FUNDAMENTALS OF CREDIT ANALYSIS 1 MV = Market Value NOI = Net Operating Income TV = Terminal Value RC = Replacement Cost DSCR = Debt Service Coverage Ratio 1. INTRODUCTION CR = Credit Risk Y.S = Yield Spread GO = General Obligation RE = Real Estate REITS = Real Estate Investment Trusts 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 issuer s default risk rises, investors will focus more on what the recovery rate might be in the event of default. Portion of a bond s 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 issuer s 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 company s debt & equity. Some companies have straightforward while others have very complex capital structures.
2 3.2 Seniority Ranking Seniority ranking refers to the priority of payments. Level of seniority can affect the value of an investor s 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 (Moody s, 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 vs. Non-Investment Investment High-Quality Upper-Medium Low-Medium Moody s S&P Fitch Aaa AAA AAA Aa1 AA+ AA+ Aa2 AA AA Aa3 AA- AA- A1 A+ A+ A2 A A A3 A- A- Baa1 BBB+ BBB+ Baa2 BBB BBB Baa3 BBB- BBB- Non-Investment Junk or High Yield Low or Speculative Ba1 BB+ BB+ Ba2 BB BB Ba3 BB- BB- B1 B+ B+ B2 B B B3 B- B- Caa1 CCC+ CCC+ Caa2 CCC CCC Caa3 CCC- CCC- Ca CC CC C C C Default C D D Reference: Level I Curriculum, Volume 5, Reading 59, Page 615-616
3 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 issuer s ability to satisfy its debt obligations. The main focus in credit analysis is to understand a company s 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. Management s legal duty to its creditors is to meet the terms of governing contracts. Equity analysts are interested in the strategies & investments that will a company s 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 Collateral Ability of the borrower to make its debt payments on time Quality & value of the assets supporting the issuer s indebtness. Covenants Character Terms & conditions of lending agreements that the issuer must comply with. Management quality
4 5.2.1 Capacity Industry Structure Porter s 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.
5 Ratios Analysis Profitability & Cash Flow Leverage Ratios Credit analysts focus on EBIT because it is useful to determine a company s 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 company s capital base that is financed with debt. Capital = total debt + shareholder s 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 EBIT / Interest Expense The ratio, the better the credit quality is 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 company s 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 issuer s level & seniority ranking of debt. 5.2.3 Covenants Covenants are integral to credit agreements & spell out what the issuer s 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 issuer s 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.
6 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 :. + 1 2 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 issuer s 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 parent s reliance on CF from its subsidiaries means the parent s 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.
7 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.