654 Reading 55 « Fundamentals of Credit Analysis The “A Cs" of credit—capacity, collateral, covenants, and character—provide a useful framework for evaluating credit risk. Cxedit analysis focuses on an issuer's ability to generate cash flow. ‘The analysis starts with an industry assessment—structure and fundamentals—and contin- ues with an analysis of an issuer's competitive position, management strategy, and track record, Credit measures are used to calculate an issuer's creditworthiness, as well as ‘to compare its credit quality with peer companies. Key credit ratios focus on leverage and interest coverage and use such measures as EBITDA, free cash flow, funds from operations, interest expense and balance sheet debt. An issuer's ability to access liquidity is also an important consideration in credit analysis. ‘The higher the credit risk, the greater the offered/required yield and potential return demanded by investors, Over time, bonds with more credit risk offer higher returns but with greater volatility of return than bonds with lower credit risk, ‘The yield on a credit-risky bond comprises the yield on a default risk-free bond with a comparable maturity plus a yield premium, or “spread, that comprises credit spread and a liquidity premium, That spread is intended to compen. sate investors for credit risk—risk of default and loss severity in the event of default-—and the credit-related risks that can cause spreads to widen and prices to decline—downgrade or credit migration risk and market liquidity risk, Yield spread = Liquidity premium + Credit spread, In times of financial market stress, the liquidity premium can increase sharply, ‘causing spreads to widen on all credit-risky bonds, with lower-quality issu cers most affected. In times of credit improvement or stability, however, credit spreads can narrow sharply as well, providing altractive investment returns Credit curves—the plot of yield spreads for a given bond issuer across the yield. ccurve—are typically upward sloping, with the exception of high premium- priced bonds and distressed bonds, where credit curves can be inverted because of the fear of default, when all creditors at a given ranking in the capital struc- ture will receive the same recovery rate without regard to debt maturity. “The impact of spread changes on holding period returns for credit-risky bonds, are a product of two primary factors: the basis point spread change and the sensitivity of price to yield as reflected by (end-of period) modified duration and convexity. Spread narrowing enhances holding period returns, whereas spread widening has a negative impact on holding period returns. Longer- duration bonds have greater price and return sensitivity to changes in spread than shorter-duration bonds. Price impact = -(MDur x ASpread) + 4Cvx x (ASpread)? For high-yield bonds, with their greater risk of default, more emphasis should be placed on an issuer's sources of liquidity, as well as on its debt structure and ‘corporate structure. Credit risk can vary greatly across an issuer's debt structure depending on the seniority ranking, Many high-yield companies have complex capital structures, resulting in different levels of credit risk depending on where the debt resides.Summary = Covenant analysis is especially important for high-yield bonds. Key covenants include payment restrictions, limitation on liens, change of control, cover- age maintenance tests (often limited to bank loans), and any guarantees from restricted subsidiaries. Covenant language can be very technical and legalistic, so it may help to seck legal or expert assistance, An equity-like approach to high-yield analysis can be helpful. Calculating and comparing enterprise value with EBITDA and debt/EBITDA can show a level of equity “cushion’ or support beneath an issuer's debt. Sovereign credit analysis includes assessing both an issuer's ability and willing ness to pay its debt obligations. Willingness to pay is important because, due to sovereign immunity, a sovereign government cannot be forced to pay its debts. = Inassessing sovereign credit risk, a helpful framework is to focus on five broad areas: (1) institutional effectiveness and political risks, (2) economic struc ture and growth prospects, (3) external liquidity and international investment position, (4) fiscal performance, flexibility, and debt burden, and (5) monetary flexibility. m= Among the characteristics of a high-quality sovereign credit are the absence of corruption and/or challenges to political framework; governmental checks and balances; respect for rule of law and property rights; commitment to honor debts; high per capita income with stable, broad-based growth prospects; control of a reserve or actively traded currency; currency flexibility; low foreign debt and foreign financing needs relative to receipts in foreign currencies; stable or declining ratio of debt to GDP; low debt service as a percent of revenue; low ratio of net debt to GDP; operationally inde of low and stable inflation; and a well-developed banking system and active money market endent central bank; track record 1 Non-sovereign or local government bonds, including municipal bonds, ae typi cally either general obligation bonds or revenue bonds. = General obligation (GO) bonds are backed by the taxing authority of the issuing non-sovereign government. The credit analysis of GO bonds has some similari- ties to sovereign analysis—debt burden per capita versus income per capita, tax , demographics, and economic diversity. Underfunded and “off-balance liabilities, such as pensions for public employees and retirees, are debt- like in nature, = Revenue-backed bonds support specific projects, such as toll roads, bridges, air- ports, and other infrastructure. ‘The creditworthiness comes from the revenues generated by usage fees and tolls levied.656 Reading 55 # Fundamentals of Credit Analysis PRACTICE PROBLEMS 1. ‘The risk that a bond's creditworthiness declines is best described by: A credit migration risk, B market liquidity risk. © spread widening risk. 2. Stedsmart Ltd and Fignermo Ltd are alike with respect to financial and oper- ating characteristics, except that Stedsmart Ltd has less publicly traded debt ‘outstanding than Fignermo Ltd. Stedsmart Ltd is most likely to have: A no market liquidity risk Blower market liquidity risk. © higher market liquidity risk. 3 Inthe event of default, the recovery rate of which of the following bonds would ‘most likely be the highest? A First mortgage debt B Senior unsecured debt Junior subordinate debt 4 During bankruptcy proceedings of a firm, the priority of claims was not strictly adhered to. Which of the following is the least likely explanation for this ‘outcome? A Senior creditors compromised. B- The value of secured assets was less than the amount of the claims. © A judge's order resulted in actual claims not adhering to strict priority of claims. 5A fixed income analyst is least likely to conduct an independent analysis of credit risk because credit rating agencies: A may at times mis-rate issues. B_ often lag the market in pricing credit risk © cannot foresee future debt-financed acquisitions. 