READING 44: FUNDAMENTALS OF CREDIT ANALYSIS

Intro and reading overview pending

LOS 44.a: Describe credit risk and credit-related risks affecting corporate
bonds.

LOS 44.b: Describe default probability and loss severity as components of

credit risk.

Credit Risk

Credit risk measures the risk of losses that come from the possibility that the bond
issuer or borrower cannot make interest and principal payments on time or cannot
pay the full amount of interest or principal that is owed.

It can be split into two components:

1. Default Risk: This is the probability that the issuer will not make interest or
principal payments in time.
2. Loss Severity: This is the value of the loss given that the issuer defaults on
their payment. It can also be stated as a percentage of the remaining amount
that is due. It can be said that this is the loss given default (expected loss
given that the issuer defaults on their payment).

Expected Loss = Default Probability x Loss Severity Given Default

When an issuer defaults on their interest or principal payment, it does not

necessarily mean that the entire amount cannot be paid. There will be some amount
that can be recovered. And so the recovery rate is the percentage of the remaining
dues that can be recovered.

Now we can see the following relationship in percentage terms:

● Loss severity (as a percentage of the outstanding amount due) measures the
outstanding amount that will be lost if the bond defaults.
● Recovery rate (as a percentage of the outstanding amount due) measures the
outstanding amount that will be recovered if the bond defaults.

Therefore,

Loss Severity (%) + Recovery Rate (%) = 1

and,

Loss Severity (%) = 1 - Recovery Rate (%)

Credit risk premium is added to the discounting factor of a bond. There are two ways
to think about this.

● Other things held constant, if a bond has higher credit risk, it will be less in
demand. It will trade at a lower price and at a higher YTM.
● Other things held constant, if a bond has higher credit risk, investors will
demand a higher yield because of the additional risk that they are taking on.

Spread Risk

What is the credit spread?

Consider the YTM of a risk-free government bond and the YTM of a corporate bond.
The corporate bond will have a higher risk of default and so a higher credit premium.
If the risk-free rate is 6% and the YTM on a corporate bond is 9% then, all other
things held constant, the credit spread is 9.00% - 6.00% = 3.00%.

The credit spread therefore measures the difference in YTM between a government
bond and a corporate bond with similar maturity but different credit quality.

The spread tightens when economic conditions are good. Why? Because the
probability that any company would default in good economic conditions reduces.
This decreases the credit risk thereby decreasing the YTM of a corporate bond.

The spread widens when economic conditions are bad. Why? Because the
probability that any company would default in bad economic conditions increases.
This increases the credit risk thereby increasing the YTM of a corporate bond.

Which other factors affect the credit risk?

Credit Migration or Downgrade Risk

If the credit ratings of a bond worsen then it means that the probability of default has
increased. If the probability of default increases then the credit risk increases and so
the yield spread increases. Refer to the credit rating chart in LOS 44.d for a better
understanding of credit ratings.
If the credit ratings of a bond improve then it means that the probability of default has
reduced. If the probability of default reduces then the credit risk reduces and so the
yield spread decreases.

Liquidity Risk

If there is lack of liquidity in the market for that specific bond then it is likely that the
seller will receive less than the market value of the bond. This is implied in the bid-
ask spread.

A wider bid-ask spread implies higher liquidity risk and a lower bid-ask spread
implies lower liquidity risk.

Questions

1. Which of the following is most likely the value of the loss if a bond defaults on its
payments?

A. Loss severity

B. Default risk

C. Recovery rate

2. The default probability of a corporate bond is 45% and the loss severity is Rs. 50
million. Calculate the expected loss.

A. Rs. 50 million

B. Rs. 27.5 million

C. Rs. 22.5 million

3. Other things held constant, the credit spread most likely widens when

A. The yield on government bonds increases

B. Economic conditions worsen

C. Economic conditions improve

4. The rating of a corporate bond migrates from AA to AAA. The yield on this bond
most likely

A. Increases

B. Reduces

C. Remains the same

Answers

1. A is correct. The loss severity is also called the loss given default. This calculates
the amount that the bondholder will lose if the bond does default. B is incorrect
because this is a probability, not a value. C is incorrect because the recovery rate is
the percentage of the exposure to the bond that will be recovered. It is calculated as
1 - Loss Severity %.

