Reading 56 LOS's

Question 1

LOS 56a: Describe credit risk and credit-related risks affecting corporate bonds.

Answer 1

Credit Risk: refers to the risk of loss resulting from a borrowers failure to make full and timely payments and has 2 components:

1. Default Risk or Default Probability- probability a borrower fails to meet its obligations
2. Loss Severity or loss given default- is the portion of the bond’s value that they investor would lose if a default actually occurred. Loss severity is equal to 1 minus the recovery rate. From this we can calculate expected loss which is:

Expected loss = Default risk x Loss severity

Spread Risk: refers to the widening of the yield spread on the bond, which will devalue the current bond, and involves 2 components:

1. Downgrade risk or Credit migration risk- This is the risk that the credit of the issuer will be downgraded during term of bond. This will cause investors to demand a higher spread for the bond lowering its price
2. Market Liquidity risk- If the bond doesn’t trade frequently enough, investors will require a higher spread to compensate. There are 2 issuer specific factors that affect liquidity:

• Size of Issuer- the less bonds out, the less frequent they are traded, therefore the higher the liquidity risk
• Credit Quality of the issuer- the lower the credit rating, the less people want to trade, thus the higher the liquidity risk.

Question 2

LOS 56b: Describe seniority rankings of corporate debt and explain the potential violation of the priority of claims in a bankruptcy proceeding.

Answer 2

Debt can be issued with different rankings in terms of senority, where the most senior or highest rank debt has first claims on assets in case of default. Debt may be classified as secured debt (holders have actual claims on assets and their cash flows) or unsecured debt or debentures (holders only have a general claim on issuers assets). Within each category there are rankings from Senior to Junior.

Secured debt may be issued due to it being required by investors or because it is cheaper due to higher ranking of claims.

Unsecured debt may be issued because it is less expensive than issuing equity, it is less restrictive than senior debt, and investors will buy if appropriate yield.

Recovery Rate are the same amongst classes regardless of time to maturity. So for example a Senior secured with 3 years to maturity will be paid the same as a senior secured with 10 years to maturity. Recovery Rates are highest for senior secured and then work their way down to Junior subordinate. Recovery times can also vary by industry and where the company is in the credit cycle.

The longer it takes to redistribute wealth in case of default, the more key employees and customers that will leave. Also the longer it takes, the more legal fees will amount. Since all rankings have a vote in the process of distribution, compromizes are made, usually resulting in lower ranked debt receiving more than they are legally entitled to.

Question 3

LOS 56c: Distinguish between corporate issuer credit ratings and issue credit ratings and describe the rating agency practice of “notching”.

Answer 3

Refer to Moody’s, S&P, and Fitch’s credit ratings. Bonds rated AAA or Aaa are of the highest ratings. Any bond above BBB- or Baa3 are considered investment grade bonds and they can more easily access debt markets and for cheaper prices. Any bond below this ranking is considered junk or high yield bonds. A rating of C (Moodys) or D (S&P and Fitch) are in default.

Corporate Family Ratings (CFR) is based on the overall creditworthiness of the issuer

Corporate Credit Rating (CCR) applies to a specific issue and is based on the senority of the debt issued along with the companys credit rating

Most bonds contain cross-default provisions that pretty much say if any one bond defaults, then the rest of the bonds of the issuer must default. This implies all bonds have the same probability of default, however these bonds can be assigned different ratings by an adjustment known as notching. When there is greater chance of default a larger notching is applied than when there is less risk.

Question 4

LOS 56d: Explain risks in relying on ratings from credit rating agencies.

Answer 4

Credit ratings can be very dynamic: Credit ratings often change during the life of a bond

Rating agencies are not infallible- recall high ratings given to subprime-backed mortgage securities in 2008

Other types of so called idiosyncratic or event risk are difficult to capture- certain risks, like regulations on a chemical company, can not be predicted in advance

Ratings Tend to lag market pricing of credit- bond prices and credit spreads tend to change more quickly than credit ratings assigned to bonds

Question 5

LOS 56e: Explain the components of traditional credit analysis

Answer 5

Analyst usually cover the 4 “Cs” when performing credit analysis

1. Capacity- capacity refers to a borrowers ability to make its payments on time and usually starts with industry analysis and moves down to the company analysis.