6 If goodwill makes up a large percentage of a company’s total assets, this most likely indicates that: A the company has low free cash flow before dividends. B- there is a low likelihood that the market price of the company’s common stock is below book value. a large percentage of the company's assets are not of high quality. 7 In order to analyze the collateral of a company a credit analyst should assess the: A cash flows of the company. B_ soundness of management's strategy. © value of the company’s assets in relation to the level of debt. 8 Inorder to determine the capacity of a company, it would be most appropriate to analyze the: A company’s strategy. © 2017 CPA Insitute, Al rights reservedPractice Problems B_ growth prospects of the industry. aggressiveness of the company’s accounting policies. 9 A credit analyst is evaluating the credit worthiness of three companies: a con. struction company, a travel and tourism company, and a beve Both the construction and travel and tourism companies are cyclical, whereas ‘the beverage company is non-cyclical. The construction company has the highest debt [evel of the three companies. The highest credit risk is most likely exhibited by the: A construction company. .ge company. B_ beverage company. travel and tourism company. 10 Based on the information provided in Exhibit 1, the EBITDA interest coverage ratio of Adidas AG is closest to: A 791K, B 10.12x. © 12.99%. Nene ee) Statement Year Ending 31 December 2010 (€in See) Gross profit 5.730 Royalty and commission income 100 ‘Other operating income a0 ‘Other operating expenses 5.046 Operating profit 4 Interest income 25 Interest expense ua Income before taxes 806 Income taxes 238 Net income: 568 Additional informati Depreciation and amortization: €249 million Source: Adidas AG Anna Financial Statements, December 2010 11 The following information is from the annual report of Adidas AG for December 2010: © Depreciation and amortization: €249 million © Total assets: €10,618 million © Total debt: €1,613 million © Shareholders’ equity: €4,616 million ‘The debt/capital ratio of Adidas AG is closest to: A 15.19%, B 25.90% © 34.94%, 657658 Reading 55 = Fundamentals of Credit Analysis 12 Funds from operations (FFO) of Pay Handle Ltd increased in 2011. In 2011 the total debt of the company remained unchanged, while additional common shares were issued. Pay Handle Ltd’s ability to service its debt in 2011, as com= pared to 2010, most likely A improved. 8 worsened. © remained the same. 18 Based on the information in Exhibit 2, Grupa Zywiec Ss credit risk is most likely: A lower than the industry. 8 higher than the industry. the same as the industry 2 European Food, Beverage, and Tobacc remo eee eee Total EBITDA debt/Tetal FFO/Total Returnon Total debt/ interest capital debt pital EBITDA coverage % % 6) Cc Co Grupa Zywiee a4 75 195 12 177 SA. Industry a2 23.6 655 285 as Median 14 Based on the information in Exhibit 3, the credit rating of Davide Campari- Milano S.p.A. is most likely: A lower than Associated British Foods ple. B higher than Associated British Foods ple. © the same as Associated British Foods ple. Exhibit 3 European Food, Beverage, and Tobacco Industry; Associated DTT ee eu ae eee ce) Financial Ratios, 2010 Total EBITDA debtitotal FFO/total Returnon Total_—_ interest, capital debt capital debt/EBITDA coverage company (%) (%) (%) ®) ) ‘Associated British 0.2 843 oa 10 Be Foods ple Davide Campari ns ns 82. 32 32. Milano SpA. European Food, 42.4 236 65 2.85 645, Beverage, and Tobacco MedianPractice Problems 659 15 Holding all other factors constant, the most likely effect of low demand and heavy new issue supply on bond yield spreads is that yield spreads will: A widen, B tighten, © not be affected. 16 Credit risk of a corporate bond is best described as the: A risk that an issuer's creditworthiness deteriorates. 8 probability that the issuer fails to make full and timely payments. C risk of loss resulting from the issuer failing to make full and timely payments, 17 The risk that the price at which investors can actually transact differs from the quoted price in the market is called: A spread risk, B credit migration risk. © market liquidity risk. 1B Loss severity is best described as the: A default probability multiplied by the loss given default B_ portion of a bond’ value recovered by bondholders in the event of default. © portion of a bond’s value, including unpaid interest, an investor loses in the event of default 19 The two components of credit risk are default probability and: A spread risk Boss severity. © market liquidity risk 20 For a high-quality debt issuer with a large amount of publicly traded debt, bond investors tend to devote most effort to assessing the issuer's: A default risk Boss severity. market liquidity risk 21 The expected loss fora given debt instrument is estimated as the product of default probability and A (1+ Recovery rate) B (1 — Recovery rate © 1/(1 + Recovery rate) 22 The priority of claims for senior subordinated debt is: A lower than for senior unsecured debt. B the same as for senior unsecured debt. © higher than for senior unsecured debt. 28 A senior unsecured credit instrument holds a higher priority of claims than one ranked as A mortgage debt. B second lien loan. senior subordinated. 24 In a bankruptcy proceeding, when the absolute priority of claims is enforced: A senior subordinated creditors rank above second lien holders2 6 2 2 » 30 a 2 3 Reading 55 # Fundamentals of Credit Analysis B_ preferred equity shareholders rank above unsecured creditors. © creditors with a secured claim have the first right to the value of that spe- cific property. In the event of default, which of the following is most likely to have the highest recovery rate? A Second lien B. Senior unsecured © Senior subordinated “The process of moving credit ratings of different issues up or down from the issuer rating in response to different payment priorities is best described as: A notching, 8 structural subordination. C cross-default provisions. “The factor considered by rating agencies when a corporation has debt at both its parent holding company and operating subsidiaries is best referred to as: A credit migration visk 8 corporate family rating. structural subordination, Which type of secutity is most likely to have the same rating asthe issuer? A Preferred stock B Senior secured bond © Senior unsecured bond Which ofthe following corporate debt instruments has the highest seniority ranking? A Second lien B Senior unsecured © Senior subordinated ‘An issuer credit rating usually applies to a company’s: A secured debt. B subordinated debt. © senior unsecured debt. “The rating agency process whereby the credit ratings on issues are moved up or down from the issuer rating best describes: A notching 8 pari passu ranking © cxoss-default provisions. “the notching adjustment for corporate bonds rated Aa2/AA is most likely: A larger than the notching adjustment for corporate bonds rated B2/B, B the same asthe notching adjustment for corporate bonds rated B2/B. smaller than the notching adjustment for corporate bonds rated B2/8. ‘Which of the following statements about credit ratings is most accurate? A Credit ratings can migrate over time. Changes in bond credit ratings precede changes in bond prices. Credit ratings are focused on expected loss rather than risk of default.Practice Problems 661 34 Which industry characteristic most likely has a positive effect on a company’s ability to service debt? ‘A Low barriers to entry in the industry B_ High number of suppliers to the industry © Broadly dispersed market share among large number of companies in the industry 35 When determining the capacity of a borrower to service debt, a credit analyst ‘should begin with an examination of: A industry structure. B industry fundamentals. © company fundamentals. 