiosyncratic or event risk are difficult to capture in
ratings.

Ratings tend to lag market pricing of credit.

5. TRADITIONAL CREDIT ANALYSIS: CORPORATE DEBT SECURITIES

Goal of credit analysis to assess an issuers ability to satisfy its debt obligations.

The main focus in credit analysis is to understand a companys ability to generate
CF rather than its willingness to pay debts (corporate bond contracts are
enforceable by law).

5.1 Credit Analysis vs. Equity Analysis: Similarities and Differences

The primary objective of management is to maximize shareholders wealth.

Managements legal duty to its creditors is to meet the terms of governing
contracts.

Equity analysts are interested in the strategies & investments that will  a
companys value & grow its earnings.

Credit analysts will look more at the downside risk.

5.2 The Four Cs of Credit Analysis: A Useful Framework

Capacity
Ability of the borrower to make its debt
payments on time

Covenants
Terms & conditions of lending agreements
that the issuer must comply with.

Collateral
Quality & value of the assets supporting the
issuers indebtness.

Character
Management quality

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 16, Reading # 56

5.2.1 Capacity

Industry Structure

Porters Framework

Power of Suppliers

Power of Customers

Few suppliers,  credit risk.

Few buyers,  credit risk.

Barriers to Entry

Substitution Risk

 Barriers,
risk.

Companies with less substitutes represent

less credit risk.

Level of Competition
Competition,  credit risk.

Industry Fundamentals

Cyclical or Non-Cyclical

Growth Prospects

Cyclical industry  revenue volatility,

more riskier than non-cyclical industries.

Weaker competitors in slow growth

industries
credit worthiness.

Published Industry Statistics

Company Fundamentals

Operating history.
Competitive position.
Management strategy & execution.
Ratio analysis.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 16, Reading # 56

Ratios Analysis

Profitability & Cash Flow

Leverage Ratios

Credit analysts focus on EBIT because it is useful

to determine a companys performance prior to
cost arising from its capital structure.

Several measures of CF:

EBITDA

Funds from operation = N.I + Dep +
amortization + deferred tax & other noncash items.

Free CF before dividends = N.I + Dep. &
amortization capex -  in non cash
working capital excludes nonrecurring
items.

Free CF after dividends = free CF before
dividends dividend payments.

Debt/capital it shows the % of a companys

capital base that is financed with debt.

Capital = total debt + shareholders
equity.

Debt/EBITDA analysts use this ratio to
look at trends over time.

FFO/debt often used by credit rating
agencies.

Coverage Ratios

EBITDA / Interest Expense

The ratio, the better the credit quality is

EBIT / Interest Expense

More conservative measure of interest coverage
(does not include dep. & amortization).

5.2.2 Collateral

Asset value analysis is typically emphasized more with weaker credit quality companies.

If default probability rises to a sufficient level, the analysts consider the collateral value in
the context of loss severity.

Value & quality of a companys assets are difficult to observe directly.

A market-based signal to impute the quality of a public company is equity market
capitalization.

Key point of collateral analysis to assess the value of the assets relative to the issuers
level & seniority ranking of debt.

5.2.3 Covenants

Covenants are integral to credit agreements & spell out what the issuers
management is obligated to do (affirmative covenants) & limited in doing
(negative covenants).

Covenants are described in bond prospectus for corporate bonds.

Strong covenants protect bond investors from the possibility of
management taking actions that would hurt an issuers credit worthiness.

5.2.4 Character

Management often has little ownership in a corporation so analysis of
character is different than it would be for owner-managed firm.

Judgments about management character includes:

An assessment of management strategy.

Management track record of past strategies.

Accounting policies & tax strategies.

History of fraud or malfeasance.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 16, Reading # 56

6. Credit risk VS. Return: yields and spreads

 Credit risk,  potential return,  volatility,
certainty of earning  return.


Credit quality,  quoted yield.

Yield on corporate bonds = real Rf + expected inflation rate + maturity premium +
liquidity premium + credit spread.

Investors in corporate bonds focus primarily on yield spread (liquidity + credit
spread) relative to comparable default free bond.

Factors affecting spreads on corporate bonds include:

Credit cycle improved credit cycle, narrower credit spread.

Broader economic conditions weaker economic conditions, wider credit
spread.

Financial market performance weak financial markets, wider credit spreads.

Heavy new issue supply, wider credit spreads, if there is insufficient demand.

For investment grade bonds investors mainly focus on spread risk rather default risk.

For small instantaneous in Y.S:

 
   


For larger spread :

 
  . 
 + 12   


7. SPECIAL CONSIDERATION OF HIGH-YIELDS, SOVEREIGN, AND MUNICIPAL CREDIT ANALYSIS

7.1 High Yield

Reasons for below investment grade ratings:

Weak operating history.

Highly leveraged capital structure.

Negative FCF.

Poor management & risky financial policies.

High yield companies are usually unable to access the debt & equity markets so liquidity is a key
focus in high yield analysis.

Sources of liquidity from strongest to weakest include:

Cash on BS.

Working capital.

Operating cash flow.

Bank credit.

Equity issuance.

Asset sale.

If amount of liquidity is < debt coming due in the next 6-12 months warning flag for bond
investors.

Forecast of future earnings & CF including several scenarios, to assess whether the issuers credit
profile is stable, improving or declining.

High yield companies tend to have many layers of debt in their capital structure.

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

Corporate structure:

In a holding company structure, the parents reliance on CF from its subsidiaries means the
parents debt is structurally subordinated to the subsidiaries debt (lower recovery rating).

Leverage ratios should be calculated at each of the debt- issuing entities as well as on a
consolidated basis.

Covenant analysis:

Change of control put in the event of acquisition bondholders have the right to require the
issuer to buy back their debt at par or at small premium.

Restricted payments limitation on cash that can be paid out to shareholders over time.

Limitations on liens limits on how much secured debt an issuer can have.

Copyright FinQuiz.com. All rights reserved.

2015, Study Session # 16, Reading # 56

7.2 Sovereign Debt

Debt issued by the Govts around the world.

Types of Sovereign Debt

External Debt

Internal Debt

Denominated in hard currency.

Generally weaker sovereigns can only assess
international debt by issuing bonds in foreign currencies
(safer store of value).

Denominated in local currency.

Easier to service because central bank can print
additional money.

Both external & internal debts are easy to service if govt. runs a budget & current account
surplus.

Key issues for sovereign analysis:

Govt ability to pay.

Govt willingness to pay (more important).

Specific characteristics that the analysts should expect in a top-quality sovereign credit include:

Political & economic profile.

Institutional effectiveness & political risks.

Economic structure & growth prospects.

Flexibility & performance profile.

External liquidity & international investment position.

Fiscal performance, flexibility & debt burden.

Monetary flexibility.

7.3 Municipal Debt

Debt issued by provincial & local Govts. as well as the various agencies & authorities they create.

GO bonds unsecured bonds issued with the full faith & credit of the issuing govt.

These bonds are supported by the taxing authority of the issuer.

Some similarities to sovereign debt analysis.

Economic analysis focuses on employment, per capita income, per capita debt,
demographics & net population growth.

Revenue bonds for specific project financing.

 Risk than GO bonds (depends on single source of revenue).

Analysis of these bonds include project analysis & financial analysis.

Key credit metric debt service coverage ratio (DSCR).

The  the DSCR, the stronger the creditworthiness.

Copyright FinQuiz.com. All rights reserved.