• For industry analysis, “Porters 5 Forces are normally” used

1. Power of suppliers- the more suppliers the less risk
2. Power of buyers/customers- the more customers the less risk
3. Barriers to entry- the higher the barriers the less risk
4. Substitution risk- the less substitute goods the less risk
5. Level of competition- the less competition the less risk
6. Besided the 5 forces, operating leverage can also be considered. Operating leverage is the amout of fixed costs companies must incur. The lower the fixed costs of companies, the less risk

The 5 Forces cover the micro factors that affect an industry but the macro should also be considered:

1. Industry Cyclicality: cyclical industries are more sensitve to performance of economy, therefore more risky
2. Growth Prospects: weaker companies with little to no growth prospects are of higher credit risk
3. Published industry statistics- should be considered and evaluated

After considering the industries capacity, the analyst will next look at the companies fundamentals:

1. Competitive position- looks at companies market share, potential growth, cost structure relative to peers, strategy, and potential financial requirements going forward
2. Track record/ operating history- this involves looking at how the company performed in the past and thru different cycles
3. Managements strategy and execution- the managers decisions must be evaluated and determined if they are possible to be executed
4. Ratios and Ratio analysis- ratios for the company are computed and compared to peers

2 Collateral- refers to the quality and value of the assets that are pledged against the issuer’s debt obligations. Analyst focus more on collateral when the probability of default is high. They will normally consider the following factors:

• The nature and amount of intangible assets on the balance sheet: some intangible assets like patents are undervalued whereas others like goodwill can be overvalued
• The amount of depreciation an issuer takes relative to its capital expenditure: if depreciation highly outweighs capital expenditure, its a good indication that management is not investing in the business sufficiently

3. Covenants- refer to the terms and conditions in a bond’s indenture that place restrictions (negative or restricitive covenants) or certain requirements (affirmative covenants) on the issuer.

Examples of affirmative are:

• making timely interest and principal payments
• maintaining all properties used in the business
• redeeming debt if company gets aquired

Examples of negative are:

• limiting the amount of cash that can be paid out to shareholders
• limiting the amount of additional secured debt that can be issued

4 Character- refers to the quality and integrity of management. They should analyze:

• Evaluate the reliability and suitability of managements strategy
• Assess managements track record of executing successful strategies
• Identify the use of accounting policies and tax strategies
• Look for history of fraud or malfeasance
• look for instances of poor treatment of bondholders

Question 6

LOS 56f: calculate and interpret financial ratios used in credit analysis

LOS56g: Exvaluate the credit quality of a corporate bond issue and a bond of that issuer, given key financial ratios for the issuer and the industry

Answer 6

A bondholder will calcualte credit from ratios from 3 categories:

1.Profitability and Cash Flow measures- these measures are important because at the end of the day, it is profits and cash flows generated by the company that are used to service debt obligations. there are 4 used:

1. Earning before interest, taxes, depreciation, and amortization EBITDA- calculated as operating income (EBIT) plus depreciation and amortization. Drawback is that it ignores certain cash expenses such as capital expenditures and investment in working capital
2. Fund from Operations FFO - calculated as net income from continuing operations plus depreciation, amortization, deferred income taxes and other non cash items
3. Free Cash flow before dividends- calculatd as net income plus depreciation and amort minus (capital expenditures minus investment in noncash working capital)
4. Free cash flow after dividends- this is money a company can use to pay down debt

2. Leverage Ratios- to compute leverage ratios, credit analysts usually adjust the company’s reported debt levels for other debt-like liablities such as operation leases. Common leverage ratios are:

• Debt/Capital- this ratio reflects the proportion of a company’s capital base that is financed with debt— the higher the ratio, the higher the risk
• Debt/EBITDA- the higher the ratio the higher the risk
• FFO/Debt- the higher the ratio, the lower the risk

3. Coverage Ratios- are used to evaluate an issuer’s ability to make interest payments. higher coverage ratios indicate better credit qualtiy. Commonly used ratios are:

• EBITDA/ Interest expense
• EBIT/ Interest expense

EBIT is more conservative, tho EBITDA is used more

Finally, when evaluating credit quality, analyst also look at an issuer’s access to liquidity in times of cash flow stress. To asses an issuers liquidity, analyst look at the following:

• Cash on the balance sheet
• Net working capital
• Operating Cash flow
• Committed bank lines of credit
• Debt coming due in the near term
• Committed capital expenditures in the near term

Question 7

LOS 56h: Describe factors that influence the level and volatility of yield spreads

Answer 7

The yield on a corporate bond is equal to the real risk-free interest rate + expected inflation rate + maturity premium + liquidity premium + credit spread. The yield spread, which is the difference from a risk-free bond and a corporate bond is:

yield spread = liquidity premium + credit spread

These spreads are affected by the following:

• Credit cycle- credit spreads widen as the credit cycle deteriorates
• Broader economic conditions- when in recession, spreads become wider
• Financial market performance overall, including equities- spreads widen in weak financial markets
• Broker-dealers willingness to provide sufficient capital for market making- when broker/dealers don’t provide enough capital, spreads widen
• General market supply and demand- credit spreads widen when there is an oversupply