2. C is correct. The loss severity is the loss given that the bond defaults with a 100%
probability. The expected loss is the loss given that the bond defaults adjusted for
the probability of default.

Expected Loss = Default Probability x Loss Severity Given Default

Expected Loss = 45% x Rs. 50 million = Rs. 22.5 million

A is incorrect because this is the loss given that the bond defaults with a 100%
probability.

B is incorrect because this is the expected amount that will be recovered if the bond
defaults.

3. B is correct. The credit spread measures the difference in the yield between
corporate bonds and government bonds with similar maturities. When economic
conditions worsen, the credit risk of corporate bonds most likely increases and this is
added to the YTM. This increases the credit spread over government bonds. A is
incorrect because if the corporate bond yields are held constant and the government
bond yield increases, the credit spread will tighten (reduce) and not widen. C is
incorrect because when economic conditions improve, the credit risk of corporate
bonds most likely decreases. This means that the YTM of corporate bonds reduces
and the spread tightens.

4. B is correct. This is a ratings upgrade and is a positive factor for the bond. The
credit risk is perceived to be lower, so the credit premium shrinks. This reduces the
YTM of the bond as the price increases due to an increase in credit quality. A is
incorrect because the risk resides on the downside (i.e., if the bond was downgraded
from AAA to AA). If the credit quality reduces then the price reduces and the YTM
increases to reflect the perception of increase in credit risk.

LOS 44.c: Describe seniority rankings of corporate debt and explain the
potential violation of the priority of claims in a bankruptcy proceeding.

Debt is ranked as per priority of repayment in case the bond issuer defaults.

Following are the general seniority rankings for debt repayment priority:

1. First lien/senior secured.

2. Second lien/secured.
3. Senior unsecured.
4. Senior subordinated.
5. Subordinated.
6. Junior subordinated.

Secured vs Unsecured vs Subordinated

Secured debt is backed by some assets that are posted as collateral. These assets
can be sold off to make payments on the defaulted portion of the bond.

Secured debt is then divided into first lien and second lien debt. First lien debt may
also be called first mortgage and this is where a specified asset is pledged as
collateral. It can also be classified into junior secured debt.

Unsecured debt is a general claim to the bond issuer’s assets and cash flows. The
highest priority here is senior unsecured debt and the lower classification is junior
unsecured debt.
Subordinated debt is even lower than unsecured debt and will be the last class to
receive payments.

All types of secured debt will always have a higher priority of claims over all types
of unsecured debt and subordinated debt.

Why is this important to a bondholder?

The ranking tells us who will get paid first in the event of a default. Secured debt is
safer than unsecured debt for the very reason that they have a higher priority of
claims.

Recovery rates are therefore highest for the most secured debt and lowest for the
most subordinated debt. So, the yield on secured debt to subordinated debt goes
from lower to higher - investors will require a higher rate of return on more risky
debt.

Also note that each bondholder within each category is treated the same. This
means that all bondholders of senior unsecured debt will have an equal claim to
payments once the secured debt holders have been paid. This is referred to as the
parri passu system.

If a company defaults or is reorganised then the senior lenders will have a claim on
assets before junior lenders and also equity holders. Although this holds
theoretically, it is sometimes possible for equity holders to get paid before the senior
lenders are paid completely.

All classes of investors who have at least some loss severity can vote on the
bankruptcy reorganisation plan. This vote can disrupt the absolute order of priority of
claims and so equity holders may get paid before the senior lenders.

Bankruptcy costs can be very high. Bankruptcy is a long process and it requires
tons of money in legal fees. The value of the company can go down financially via
such fees or loss of business and also non-financially via loss of key staff and key
managers.

