Level I – Fixed Income Securities

Fundamentals of Credit Analysis

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 Contents
1. Introduction
2. Credit Risk
3. Capital Structure, Seniority Ranking and Recovery Rates
4. Rating Agencies, Credit Rating And Their Role in Debt Markets
5. Traditional Credit Analysis
6. Credit Risk vs. Return
7. Special Considerations of High Yield, Sovereign and Municipal Credit
Analysis

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 2. Credit Risk
Credit risk has two components

Default risk (or default probability)

Loss severity (or loss given default)

Expected loss =

Spread risk is another form of credit risk

Credit migration (or downgrade risk)

Market liquidity risk Example 1

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 3. Capital Structure, Seniority Ranking And Recovery Rates

3.1 Capital Structure

3.2 Seniority Ranking

Example 2

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3.3 Recovery Rates

Pari passu (“on an equal footing”)

Recovery rates vary by seniority ranking

Vary by industry

Depend on when they occur in a credit cycle

High variability

Priority of claims: not always absolute

Example 3

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 4. Rating Agencies
Moody’s, S&P and Fitch play a dominant role

4.1 Credit Ratings

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4.2 Issuer vs. Issue Rating

Notching

Structural subordination

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4.3 Risks in Relying on Agency Ratings

1. Credit ratings can be very dynamic

2. Rating agencies are not infallible

3. Idiosyncratic or event risk is difficult to capture

4. Ratings lag market pricing of credit

Example 4

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5. Traditional Credit Analysis: Corporate Debt Securities

5.1 Credit Analysis vs. Equity Analysis

5.2 The Four Cs of Credit Analysis

•Capacity

•Collateral

•Covenants

•Character

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Capacity
Industry structure

Power of suppliers

Power of buyers/customers

Barriers to entry

Substitution risk

Level of competition

Degree of operating leverage

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Industry fundamentals

Cyclical vs. non-cyclical

Growth prospects

Published industry statistics

Company fundamentals

Competitive position

Track record/operating history

Management’s strategy and execution

Ratios and ratio analysis (next slide)

Example 5

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Profitability and Cash Flow Measures

EBITDA

Funds from operations (FFO)

Free cash flow after dividends

Leverage ratios

Debt/capital

Debt/EBITDA

FFO/Debt

Coverage ratios

EBITDA/interest expense

EBIT/interest expense

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Issuer liquidity

Cash on balance sheet

Net working capital

Operating cash flow

Committed bank lines

Debt coming due and committed capital

expenditures in next couple of years

Example 6

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Collateral

Covenants

Character

Example 7

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6. Credit Risk vs. Return: Yields and Spreads

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Yield on corporate bond = Real risk-free
free interest rate + Expected inflation +
Maturity premium + Liquidity premium + Credit spread

Yield spread = Liquidity premium + Credit spread

Spreads on corporate bonds are impacted by:

Credit cycle

Broader economic conditions

Financial market performance overall, including equities

Broker-dealers’
dealers’ willingness to provide sufficient capital for market listing

General market supply and demand

Example 8
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Return impact (without convexity adjustment)

Return impact (with convexity adjustment)

Example 9

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 7. Special Considerations of High-Yield,
High Sovereign, and
Municipal Credit Analysis

7.1 High Yield

Bonds rated below BBB-

Also called Junk Bonds or non-investment
investment grade bonds

Possible reasons for Junk Bond status…

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Special considerations:

Greater focus on liquidity and Corporate structure

cash flow

Covenant analysis
Detailed financial projections

Equity-like approach to high-yield

Debt structure analysis

Example 10

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7.2 Sovereign Debt

Historically viewed as “risk-free”

Best able to service debt if a sovereign runs twin surpluses

Two key issues: ability to pay and willingness to pay

Credit rating agencies distinguish between local currency debt and foreign currency debt

Review simplistic framework presented in the curriculum (adapted from S&P’s methodology)

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Political and economic Flexibility and performance
profile profile

Effectiveness, stability and predictability External liquidity and international

of policy making institutions investment positions

Fiscal performance, flexibility and debt

Perceived commitment to honor debts burden

Monetary flexibility
Economic structure and growth prospects

Example 11

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7.3 Non-Sovereign Government Debt

Debt issued by state, provincial and local governments

Generally refers to US municipal bonds

General obligation bonds

GO bonds are unsecured and issued with full faith and credit of issuing government

Credit analysis: employment, per capita income, per capita debt

Over-reliance
reliance on one or two types of tax revenue (ex: capital gains or sales tax) can signal credit risk

Revenue bonds

Credit analysis similar to corporate bonds

Look at debt service coverage ratio: how much revenue to cover debt service payments

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 Conclusion
• Read the summary

• Review learning objectives

• Examples

• Practice problems

• Practice questions from other sources

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