Question 8

LOS 56i: Calculate the return impact of spread changes

Answer 8

The return impact of a change in the credit spread depends on:

1. the magnitude of the change in spread
2. the sensitivity of the price of the bond in changes in interest rates

For small, instantaneous changes in the yield spread, the return impact can be estimated using the following formula

Return impact = - Modified duration x change in spread

for larger changes in the yield spread, we must also incorporate convexity:

Return impact = -(Modified Duration x change in spread) + (1/2 x Conxevity x change in spread squared)

Question 9

LOS 56j: Explain Special considerations when evaluating the credit of high-yield, sovereign, and municipal debt issuers and issues

Answer 9

High yield bonds entail greater risk of default than investment grade bonds. As a result credit analysts pay more attention to recovery analysis. The following factors are given special consideration:

• Liquidity- high-yield companies will only have limited access to liquidity :
  
  • Cash on the balance sheet
  • Working capital
  • Operating cash flow
  • Bank credit facilities
  • Equity Issuance
  • Asset sales

With liquidity we want to consider these measures and compare them to any upcoming debt that is due. If there is a liquidity shortage, there will be concerns of a default

• Financial Projections- analyst should forecast earnings and cash flows several years into the future to assess whether the issuer’s credit profil will remain stable, improve, or deteriorate
• Debt structure- high-yield companies usually have many layers of debt in their capital structure, with each layer having different senority and hence different recovery rates. Analysts should calculate leverage for each level of the debt structure

When a company has a high proportion of secured debt (bank debt) they are said to be top-heavy. bank debt has stringent covenants and short maturities, both contributing to higher risk of default with lower recovery rates for these top heavy companies.

Corporate Structure- credit analysis becomes a little more complicated for companies that have a holding company structure. The parent company owns stock in the subsidiary and relies on dividend payments to service its own debt. If the subsidiary runs into financial trouble, then the parent company’s ability to meet its own debt obligations will become impaired. This makes the debt of the parent company subordinate to that of the subsidiary and will often have slower recovery rates.

Covenant analysis- Some important covenants for high yield bonds are listed below:

• Change of control put- says if the issuer of a bond is aquired by another company, the holders are able to sell their bonds back at par or some premium
• Restricted Payments- protects creditors by limiting the amount of cash the company can pay out to its shareholders
• Limitations on liens and additional indebtedness- protects unsecured creditors by placing a limit on the amount of secured debt the company can issue
• restricted vs unrestricted subsidiaries- restriced subsidiaries are those that guarantee holding company debt. This guarantee puts the parents debt holders on equal footing (pari passu) with the subsidiaries own debt holders.

Equity like Approach to High Yield Analysis- high yield bonds can act as a hybrid between investment grade bonds and equities:

• Movements in prices and spreads for high yield bonds are less influenced by interest rate changes compared to investment grade
• Returns on high yield bonds are highly correlated with movements in equity markets

Therefore we can calculate multiples (EV/EBITDA or debt/EDBITDA) and compare them across several issuers

Sovereign Debt - refers to debt issued by national governments. A basic framework for evaluating sovereign debt is built around the following:

• Political and Economic Profile
  
  • Effectiveness, stability, and predictability of policy making
  • Perceived commitment to honor debts
  • Economic structure and growth prospects
• Flexibility and performance profile
  
  • External liquidity and international investment position
  • Fiscal performance. flexibility, and debt burden
• Monetary flexibility
  
  • ability to use monetary policy to address domestic economic objectives
  • credibility of monetary policy
  • effectiveness of monetary policy transmission via domestic capital markets

Credit rating agencies typically issue a credit rating for both local currency debt and foreign currency debt, as defaults tend to be more frequent in the foreign currency debt

Municipal Debt- Nonsovereign or subsovereign government entities include local and state governments. The majority of municipal bonds are either general obligation or revenue bonds

General Obligation Bonds are unsecured bonds issued with the full faith and credit of the issuing entity, and are supported by the taxes of the issuer. Similiar to sovereign besides the fact that municipalities must balance their budget, as they can not use the monetary system. The economic analysis of a GO bond focuses on:

• Employment
• Per capita debt
• Tax bas
• Demographics
• Infrastructure
• Volatility and variability of tax revenues
• Unfunded pension and post-retirement obligations
• The issuers ability to operate within the budget

Revenue Bonds are issued for financing a specific project (building a new hospital) and are serviced from the revenues of that project. This makes them similar to corporate bonds, in that the value comes from the cash generating ability of the project. A key ratio used to analyze these bonds is debt service coverage ratio (DSCR) which measure how much revenue is available to cover debt payments after meeting operating expenses