A Note on Recovery Rates

We have seen the seniority of recovery in the event of a default but the recovery rate
itself depends on, but is not limited to, the following factors:
 ● Industry factors: If a company is the victim of a structural decline caused by
a long-term trend (for example a newspaper publisher), then recovery rates
are likely to be low. If a company is simply suffering from the effects of an
economic downturn, then recovery rates may be relatively higher depending
on the issuer.
● Timing of default in the credit cycle: Credit cycles refer to the cycle of
availability and shortage of credit. For instance, if a recovery occurs during a
credit expansion then recovery rates may be higher than if the recovery
occurs during a period of credit tightening. The greater the money supply and
availability of funds in credit markets, the higher the recovery rate.
● Recovery rates are averages: Recovery rates can vary across industries
and within industries. For instance, recovery rates for cyclical firms may be
lower than recovery rates for defensive firms. Even within these categories of
cyclicality, there may be a cyclical firm that has a higher recovery rate than a
similar cyclical firm.

Questions

1. Which of the following types of debt are most likely backed by specific assets?

A. Subordinated debt

B. Senior unsecured debt

C. Senior secured debt

2. Which of the following is most likely to have the lowest recovery rate?

A. Senior unsecured debt

B. Equity holders

C. First lien debt

3. Recovery rates are least likely to be higher during periods of

A. Weak credit cycles

B. Strong credit cycles

C. Low interest rates

Answers

1. C is correct. The term “secured” indicates that the debt is backed by one or more
collateral assets. A and B are incorrect because only secured debt is backed by
assets. They simply have a general claim to all of the assets and cash flows in case
of bankruptcy.

2. C is correct. The recovery rate is highest for secured debt relative to unsecured
and subordinated debt. Secured debt is classified as first lien debt and second lien
debt (where first lien has the first claim to assets). The proceedings from a default
will be paid first to first lien debt and then the following classes will receive a
payment in the order of seniority rankings. B is incorrect because all debt holders are
most likely to have a higher priority than all equity holders.

3. A is correct. Recovery rates are likely to be low when there is lack of money
supply relative to the demand for money. During weak (or tight) credit cycles, there is
less money flowing in the system. Firms that have defaulted are less likely to recover
a higher percentage of what they have lost due to default. Strong credit cycles are
expansionary and they encourage more money supply. Low interest rates are also
linked to an increase in money supply.

LOS 44.d: Distinguish between corporate issuer credit ratings and issue credit
ratings and describe the rating agency practice of “notching.”

Bonds with similar credit risk have similar credit ratings. These ratings are assigned
by companies like Standard and Poor, Moody’s and Fitch. Following are the
comparisons of their ratings terminology:

INSERT R44_LOSd_1

It is important to know the different credit ratings for which a bond is investment
grade and non-investment grade for each method of ratings. Triple A bonds are the
highest rated while C and D grade bonds are the lowest rated.
Baa3 or BBB– bonds (and higher) are considered investment grade bonds while
those lower than Baa3 or BBB– are considered speculative grade bonds, high
yield bonds or junk bonds. C and D grade bonds are all the bonds in default.

Bonds may also have a cross default provision. So, if a company defaults on one
of its bond issues then this provision may trigger a default on all of the other issues
as well.

Notching

Ratings agencies rate the issuer and the individual debt issues. For example,
Reliance as a company may have a credit rating of BBB+ but its individual bond
issues may have a lower rating depending on the characteristics of that issue.

The company’s credit rating as a whole is called the corporate family rating (CFR)
and the individual issue ratings are called corporate credit ratings (CCR). Issuers
are rated based on the quality of their senior unsecured debt.

When individual debt issues are rated differently from the overall credit rating of the
issue, it is called notching.

Highly-rated companies usually have similar credit ratings for their issues and their
issues are not notched. If there is very little difference in the expected recovery rate
of all the bonds of a company then the individual issues may not be notched at all.

So, notching is more likely for issues with lower creditworthiness. It is possible for
an individual issue of a company to be notched two levels below its issuer credit
rating.