36 Which of the following accounting issues should mostly likely be considered a character warning flag in credit analysis? A. Expensing items immediately B Changing auditors infrequently Significant off-balance-sheet financing 37 In credit analysis, capacity is best described as the: ‘A quality of management. B ability of the borrower to make its debt payments on time, © quality and value of the assets supporting an issuer's indebtedness. 38 Among the Four Cs of credit analysis, the recognition of revenue prematurely most likely reflects a company's: A character. B covenants. © collateral, Use the following Exhibit for Questions 39 and 40 Return EBIT/ EBITDA EBITDA on interest interest Debt/ Margin Expense Expense EBITDA (9) 4) 00, 00, Ci CompanyA 519508 16 CompanyB 286363 8D os Company 2166 39 1a 25 39 Based on only the leverage ratios in Exhibit 4, the company with the highest credit risk is: ‘A Company A. B Company B. © Company C.662 Reading 55 « Fundamentals of Credit Analysis 40 Based on only the coverage ratios in Exhibit 4, the company with the highest credit quality is A Company A. B Company B. © Company C. Use the following Exhibits for Questions 41 and 42 Bee) Company X Company ¥ Net revenues: 507 37 Operating expenses 496 74. (Operating income 1a 133. Interest income 00 00 Interest expense 06 os. Income before income taxes os. 125 Provision for income taxes 02. 35. Net income ny¥ ASSETS Current assets 103 2s Property plant, and equipment, net 35 204 Goodwill 83 85.0 Other assets og 5a Total assets 23.0 132.1 LIABILITIES AND SHAREHOLDERS’ EQUITY (Gureent lsbilities ‘Accounts payable and accrued expenses 84 162 Short-term debt as a7Practice Problems 6 (Continued) Total current liabilities Long-term debt Other non-curzent liabilities Total liabilities ‘Total shareholders’ equity Tota libillties and shareholders’ equity CASH FLOWS FROM OPERATING ACTIVITIES [Net income Depreciation Goodwill impairment (Changes in working capital Net cash provided by operating activities CASH FLOWS FROM INVESTING ACTIVITIES [Additions to property and equipment Additions to marketable securities Proceeds from sale of property and equipment Proceeds feom sale of marketable securities Net cash used in investing activities CASH FLOWS FROM FINANCING ACTIVITIES: Repurchase of common stock Dividends to shareholders ‘Change in short-term debt Additions to longeterm debt Reductions in long-term debt Net cash ~ financing activities Reece ae Company X 59) Dw? 13 250 Company X 03 10 290 oo 33 -10 on 02 03 06 “18 -03 00 39 34 “13 ns) Company ¥ 28 22 eal 640 1321 Company ¥ 90 38 16 -04 140) 10 00 29 09. LL -40 61 34 39 25 =I (continued) 663664 Reading 55 # Fundamentals of Credit Analysis Pact) NET INCREASE IN CASH AND CASH a os. EQUIVALENTS 41. Based on Exhibits 5-7, in comparison to Company X, Company Y has a higher: 2 "7 A debticapital ratio. B debt/EBITDA ratio, free cash flow after dividends/debt ratio. Based on Exhibits 5-7, in comparison to Company Y, Company X has greater: A leverage, B interest coverage. © operating profit margin. Cxedit yield spreads most likely widen in response to: A high demand for bonds. B_ weak performance of equities strengthening economic conditions. “The factor that most likely results in corporate credit spreads widening is: ‘Aan improving credit cycle, B weakening economic conditions. © aperiod of high demand for bonds, Cxedit spreads are most likely to widen: A ina strengthening economy. Bas the credit cycle improves. in periods of heavy new issue supply and low borrower demand. Which of the following factors in credit analysis is more important for general obligation non-sovereign government debt than for sovereign debt? A Per capita income B- Power to levy and collect taxes © Requirement to balance an operating budget In contrast to high-yield credit analysis, investment-grade analysis is more likely to rely on: A spread risk, B- anassessment of bank credit facilities. © matching of liquidity sources to upcoming debt maturities. Which of the following factors would best justify a decision to avoid investing in a country’s sovereign debt? A Freely floating currencyPractice Problems BA population that is not growing © Suitable checks and balances in policymaking, 6652 “ Reading 55 # Fundamentals of Credit Analysis SOLUTIONS A is correct. Credit migration risk or downgrade risk refers tothe risk that a bond issuer's creditworthiness may deteriorate or migrate lower. The result is that investors view the risk of default to be higher, causing the spread on the issuer's bonds to widen ‘Cis correct. Market liquidity risk refers to the risk that the price at which inves- tors transact may be different from the price indicated in the market. Market liquidity risk is increased by (1) less debt outstanding and/or (2) a lower issue credit rating. Because Stedsmart Ltd is comparable to Fignermo Ltd except for less publicly traded debt outstanding, it should have higher market liquidity risk As correct. First mortgage debt is senior secured debt and has the highest priority of claims. First mortgage debt also has the highest expected recovery rate. First mortgage debt refers to the pledge of specific property. Neither senior ‘unsecured nor junior subordinate debt has any claims on specific assets. Bis correct. Whether or not secured assets are sufficient fo the claims against them does not influence priority of claims. Any deficiency between pledged assets and the claims against them becomes senior unsecured debt and still adheres to the guidelines of priority of claims Cis correct. Both analysts and ratings agencies have difficulty foreseeing future debt-financed acquisitions. Cis correct. Goodwill is viewed as a lower quality asset compared with tangible assets that can be sold and more easily converted into cash, (Cis correct. The value of assets in relation to the level of debt is important to assess the collateral of the company; that is, the quality and value of the assets that support the debt levels ofthe company. Bis correct. The growth prospects of the industry provide the analyst insight regarding the capacity of the company. ‘Ais correct. The construction company is both highly leveraged, which increases credit risk, and in a highly cyclical industey, which results in more volatile earnings. Bis correct. Ihe interest expense is €113 million and EBITDA = Operating profit + Depreciation and amortization = €894 + 249 million = €1,143 million. EBITDA interest coverage = EBITDA/Interest expense = 1,143/113 = 10.12 times. Bis correct. ‘Total debt is €1,613 million with Total capital = ‘Total debt + Shareholders’ equity = €1,613 + 4,616 = €6,229 million. The Debt/Capital ratio = 1,613/6,229 = 25.90%. ‘Ais correct. Ifthe debt of the company remained unchanged but FFO. increased, more cash is available to service debt compared to the previous year. Additionally, the debt/capital ratio has improved. It