cfa level 1 fundamentals of credit analysis

8/12/2019 CFA Level 1 Fundamentals of Credit Analysis

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Fundamentals of Credit Analysis

Credit analysishas a crucial function in the debt capital marketsefficiently allocatingcapital by properly assessing credit risk, pricing it accordingly, and repricing it as risks

change. Credit riskrefers 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 isthe 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. !he expected loss is the probability of default multiplied by the lossseverity. "oss severity is often e#pressed as ($ %ecovery rate, where the recovery rate

is the percentage of the principal amount recovered in the event of default. Spread riskis

the possibility that a bond loses value because its credit spread widens relative to itsbenchmark. &pread 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 marketdue to a widening of the bidask spread on an issuer's bonds it is increased by less debt

outstanding and)or a lower issue credit rating.

!he composition of an issuer's debt and e*uity is referred to as its +capital structure+.ebt ranks ahead of all forms of e*uity with respect to priority of payment. Corporate

detis ranked by seniority or priority of claims. Secured detis a direct claim on specific

firm assets and their associated cash flows and has priority over unsecured det, theholders of which only have a general claim on the issuer's assets and cash flow. &ecured

or unsecured debt may be further ranked as senior or subordinated. -n 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. riority of claims may be summari/ed as follows0!irst mortgage(pledge of a

specific property, e.g., a power plant for a utility or a specific casino for a gamingcompany orfirst lien(pledge of certain assets that could include buildings but might also

include property and e*uipment, licenses, patents, brands, and so on, &econd or

subse*uent lien, &enior secured debt, &enior unsecured debt, &enior subordinated debt,

&ubordinated debt and 1unior subordinated debt. !he highest priority of claims has thelowest 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 rankpari passu (+on an e*ual

footing+, i.e., e*ual priority of claims for different debt issues in the same category. 2ighdefault rates and loss severity are indicators of potential lower recovery rates. -f the value

of a pledged property is less than the amount of claim, then the difference becomes a

senior unsecured claim."solute priority of claimsin a (negotiated bankruptcy

settlement might be violated because creditors negotiate)compromise a different outcome.!he three ma3or global credit rating agencies#oody$s, S%&, and!itc'play a central, if

somewhat controversial, role in the credit markets and use similar, symbolbased ratingsthat are basically an assessment of a bond issue's risk of default. 4onds rated tripleA

(Aaa or AAA are said to be +of the highest *uality, with minimal credit risk+. 4onds

rated 4aa5)444 or higher are called +investment grade+. 4onds rated 4a$ or lower by6oody's and 447 or lower by &8 and Fitch, respectively have speculative credit

characteristics and increasingly higher default risk as a group, these bonds are referred to


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as low grade,speculative grade, non-investment grade, elow investment grade,'ig'

yield orunk onds. !he rating is reserved for securities that are already in default in

&8's and Fitch's scales. For 6oody's, bonds rated C are likely, but not necessarily, indefault. 9ther not so well known rating agencies includeDominion ond *ating Service

(D*S)in Canada and#ikuni % Co+in 1apan. ,ssuer credit ratings, or

corporate family ratings (C!*), reflect a debt issuer's overall creditworthiness. &eniorunsecured debt is usually the basis for an issuer credit rating. ,ssue credit ratings, or

corporate credit ratings (CC*), reflect the credit risk of a specific debt issue.otc'ing

of issue credit ratings can be upward or downward relative to an issuer credit rating toreflect the seniority and other provisions of a debt issue. As a general rule, the higher the

senior unsecured rating, the smaller the notching ad3ustment will be. Structural

suordinationmeans that cash flows from a subsidiary are used to pay the subsidiary:s

debt before these cash flows are upstreamed to the parent (holding company to serviceits debt. As a result, parent company debt is effectively subordinate to the subsidiary's

debt.

"enders and bond investors should not rely e#clusively on credit ratings from rating

agencies for the following reasons0 $ Credit ratings can change during the life of a debtissue, ; %ating agencies cannot always 3udge credit risk accurately, 5 Firms are sub3ect

to risk of unforeseen events (creditnegative outcomes that credit ratings do not reflect,like adverse litigation, and high severity events as earth*uake 8 hurricane, 8 4-! 7 epreciation and amorti/ation!unds !rom 1perations (!!1)= ?- from continuing operations 7 epreciation and

amorti/ation 7 eferred income ta#es 7 9ther noncash items

!ree cas' flow= cash flow from operations (CF9 capital e#penditures @ dividends

0otal Capital= !otal debt 7 &hareholders' e*uity

Credit analysts should add to a company:s total debt its obligations such as operating

lease payments, offbalancesheet financing and underfunded pension plans hen


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ad3usting for leases, analysts will typically add back the imputed interest or rent e#pense

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 riskcompared to lower seniority. -f 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 *uality

sincegoodwill is viewed as a lower *uality asset compared with tangible assets that canbe sold and more easily converted into cash. "ow capital e#penditures relative to

depreciation e#pense could imply that management is insufficiently investing in its

business, leading to lower*uality assets, potentially reduced future CF9, and high lossseverity in the event of default. An analysis of the 'uman capitalof a company is the

purpose of assessing the strength of its balance sheets or, stated differently, the value and

*uality of assets supporting the issuer's indebtedness (i.e., collateral. Covenants provide

limited protection to investmentgrade bondholders and often only somewhat strongerprotection to highyield investors. A re*uirement 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 groupsfocused on strengthening covenants include0 the

Credit %oundtable in B& and the >uropean 6odel Covenant -nitiative in B.Corporate bond yields comprise the real riskfree rate, e#pected inflation rate, credit

spread, maturity premium, and li*uidity premium. An issue:syield spreadto itsbenchmark includes its credit spread and li*uidity premium. !he 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 brokerdealers, and supply and demandfor debt issues. Dield spreads tend to narrow when the credit cycle is improving, the

economy is e#panding, and financial markets and investor demand for new debt issues

are strong (as investors +reaching for yield+ increase their demand for bonds -f yieldspreads narrow, the prices of corporate bonds increase relative to the prices of !reasuries.