Structural Subordination

Suppose there is a holding company like Tata Investment Corporation. One of their
subsidiaries is Simto Investment Company. Suppose Simto’s covenants have a
restriction that cash or assets cannot be passed up to Tata Investment Corporation
until Simto’s bondholders have been paid. Now even if Tata’s bonds are more senior
to Simto’s, Simto’s bondholders will have a priority claim to the cash flows.

The parent company’s bonds are therefore subordinated to the subsidiary’s bonds.
So, it is important to see the covenants of a subsidiary’s bonds in a holding company
structure.
ESG Ratings

Environmental, social and governance analysis has also found its way into the
assessment of credit quality of a company. The following factors may improve the
credit rating of a company.

● Environmental: If a company practices environmental sustainability or caters

to demand for sustainable practices. Additionally, if a company fulfils global
agendas regarding sustainability.
● Social: If a company encourages a diverse work culture, community
involvement, minimising the salary gap between median-income employees
and the Board of Directors, etc.
● Governance: If a company practices diversity in the board and encourages
strong internal oversight.

LOS 44.e: Explain risks in relying on ratings from credit rating agencies.

Dynamic Ratings

The financial conditions of a company can change many times, for better or worse.
This will require ratings agencies to upgrade or downgrade the ratings several times
depending on their perception of the company’s default risk.

Imperfect Ratings

It is possible for ratings agencies to give a false rating depending on imperfect

information or lack of predictability. If a bond is rated higher than it should be then
that poses a risk to investors.

Fun Fact: One of the key criticisms of ratings agencies during the 2007/08 financial
crisis was that they did not give appropriate ratings on mortgage-backed securities.
This was disastrous because even the supposedly A-rated bonds were not exactly
investment-grade quality.

Difficulty of Risk Assessment

Lack of predictability and uncertainty over a period of time increases the risk of
having correct ratings. For example, lawsuits due to changes in regulation for carbon
emissions is a difficult risk to predict. Any such unpredictable event can change the
credit rating of a company.
Market Pricing

Credit ratings rely on historical data and on possible future events. If markets are
efficient then the market will always price assets in such a way that the future events
are possibly already priced in. So as far as markets are concerned, ratings upgrades
or downgrades might as well be old news in some situations.

The market also prices in several other factors, not just credit risk. So, two bonds
with the same credit rating can trade at different prices. Suppose there is a AAA-
rated bond of HDFC Bank and a AAA-rated bond of Reliance. The two companies
have completely different risk profiles in terms of the industries that they are in. This
will be priced into the bond price.

Questions

1. A cross default provision most likely means that

A. If a company defaults on one of its bond issues, then the equity shareholders may
be protected from the default

B. If a company defaults on one of its bond issues, then the other bond issues may
be considered defaulted

C. If a company defaults on one of its bond issues, then the other bond issues may
be protected from a default being triggered

2. A high-yield issuer has an overall rating of BB+ based on its senior unsecured
debt, but one of its individual bond issues is rated BB. Does this differentiation most
likely fit the criteria for notching and why?

A. Yes, because notching applies only to speculative-grade ratings

B. No, because the ratings are both in the same category of speculative-grade
ratings

C. Yes, because the ratings on the two bonds are different

3. Which of the following is most likely a concern regarding the time lag between
ratings and market pricing?

A. Ratings change before the market prices, making market prices inefficient

B. Ratings change after the market prices reflect new information

C. Rating and market prices are more or less simultaneous, so excess profits cannot
be made by knowing additional information

Answers

1. B is correct. A cross default provision means that if a firm defaults on one of its
issues, then this may trigger a default for other issues of the same firm. A is incorrect
because equity holders are not protected by covenants of debt issues.

2. C is correct. Notching applies to any bond that has been given a different rating
than its issuer’s overall rating. A is incorrect because notching does not apply only to
speculative-grade debt. B is incorrect because the two ratings can be in the same
category.

3. B is correct. The market prices in new information before the ratings change. So, it
is likely that a change in ratings is old news - the ratings change has already been
priced in. A is incorrect because this is the opposite of the correct answer. C is
incorrect because ratings take more time to adjust than market prices. Market prices
are most likely efficient regarding a change in ratings.