would imply that the ability of Pay Handle Ltd to service their debt has improved. ‘Ais correct. Based on four of the five credit ratios, Grupa Zywiec SAés credit quality is superior to that of the industry. ‘Ais correct. Davide Campari-Milano S.p.A. has more financial leverage and less interest coverage than Associated British Foods ple, which implies greater credit risk,Solutions ” ” 2» n n B 4 a 2% a a » 30 n Ais correct. Low demand implies wider yield spreads, while heavy supply will, widen spreads even further, Cis correct. Credit risk is the risk of loss resulting from the borrower falling to make full and timely payments of interest and/or principal Cis correct. Market liquidity tisk is the risk that the price at which investors can actually transact—buying or selling —may differ from the price indicated in the market. Cis correct, Loss severity is the portion of a bond's value (including unpaid Interest) an investor loses in the event of default. Bis correct. The two components of credit risk are default probability and loss severity. In the event of default, oss severity is the portion of a bond's value (including unpaid interest) an investor loses. A and C are incorrect because spread and market liquidity risk are credit-related risks, not components of, credit risk Ais correct, Credit risk has two components: default risk and loss severity. Because default risk is quite low for most high-quality debt issuers, bond inves- tors tend to focus more on this likelihood and less on the potential loss severity. Bis correct. The expected loss for a given debt instrument is the default prob- ability multiplied by the loss severity given default. The loss severity is often expressed as (1 — Recovery rate). Ais correct, Senior subordinated debt is ranked lower than senior unsecured debt and thus has a lower priority of payment. Cis correct. Ihe highest-ranked unsecured debt is senior unsecured debt. Lower-ranked debt includes senior subordinated debt. A and B are incorrect because mortgage debt and second lien loans are secured and higher ranked Cis correct. According to the absolute priority of claims, in the event of bank- ruptcy, creditors with a secured claim have the right to the value of that specific property before any other claim. Ais correct. A second lien has a secured interest in the pledged assets. Second, lien debt ranks higher in priority of payment than senior unsecured and senior subordinated debt and thus would most likely have a higher recovery rate. Ais correct: Notching is the process for moving ratings up or down relative to the issuer rating when rating agencies consider secondary factors, such as prior ity of claims in the event of a default and the potential loss severity. Cis correct. Structural subordination can arise when a corporation with 2 holding company structure has debt at both its parent holding company and operating subsidiaries. Debt atthe operating subsidiaries is serviced by the cash flow and assets of the subsidiaries before funds are passed to the parent holding company. Cis correct. The issuer credit rating usually applies to its senior unsecured debt. Ais correct, Second lien debt is secured debt, which is senior to unsecured debt and to subordinated debt. Cis correct. An issuer credit rating usually applies to its senior unsecured debt. Ais correct, Recognizing different payment priorities, and thus the potential for higher (or lower) loss severity in the event of default, the rating agencies have adopted a notching process whereby their credit ratings on issues can be moved up or down from the issuer rating (senior unsecured).Reading 55 # Fundamentals of Credit Analysis 32 Cis correct. Asa general rule, the higher the senior unsecured rating, the smaller the notching adjustment. Thus, for corporate bonds rated Aa2/AA, the rating agencies will typically apply smaller rating adjustments, or notches, to the related issue. 3B A is correct. Credit migration is the risk thal a bond issuer's creditworthiness deteriorates, or migrates lower. Over time, credit ratings can migrate signifi cantly from what they were at the time a bond was issued. An investor should not assume that an issuer's credit rating will remain the same from the time of purchase through the entire holding period. 34 Bis correct. An industry with a high number of suppliers reduces the suppliers’ negotiating power, thus helping companies control expenses and aiding in the servicing of debt. 35 Ais correct. Credit analysis starts with industry structure—for example, by ooking at the major forces of competition, followed by an analysis of industry fundamentals—and then turns to examination of the specific issuer: 36 Cis correct. Credit analysts can make judgments about management's character by evaluating the use of aggressive accounting policies, such as timing reve- rue recognition. This activity is a potential warning flag for other behaviors or actions that may adversely affect an issuer's creditworthiness. 37. Bis correct. Capacity refers to the ability of a borrower to service its debt. Capacity is determined through credit analysis of an issuer's industry and of the specific issuer. 3B A is correct. Credit analysts can make judgments about management's charac ter in a number of ways, including by observing its use of aggressive accounting policies and/or tax strategies. An example of this aggressiveness is recognizing revenue prematurely. 39. Cis correct. The debt/capital and debt/EBITDA ratios are used to assess a com- pany’ leverage. Higher leverage ratios indicate more leverage and thus higher credit isk, Company C’s debticapital (46.3%) and debt/EBITDA (2.5%) leverage ratios are higher than those for Companies A and B, 40 Bis correct. Ihe EBITDAJinterest expense and EBI'T/interest expense ratios are coverage ratios. Coverage ratios measure an issuer's ability to meet its interest payments. A higher ratio indicates better credit quality. Company B's EBITDA/ interest expense (62.4%) and EBI/interest expense (58.2x) coverage ratios are higher than those for Companies A and C. 41 Cis correct because Company Y has a higher ratio of free cash flow after divi- dends to debt than Company X, not lower, as shown in the following table, Free cash flow after dividends as a % of debt - PF after dividends Debt Company X Company Cash flow fom operations 133 e140 Less Net capital expenditures 08 Dividends 03 Free cash low after dividends ma is Debt 122. 