Dield spreads tend to widen when the credit cycle, the economy, and financial markets

are weakening, higherthannormal li*uidity premium and in periods when the supply ofnew debt issues is heavy or roker-dealer capitalis insufficient for market making&elling lowerrated bonds and buying higherrated bonds is an appropriate strategy if an

economic contraction is anticipated.

Analysts can use duration (6ur and conve#ity (Cv# to estimate the impact on return

(the percentage change in bond price of a change in credit spread.

For small spread changes0 return impact E @duration Gspread

For larger spread changes0 return impact E @duration Gspread 7 $); conve#ity

(Gspread;

"onger 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 tochanges in spread.

Credit curves (spread curves)@the plot of yield spreads for a given bond issuer across the

yield curve@are typically upward sloping, with the e#ception of high premiumpriced

bonds and distressed bonds, where credit curves can be inverted because of the fear ofdefault, when all creditors at a given ranking in the capital structure will receive the same

recovery rate without regard to debt maturity.


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2igh yield (3unk bonds are more likely to default than investment grade bonds, which

increases the importance of estimating loss severity. %easons for below investment grade

ratings include0 2igh leverage, eak or limited operating history, "ow or negative freecash flow, 2ighly cyclical business, oor management, %isky financial policies, "ack of

scale and)or competitive advantages, "arge offbalance sheet liabilities 8 eclining

industry (e.g., newspaper publishing. Analysis of high yield debt should focus onli*uidity, pro3ected financial performance, the issuer's corporate and debt structures, 8

debt covenants. ,ssuer liquidity is a bigger consideration for highyield companies than

for investment grade companies as many highyield companies are privately held andthus don't have access to public e*uity markets also there is no highyield commercial

paper (C market, and bank credit facilities often carry tighter restrictions for highyield

companies. &ources of li*uidity (in order of reliability are0 4alance &heet cash, orking

capital, CF9, 4ank credit facilities, >*uity issuance 8 Asset sales. 2ighyield companiesthat have a lot of secured debt (typically bank debt relative to unsecured debt are said to

have a +top 'eavy+ capital structure. -n a 'olding companystructure, the parent owns

stock in its subsidiaries !he parent's reliance on cash flow (via dividends or an

intercompany loan from its subsidiaries means the parent's debt isstructurallysuordinatedto the subsidiaries' debt and thus will usually have a lower recovery rating

in default.

Covenant analysisis especially important for highyield bonds. A c'ange of control put

covenant re*uires a company)issuer to redeem (buy back their debt (a +put option+ in

the event of the company being ac*uired, often at par or some premium to par value Forinvestmentgrade issuers, this covenant typically has a twopronged test0 ac*uisition of

the borrower and a conse*uent downgrade to a highyield rating. A restricted payments

covenant provides some protection to the bondholder)creditors by limiting the amount ofcash paid to e*uity holders. !he limitations on lienscovenant is meant to put limits on

how much secured debt an issuer can have.*estricted susidiariesfavor the parent

holding company by making its debt pari passu with a subsidiary:s debt, rather than beingstructurally subordinated to the subsidiary:s debt. 4ank covenants can be more restrictivethan bond covenants and may include socalled maintenance covenants, such as leverage

tests, whereby the ratio of , say, debt)>4-!A may not e#ceed +#+ times.

2ig'-yield ondsare sometimes thought of as a +hybrid+ between higher *uality(investmentgrade corporate bonds and e*uity securities. !heir more volatile price and

spread movements are less influenced by interest rate changes than are higher*uality

bonds, and they show greater correlation with movements in e*uity markets. An e*uitylike approach to 'ig'-yield analysiscan be helpful. Calculating and comparing enterprise

value(>*uity market capitali/ation 7 !otal debt @ >#cess cash with >4-!A and

debt)>4-!A can show a level of e*uity +cushion+ or support beneath an issuer's debt.

/3is a measure of what a business is worth (before any takeover premium since anac*uirer would either have to pay off or assume the debt. ?arrow differences between the

>H)>4-!A and debt)>4-!A ratios for a given issuer indicate a small e*uity cushion

and, therefore, higher risk for bond investors.

All sovereigns are best able to service both external(denominated in hard currency, often

the B& dollar and localdebt if they run +twin [email protected]., a govt. budget surplus as

well as a current account surplus (net e#porter of capital to the world. Sovereign creditanalysisincludes assessing both an issuer's ability and willingness to pay."ilityto pay


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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 highinflation or hyperinflation and increase default risk on local debt as well. An increase in

income per capita improves a sovereign:s ability to repay its debts by increasing ta#

revenue. 4illingnessrefers to the possibility that a country refuses to repay its debts -t isimportant because due to the principle ofsovereign immunity, a sovereign government

cannot be forced to pay its debts. !he five key areas for evaluating and assigning a credit

rating for sovereign bonds are0 $ -nstitutional effectiveness and political risks, ;>conomic structure and growth prospects, 5 -nternational investment position (includes

analysis of the country's foreign e#change supply (e#ternal debt, its e#ternal debt, and

the status of its currency,

cfa level 1 fundamentals of credit analysis

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