LOS 44.f: Explain the four Cs (Capacity, Collateral, Covenants, and Character)
of traditional credit analysis.

The four Cs are a good checklist for credit analysis. They assess capacity, collateral,
covenants and character.

Capacity

This is simply an assessment of the ability to repay debt. There are three levels to
assess the capacity of an issuer to repay debt.

Industry Structure
Industry structure can be assessed by Porter’s five forces: threat of entry, power of
suppliers, power of buyers, threat of substitution, and rivalry among existing
competitors. These are covered in detail during equity valuation.

Industry Fundamentals

This is an assessment of the macroeconomic factors and growth prospects of the

industry in which the company is in.

It is important to make a distinction between cyclical and non-cyclical companies.

For example, FMCG companies will not be as affected by business cycles as an
infrastructure company. Non-cyclical companies typically have less volatile earnings
and cash flows and so are less risky.

The creditworthiness of a company is also dependent on the nature and

prevalence of the industry. For example, healthcare companies may have become
much more creditworthy than before since the start of the pandemic in 2020. On the
other hand, companies in weaker industries that have not been growing as fast as
the economy will have lower creditworthiness.

Ratings agencies, investment banks and other such publications give a good idea
of industry performance across the economy.

Company Fundamentals

There are a few key company fundamentals to assess the position of the company
in the industry

● Competitiveness: This checks if the company’s market share is increasing,

decreasing or constant over time.
● Operating history: This checks the financial performance of a company
(revenue, margins, profitability) over different market cycles and the current
management’s tenure. The strategic goals of management and the ability of
management to execute previous goals must also be considered.
● Ratios and ratio analysis: We will see later how coverage and leverage
ratios (specifically for credit analysis) are good tools to assess the financial
health of a company.

Collateral
The quality of assets is an important factor in credit analysis because it is important
to know which assets are backing the bond issue. Note that it is difficult to calculate
the market value of these assets. It is more important for less creditworthy
companies.

Following are the important factors to consider for asset quality analysis:

Intangible Assets

Patents and goodwill are the major intangible assets that an analyst must consider.
Patents are considered high-quality because they can be easily sold to generate
cash. Goodwill is not held so highly because it is usually written down when the
company performs poorly.

Depreciation

If a company is depreciating their assets quicker than they are replacing them, it
indicates deterioration of assets. Management is not investing adequately into the
company and it can signal lack of expansion or asset growth.

The quality of assets may be poor too and so they may not be generating enough
cash flow. This will increase the loss severity of a bond.

Equity Market Capitalization

Suppose a stock’s price is trading below its book value (a P/B ratio that is less than
1.00). This indicates that investors are not even willing to pay the book value (the
bare minimum) of the company’s equity. This is a red flag but the reasons and
growth potential must be assessed.

Human and Intellectual Capital

Intellectual capital is difficult to assess but it can be that intangible assets have high
value. These could be in terms of patents and copyrights. Additionally, it is difficult to
assess workforce talent and the intellectual contribution of top executives.

Covenants

Covenants have been described before and can be divided into negative covenants
and affirmative covenants.

Negative Covenants
These are what the debt issuer cannot do. Some examples of negative covenants
are:

● Restrictions on dividend payments and share repurchases in order to have

excess cash to repay debt.
● Restrictions on the additional debt raises which can be imposed by a limit on
the debt-to-equity ratio.
● Restrictions on issuing debt with higher priority of claims than the current debt
issue.
● Restrictions on pledging collateral that is not yet pledged.
● Restrictions on assets sales.
● Restrictions on company investments outside the current strategic goals.
● Restrictions on mergers and acquisitions.

Affirmative Covenants

These are things that the debt issuer must do. These serve administrative purposes.
Some examples of affirmative covenants are:

● Payment of interest, principals and relevant taxes.

● Insuring the pledged assets.
● Continuance of the current business activities of the company.
● Abiding by relevant laws and regulations.