298Solutions 669 Company X Company Free cash low after dividends asa % ofdebt (22/122)*100 (68/298) x 100, Free cash flow after dividends as a % of debt 18.0% 228% Ais incorrect. Company Y has a lower debt/capital ratio than Company X, as shown in the following table. Debt Debt divide by Capital ) = Ba ray Company X Company Debt 2122 2298 Capital Debt 2 298 + Equity 13 oa Capital 2135 2938 Debt/Capita (%) (122/135) x 100 (29/93.8) x 100 DebtiCapital (8) 90.8% 3.8% Bis incorrect because Company ¥ has a lower debU/EBITDA ratio than Company ¥, not higher, as shown in the following table. Company X Company ¥ (Operating income aud 4133, BIT aul 2133 plus Depre 19 38 Amortization, 00 oo EBITDA ea a7 Debt e122 e298 Debt/EBITDA, 1324 298/171 DebU/EBITDA 581 174 42 Ais correct. Compared with Company Y, based on both their debt/capital ratios and their ratios of free cash flow after dividends to debt, which are measures of leverage commonly used in credit analysis, Company X is more highly lever- aged, as shown in the following table. Debt Debt divided by Capital ) = Bray Company X Company ¥ Debt 222 2298 (continued)670 8 "7 Reading 55 # Fundamentals of Credit Analysis Company X Capital Debt + Equity Capital Debt/Capital (%) my 22 298 43 oo 265 38 (122/135) x 100 (29.8/93.8) « 100, s0a% 318% Free cash flow after dividends as a % of debt = Company X Company Cash flow from operations Less Net capital expenditures Dividends Free cash flaw after dividends Debt Free cash flow after dividends as 8 % of debt Free cash flow after dividends as a % of debt FCF after dividends Debt 3 £140) 08 ol 03 64 m2 E68 e122, 298 (22/122) x10 (68/288) x 100 18.0% 228% Bis correct. In weak financial markets, including weak markets for equities, credit spreads will widen. Bis correct. Weakening economic conditions will push investors to desire a greater risk premium and drive overall credit spreads wider, Cis correct. In periods of heavy new issue supply, credit spreads will widen if demand is insufficient. Cis correct. Non-sovereign governments typically must balance their operating budgets and lack the discretion to use monetary policy as many sovereigns can, Ais correct, Most investors in investment-grade debt focus on spread risk—that is, the effect of changes in spreads on prices and returns—while in high-yield analysis, the focus on default risk is relatively greater. Bis correct. Among the most important considerations in sovereign credit, analysis is growth and age distribution of population. A relatively young and ‘growing population contributes to growth in GDP and an expanding tax base and relies less on social services, pensions, and health care relative to an older population.A ptiori probability A probability based on logical analysis rather than on abservation or personal judgment. Abnormal return The amount by which a securitys actual return differs from its expected return, given the security’ risk and the market's rete, Absolute advantage A country’s ability to produce a good ‘or service at alower absolute cost than its trading partes Absolute dispersion ‘Ihe amount of variability present ‘without comparison to any reference point or benchmark, Absolute frequency ‘The number of observations ina given interval (for grouped data), Accelerated bookbuild An offering of securities by an invest ‘ment bank acting as principal that is accomplished in only fone or two days, Accelerated methods Depreciation methods that allocate 1 relatively large proportion of the cast of an asst to the carly years ofthe asset's useful life Accounting costs Monetary value of economic resources used in performing an activity. These can be expliet, out of-pocket, current payments, of an allocation of historical payments (depreciation for resources. They do not include Implicit opportunity costs. Accounting profit Income as reported on the income state ‘ment, in accordance with prevailing accounting standards, before the provisions for income tax expense. Also called income before taxes or pretax income. ‘Accounts payable Amounts that business owes to its vendors for goods and services that were purchased fom them but Which have not yet been pai. Accounts receivable tumover Ratio of sales on credit tothe average balance in accounts receivable, Accrued expenses Liabilities related to expenses that have been incurred but not yet paid as ofthe end of an sccount- ing petiod—an example of an accrued expense i rent that hhas been incurred but not yet pai, resulting in a liability ‘ent payable” Also called acerued liabilities Accrued interest Interest earned but not yet pai. Acid-testratio A stringent measure of liquidity thst indicates s ability to satisy current libilties with its most liquid assets, calculated as (cash + short-term marketable investments + receivables) divided by current liabilities. Acquisition methed A method of accounting for a busi ‘ness combination where the acquirer is required to mea: sure each identifiable asset and liability at fair value. This method was the result of aint project of the IASB and FASB aiming at convergence in standards for the account ing of business combinations. Action lag Delay from policy decisions to implementation, ‘Active investment An approach to investing in which the Investor seeks to outperform a given benchmark Active return The return on a portfolio minus the return on the portfolio’: benchmark Active strategy In elerence to short-term cash management, tn investment strategy characterized by monitoring and attempting to capitalize on market conditions to optimize the risk and return relationship of short-term investments Glossa Activity ratios Katios that measure how efficiently & com- pany performs day-ta-day tasks, such as the collection of Feceivables and management of inventory. Also called asset tuiization ratios ot operating efficiency ratios, Add-on rates Bank certlicates of deposit, repos, and indexes such as Libor and Euribor are quoted on an add-on rate basis (bond equivalent yield basis) ‘Addition rule for probabilities A principle stating thatthe probability that A or B occurs (both occur) equals the probability that A occurs, plus the probability that B occurs, ‘minus the probability that both A and B oceut: Agency bonds See quasi-governnient bond. Agency RMBS_in the United States, securities backed by residential mortgage loans and guaranteed by « federal agency or guaranteed by either ofthe two GSEs (Fannie Mae and Freddie Mac). Aggregate demand ‘The quantity of goods and services that households, businesses, government, and foreign customers want to buy at any given level of prices Aggregate demand curve Inverse relationship between the price level and real output Aggregate income The value of all the payments earned by the supplies of factors used in the production of goods and services Aggregate output “The value of all the goods and services produced in a specified period of time Aggregate supply The quantity of goods and services pro: ducers are willing to supply at any given level of price. Aggregate supply curve The level of domestic output that companies will produce at cach price level, Aging schedule A breakdown of accounts into categories of ‘days outstanding. All-or-nothing (AON) orders An order that includes the instruction to trade only ithe trae fil the entire quantity (size) specified Allocationally efficient _ Said of a market, a financial system, for an economy that promotes the allocation of resources to their highest value uses. Alternative data Non-traditional dsta types generated by the use of electronic devices, social media, satelite and sensor networks, and company exhaust, Alternative investment markets Market for investments other than traditional securities investments (ie, tradi tional common and preferred shares and traditional fixed income instruments). The term usualy encompasses direct and indirect investment in realestate (including timber. land and farmland) and commodities (including precious retals); hedge funds, private equity and other investments requiring specialized due diligence ‘Alternative trading systems Trading venues that function like exchanges but that do not exercise regulatory authority over