Covenants must not be overly restrictive nor too loose-ended. For example, by not
allowing sale of certain assets, a company may not earn enough cash flow to make
certain payments or to expand their operations. On the other hand, it is not beneficial
for the credit rating of a company if they take on excessive debt.

Character

This is all about the qualitative aspects of management quality. It includes the
analysis of the following:

● Soundness of strategy: This assesses if management can develop a

strategy that is reasonable and beneficial and how well management can
execute the strategy.
 ● Track record: This assesses how well management has previously executed
its strategy and how it has dealt with bankruptcies, restructurings, or other
distress situations that led to additional borrowing if it has had any such
circumstances
● Accounting policies and tax strategies: Some accounting policies can be
aggressive and may lead to low quality of financial statements. Revenue
recognition, overstating the fair valuation of assets, and delaying the
recognition of costs are a few examples of aggressive policies. Tax policies
that hide certain issues, frequently re-stating the financial statements and
frequently changing the auditors are also some red flags.
● Fraud and malfeasance record: This is the assessment of any previous
legal and regulatory concerns that a company might have faced.
● Prior treatment of bondholders: This assesses if equity holders have been
treated better than bondholders. For example, if a company declares a special
dividend and then their ratings have been downgraded because of increased
credit risk due to less cash flow, this is a red flag for credit analysis.

Questions

1. The analysis of company fundamentals is incorporated in which of the following

analysis?

A. Character analysis

B. Capacity analysis

C. Collateral analysis

2. Which of the following is the least difficult to analyse for a credit analyst?

A. Quality of a firm’s human capital and management talent

B. Quality of a firm’s intangible assets like goodwill or patents

C. Quality of a firm’s competitive position and changes in market share over time

3. Which of the following is most likely a negative covenant?

A. A maximum debt-to-equity ratio

B. The need to insure pledged assets

C. Following the relevant regulations

4. Which of the following is most likely a red flag for character analysis?

A. Accounting policies that recognise revenue quickly and delay the recognition of
expenses

B. Adequately re-formulating the corporate governance policy after a malfeasance

has occurred

C. Setting a strategy that prioritizes long-term growth over short-term goals

Answers

1. B is correct. Capacity analysis involves the analysis of industry structure, industry

fundamentals and company fundamentals. A is incorrect because this is a qualitative
analysis of the company’s strategy and track record. C is incorrect because this is a
very specific analysis of the assets of a company.

2. C is correct. An analyst may find it easier to analyse a firm’s operating history,

financial health, and market position since these are readily available quantitative
factors. A is incorrect because it is difficult to put a quantitative value to such metrics.
B is incorrect because it is not the easiest to analyse out of the three options. For
instance, goodwill impairment or the value of patents must be reassessed frequently.

3. A is correct. A maximum debt-to-equity ratio is a restrictive covenant. Anything

that restricts a company from taking certain actions may be considered a negative
covenant. B and C are both affirmative (positive) covenants because these are
things that a company must do. It is not a restriction.

4. A is correct. These are examples of aggressive accounting policies and they may
lead to an overstatement of profits. This threatens the quality of financial reporting. B
is incorrect because even though a malfeasance has occurred, the corporate
governance policy has been re-formulated. This reduces the likelihood of future
malfeasance. C is incorrect because the long-term stability and financial health of a
company should be prioritized over short-term goals.

LOS 44.g: Calculate and interpret financial ratios used in credit analysis.

LOS 44.h: Evaluate the credit quality of a corporate bond issuer and a bond of
that issuer, given key financial ratios of the issuer and the industry.

There are several financial ratios and indicators that can be used specifically for
credit analysis to compare and assess different companies over a period of time.

Following are a few indicators that can be assessed individually and as ratios.

Profitability and Cash Flow

The key point to remember is that profitability is not the same as cash flow. Cash
flow must not include any non-cash charges and it must include capital expenditures
and receipts.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

This is simply the operating income and then depreciation and amortization is
added back.