theie subscribers except with respect to the conduct of the subscribers’ trading in thei trading systems. Also called electronic communications networks ot multilateral trading facilites. can depository receipt AUS dollar-denominated secu: rity that trades like a common share on US exchanges, ‘AmerG2 ‘Americandepository share ‘The underlying shares on which “American depository receipts are based, they trade in the issuing company’s domestic market. American-style Said of an option contract that can be exer ised at any time up to the option’ expiration date Amortisation ‘The process ofallocating the cost of intangible long-term assets having a finite useful life to accounting. periods; the allocation ofthe amount of bond premium tr discount to the periods remaining until bond maturity. Amortised cast Ihe historical cost intially recognised cost) ‘of an asst, adjusted for amortisation and impairment. Amortizing bond Bond witha payment schedule that cals for periodic payments of interest and repayments of principal Amortizing loan Loan with a payment schedule that calls for periodic payments of interest and repayments of principal Annual percentage rate The cost of borrowing expressed as yearly rate Annuity A finite set of level sequential cashflows. Annuity due An annuity having. first cash flow that is paid Immediately: Anticipation stock Excess inventory thats held in anticipation ‘of increased demand, often because of seasonal patterns fof demand, Antidilutive With reference toa transaction or a security, one that would increase earnings per share (EPS) or result in EPS higher than the company’s basic EPS—antidilutive securities are not included in the calculation of diluted EPS. Arbitrage 1) The simultaneous purchase of an undervalued asset oF portfolioand sale ofan overvalued but equivalent asset of portfolio, in order to obtain rskless profit on the price diferential, Taking advantage of a market inefficiency Jnarisk-free menner. 2) The condition ina financial market in which equivalent assets or combinations of asses sell for thro different prices, creating an opportunity to profit at no risk with no commitment of money. ina well-functioning. financial market, few arbitrage opportunities ate possible. 3) Ariskfree operation that earns an expected positive net profit but requires no net investment of money. Arbitrage-free pricing "The overall process of pricing deriv- atives by arbitrage and risk neutrality. Also called the pricipleof no arbitrage. Arbitrageursraders who engage in arbitrage. See arbitrage, ‘Arithmeticmean ‘The sum of the observations divided by the ‘number of observations. ‘Arms index A flow of funds indicator applied toa broad stock market index to measure the relative extent to which money is moving into or out of rising and declining stocks. Artificial intelligence Computer systems that exhibit cognitive and decision-making ability comparable (or superior) to that of humans, Asian all option A European-style option with a value at ‘maturity equal tothe difference between the stock price ‘maturity and the average stock price during the fe of 1 option, or $0, whichever is greater. The price at which a dealer or trader is willing to sell an asset, typically qualified by a maximum quantity (ask. size). See afer. Asksize The maximum quantity ofan asset that pertains to 8 specific ask price from a trader For example, ifthe ask f A shate issue is $30 for a size of 1,000 shares, the trader is offering to sell at $30 up to 1,000 shares, Assetallocation ‘The process of determining how investment funds should be distributed among asset classes, Ask Glossary Asset-backed securities A type of bond issued by a legal entity called a spectal purpose entity (SPE) on a collection of assets that the SPE owns. Also, securities backed by receivables and loans other than mortgages. Asset-basedloan A loan that is secured with company assets ‘Asset-based valuation models Valsation based on estimates ‘of the market value of company's assets, ‘Asset beta The unlevered beta; reflects the business risk of the assets; the asse’s systematic risk Assetclass A group of assets that have similar characteristics, attributes, and risk/return relationships. Asset swap Converts the periodic fixed coupon of a specific bond toa Libor plus or minus a spread. ‘Asset utilization ratios — Katios that measure how efficiently a company performs day-to-day tasks, such asthe collection of receivables and management of inventory. Assets Resources controlled by an enterprise as a result of ‘past events and from which future economic benefits to the enterprise are expected to flow. Assignment of accounts receivable receivable as collateral fora loan. At the money An option in which the underlying’s price ‘equals the exercise price Auction A type of bond issuing mechanism often used for sovereign bonds that involves bidding. ‘Autarkic price "The price of a good or service in an autarkic economy, ‘Autarky — A state in which a country does not trade with other countries. ‘Automated Clearing House (ACH) An electronic payment network availble to businesses, individuals, and finan- cial institutions in the United States, US Territories, and Canada. ‘Automatic stabilizer A countercyclical factor that automat- jeally comes into play as an economy slows and unemy- ployment rises, Available-forsale Debt and equity securities not classified as lther held-to-maturty or held-for-trading securities, “The investor is willing to sell but not actively planning to sell, In general, vailable-for-rale securities are reported st fair value on the balance sheet. Average fixed cost Total fixed cost divided by quantity produced. Average life See weighted average life Average product Measutes the productivity of inputs on average and is calculated by dividing total product by the total number of units for @ given input that is used to generate that output. Average revenue ‘otal revenue divided by quantity sol. ‘Average total cost Total cost divided by quantity produced. ‘Average variable cost Tota variable cos divided by quantity produced. Back simulation Another term for the historical method of estimating VaR. "This ter is somewhat misleading in that the method involves nota simulation of the past but rather ‘what actually happened in the past, sometimes adjusted to reflect the fact that a different portfolio may have existed in the past than is planned for the future. Back-testing With reference to portiolio strategies, the appli cation ofa steategy’s portfolio selection rules to historical data to assess what would have been the strategy’s historical performance. “The use of accountsGlossary Backup lines of credit type of credit enhancement provided bya bank to an issuer of commercial paper to ensure that the issuer will have access to sutfcient liquidity to repay maturing commercial paper if issuing new paper is not a viable option lance of payments A double-entry bookkeeping system that summarizes a country’s economic transactions with the rest of the world fora particular period of time, typically ‘calendar quarter of year. Balance of trade deficit When the domestic economy is spending more on foreign goods and services than foreign economies ate spending on domestic goods and services. Balance sheet ‘The financial statement that presents an entity ‘current financial position by disclosing resources the entity controls (its assets) and the claims on those resources (ts liabilities and equity claims), as of @ particular point in time (the date ofthe balance sheet). Also called statement of financial postion or statement of nancial condition Balance sheet ratios Financial ratios involving balance sheet items only. Balanced _ With respect toa government budget, one in which spending and revenues (Laxes) are equal Balloonpayment Large payment required at maturity to retire ‘ bond's outstanding principal amount, Bank discount basis _ A quoting convention that annuslizes, on 8 360-day year, the discount asa percentage of face value Bar chart A price chart with four bits of data for each time interval-the high, low, opening, and closing prices. A vertical line connects the high and low. A cross-hatch Teft indicates the opening price and a cross-hateh right indicates the close. Barter economy An economy where economic agents as house-holds, corporations, and governments “pay” for goods and services with another good or service Baserates ‘The reference rate on which a bank bases lending rates taal other customers Basic EPS Net earnings available to common shareholders (Le, net income minus preferred dividends) vided by the weighted average number of common shares outstanding Basis point Used in stating yield spreads, one basis point equals one-hundredth of a percentage point, or 0.01%. Basket oflisted depository receipts An exchange-traded fund (ETF) that represents a portfalio of depository receipts Bearer bonds Bonds for which ownership is not recorded: ‘only the clearing system knows who the bond owner is Behavioral finance A licld of finance that examines the psychological variables that affect and often distort the lnvestment decision making of investors, analysts, and portfolio managers. Behind the market Seid of prices specified in orders that are worse than the best current price: eg, fora limit buy ‘order, limit price below the best bid. Benchmark A comparison portfolio; a point of reference or comparison. Benchmark issue The latest sovercign bond issue fore given ‘maturity, It serves as a benchmark against which to com pare bonds that have the same features but that are issued by another type of issuer Benchmark rate Typically the yield-to-maturty on a gov- ‘ernment bond having the same, or close to the same, time-to-maturty Benchmark spread ‘The yield spread over a specific bench mark, usually measured in basis points Bermuda-style Said of an option contract that can be exer- ‘ised on specified dates up tothe aption’s expiration date. Bernoulli random variable A random variable having the outcomes 0 and 1 Bernoulli trial An experiment st bid The highest bid in the market. Besteffort offering An offering of security using an inves ‘ment bank in which the investment bank, as agent for the Issuer, promises to use its best forts to sell the offering but does not guarantee that a specific amount will be sol elass_An ESG implementation approach that seeks to identify the most favorable companies in an industey based on ESG considerations Best offer The lowest offer (ask price) in the market Beta A measure of the sensitivity of a given investment or portfolio to movements in the overall market. Bid “The price at which a dealer or trader is willing to buy an asset typically qualified by a maximum quantity id-ask spread The difference between the prices at which dealers will buy from a customer (bid) and sell co a cus: tomer (offer or ask). Its often used as an indicator of liquidity. Bid-offer spread the difference hetween the prices at which dealers will buy from a customer (bid) and sell to a cus- tomer (offeror ask). It is often used as an indicator of liquidity, Bid size The maximum quantity of an asset that pertains to a specific bid price from a trader. Data The vast amount of data being generated by industry, ‘governments, individuals, and electronic devices that arises from both traditional and non-traditional data sources lateralloan loan from a single lender toa single borrower. Binomial model A model for pricing options in which the uunderying price can move to only one of two possible new prices nomial random variable The number of successes in Bernoulli trials for which the probability of success is constant for all trials and the trials are independent Binomial tree The graphical representation of a model of asset price dynamics in which, at each period, the asset moves {ep with probability p or down with probsbilty (1 ~p). teoin A cryptocurrency using blockchain technology that ‘was created in 2008, Block brokers A broker (agent) that provides brokerage ser vices for large-size trades. Blockchain A type of digital ledger in which information is recorded sequentially and then linked together and secured tasing cryptographic methods, Blue chip Widely held large market capitalization companies that are considered financially sound and are leaders in their respective industry or local stock market. Bollinger Bands A price-based technical analysis indicator consisting of a moving average plus a higher line repre: senting the moving average plus «set number of standard eviations from average price (for the same number of, periods as used to calculate the moving average) and 2 Tower line tht is a moving average minus the same number of standard deviations snd Contractual agreement between the issuer and the bondholders ‘can produce one of twoBond equivalent yield _A calculation of yield thats annualized using the ratio of 365 to the number of éays to maturity. Bond equivalent yield allows forthe restatement and com parison of securities with diferent compounding periods. Bond indenture The governing legal ceelt agreement, typ. {cally incorporated by reference in the prospectus. Also called trust deed. Bondmarket vigilantes Bond market participants who might reduce their demand for long-term bonds, thus pushing. ap their yields Bond yield plus risk premium approach An estimate of the cost af common equity that is produced by summing the before-tax cost of debt and a risk premium that captures the additional yield on a company's stock relative to its bonds. “The additional yield is often estimated using historical spreads between bond yields and stock yields, Bonus issue of shares A type of dividend in which a com- ‘pany distributes adeitional shares ofits common stack to sharcholdets instead of eash. Book building Investment bankers’ process of compiling & “book” oF list of indications of interest to buy past of an offering Book value The net amount shown for an asset or liability fon the balance shect; book value may also refer to the ‘company’s excess of total assets aver total libilties, Also called carrying value. Boom An expansionary phase characterized by economic growth “testing the limits” of the economy. Bottomup analysis With reference to investment selec ‘on processes, an approach that involves selection from all securities within a specified investment universe, ic. without prior narrowing of the universe on the basis of ‘macroeconomic or overall matket considerations. Break paint In the context of the weighted average cost of capital (WACC), a break point is the amount of capital at which the cost of one of more of the sources of capital changes, leading (o a change in the WACC, Breakeven point The nismber of units produced and sold at Which the company's net income is zero (Revenues = Total cost); in the ease of perfect competition, the quantity at Which price, average revenue, and marginal revenue equal verage total cost, Bridgefinancing Interim financing that provides funds until ‘permanent financing can be arranged. Broad money Encompasses narrow money plus the entire range ofliguid assets that can be used to make purchases, Broker 1) An agent who executes orders to buy or sell secu- sities on behalf ofa client in exchange for a commission, 2) See futures commision merchants Broker-dealer 4 financial intermediary (often a company) chat may function as a principal (dealer) or as an agent (broker) depending on the type of trade. Brokered market A market in which brokers arrange trades among thei clients. Budget surplus/deficit ‘The difference between government event and expenditure fora stated fixed period of time, Business risk ‘Ihe risk associsted with operating earnings. ‘Operating earnings are uncertain because total revenues and many ofthe expenditures contributed to produce those Buyside firm An investment management company or other Investor that uses the services of brokers or dealers (ie the cient of the sell side firms). Glossary Buyback A transaction in which @ company buys back its ‘own shares. Unlike stock dividends and stock spit, share repurchases use corporate cash Buyout fund A fund that buys all the shares of a public ‘company so that, in effect, the company becomes private, Call Anoption that gives the holder the right to buy an under lying asset from another party ata fixed price over a specific period oftime Callmarket A market in which trades occur only ats particular time and place (ie, when the market is called). Call money rate The interest rate that buyers pay for their margin loan. Call option An option that gives the holder the right to buy ‘an underlying asset (rom another party at a fixed price over a specific period of time. Callprotection The time during which the issuer ofthe bond ‘isnot allowed to exercise the call option, Callable bond A bond containing an embedded call option ‘that gives the issuer the right to buy the bond back from the investor at specified prices on pre-determined dates. Callable common shares Shares that give the issuing company Ine option (or right), but not the obligation, to buy back the shares from investors ata eal price that is specified when the shares are originally issued, Candlestick chart A price chart with four bits of data for each time interval. A candle indicates the opening and closing. price for the interval. The body of the candle is shaded if the opening price was higher than the closing pre, and the body is clea ifthe opening price was lower than the closing price, Vertieal lines known as wicks oF shadows extend from the top and bottom of the candle to indicate the high and the low prices for the interval, Cannibalization | Cannibalization occurs when an investment takes customers and sales away from another part of the company, Capacity The ability of the borrower to make its debt pay: ‘ments on time. account A component of the balance of payments sccount that measures transfers of capital Capital allocation line (CAL) A graph line that describes the ‘combinations of expected return and standard deviation of return available to an investor from combining the optimal portfolio of risky assets with the risk-free asset Capitalasset pricing medel (CAPM) An equation describing the expected return on any asset (or portfolio as a linear function ofits beta relative to the market portfolio Capital budgeting The allocation of funds to relatively ong- ange projects or investments Capital consumption allowance A measure of the wear and tear (depreciation) ofthe capital stock that occurs in the production of goods and services. Capital deepening investment increases the stock of capital relative to labor expenditure cay Expenditure on physical capital (fixed Type of index linked bond. The cou- pon tate is fixed but is applied to a principal amount that increases in line with increases in the index during the bond's life. Capital lease Sec finance lease Capital market expectations An investor's expectations concerning the risk and return prospects of asset classes,Glossary Capital market line _ (CML) The line with an intercept point ‘equal to the risk-free rate that is tangent to the efficient frontier of risky assets; represents the efficient frontier ‘when a risk-free asset is available for investment, Capital market securities Securities with maturities at issu ance longer than one year. Capital markets Financial markets that trade securities of longer duration, such as bonds and equities. Capital rationing capital rationing environment assumes that the company has a fixed amount of funds to invest. Capital restrictions Controls placed an foreigners’ ability to ‘own domestic assets and/or domestic residents’ ability to own foreign assets jtalstock The accumulated amount of buildings, machin. xy, and equipment used to produce goods and s Capital structure |The mix of debt and equity that company uses to finance its business; company's specific mixture ‘of long-term financing, Captive finance subsidiary A wholly-owned subsidiary of ‘8 company that is established to provide financing of the sales ofthe parent company. The net of the costs and benefits of holding, storing, “carrying” an asset Carrying amount The amount at which an asset of liability is valued according to accounting principles. Carrying value ‘Ihe net amount shown for sn asset of liabil- ity on the balance sheet; Book value may also refer tothe company’s excess of total assets aver tatal liabilities. For a bond, the purchase price plus (or minus) the amortized amount of the discount (or premium). Cartel Participants in collusive agreements that are made ‘openly and formally. Cash collateral account Form of external credit enhance- ‘ment whereby the issuer immediately borrows the credit enhancement amount and then invests that amount, usually ln highly rated short-term commercial paper Cash conversion cycle A financial metric that measures the length of time required for a company to convert cash invested in its operations to cash received as result of its operations; equal to days of inventory on hand + days of sales outstanding - number of days of payables. Also called net operating cycle. Cash flow additivity principle The principle that dollar amounts indexed at the same point in time are additive Cash flow from operating activities ‘The net amount of cash provided from operating activities Cash low from operations ‘The net amount of cash provided from operating activities. Cash flow yield ‘The internal rate of return on a series of cash flows, Cash market securities Money market securities settled on "same day" or “cash settiemens” basis Cash markets See spor markets Cash prices — Sec spot price Cash-settled forwards See non-deliverable forwards. CBOE Volatility Index A measure of near-term market vol- tility as conveyed by S&P $00 stock index option prices. CD equivalent yield A yield on a basis comparable to the ‘quoted yield on an interest-bearing money market instru- ‘ment that pays interest on a 360-