However, it does not include expenses for capital expenditures and capital receipts
like purchases or sales of fixed assets. These are large cash outflows and inflows
and cannot be ignored in the credit analysis.

EBITDA = Operating Income + Depreciation and Amortisation

Funds From Operations (FFO)

FFO is the net income and non-cash items like depreciation and amortization and
deferred taxes (among others) are added back. This is similar to the cash flow from
operations but does not include working capital changes.

FFO = Net Income + Depreciation and Amortisation + Other Non-Cash Charges

Free Cash Flow Before Dividends

You can think of this as the ability to pay dividends. Hypothetically, if a company
had a free cash flow of Rs. 100 crore, it could potentially pay all of it as dividends to
the shareholders.
This is the FFO less increases in working capital, less capital expenditures.

FCF Before Dividends = FFO - Working Capital Increase - Capital Expenditures

or

FCF Before Dividends = Net Income + Depreciation and Amortisation + Other Non-
Cash Charges - Working Capital Increase - Capital Expenditures

Free cash flow after dividends

This shows the cash flow that can be used to pay down additional debt. It is the
bottom line of all cash flow remaining after regular interest payments and dividend
has been paid.

If it is greater than 0 then it is likely that the company is healthy to de-leverage (pay
off excess debt) and is good for the creditworthiness of a company.

FCF After Dividends = FCF Before Dividends - Dividend Payments

or

FCF After Dividends = FFO - Working Capital Increase - Capital Expenditures -

Dividend Payments

or

FCF After Dividends = Net Income + Depreciation and Amortisation + Other Non-
Cash Charges - Working Capital Increase - Capital Expenditures - Dividend
Payments

How do we use these in ratios?

There are a few key leverage ratios and coverage ratios that are helpful to assess
the financial health of a company.

Note that these ratios cannot be seen only from an individual company’s perspective.
They must be compared to other companies in the same industry.

Leverage Ratios

Debt-to-Capital Ratio
Capital is the total capital that is provided by both, equity shareholders and by
debtholders. This ratio shows the proportion of debt in the total capital structure.

Debt-to-Capital Ratio = Total Debt/Total Capital

● A lower ratio indicates less credit risk

● A higher ratio indicates higher credit risk

Note that if there is a high amount of intangible assets like goodwill or patents then
the assets must be adjusted on an after-tax basis. This will change the capital and
the ratio.

Debt-to-EBITDA

We saw that EBITDA is the closest measure of operating income from a cash flow
perspective. This is an important ratio as it approximately shows the capacity to
repay debt from operating activities.

Firms with seasonal revenue will have a varying EBITDA from one quarter to the
next.

Debt-to-EBITDA = Total Debt/EBITDA

● A higher ratio indicates higher leverage and higher credit risk.

● A lower ratio indicates lower leverage and lower credit risk.

FFO-to-Debt

This shows the capacity of a company to repay debt from funds from
operations. FFO is a more accurate measure for ability to repay debt since it
removes all non-cash charges from net income and considers even non-operating
expenses.

FFO-to-Debt = FFO/Total Debt

● A higher ratio indicates lower credit risk

● A lower ratio indicates higher credit risk

FCF After Dividends-to-Debt

This shows the capacity of a company to repay debt from funds from
operations. It is the most accurate measure of the company’s capacity to
deleverage since FCF is basically the bottom line of all cash flow measures.

FCF After Dividends-to-Debt = FCF After Dividends/Total Debt

● A higher ratio indicates a higher ability to service debt

● A lower ratio indicates lower ability to service debt

Coverage Ratios

EBITDA-to-Interest Expense

This shows the capacity of a company to pay interest on debt from their EBITDA.
Depreciation and amortisation is a non-cash item and so from an operating income
perspective, this ratio is suitable to use.

EBITDA-to-Interest Expense = EBITDA/Total Interest Expense

● A higher ratio indicates a higher ability to pay interest expenses by using

EBITDA.
● A lower ratio indicates a lower ability to pay interest expense by using
EBITDA.

EBIT-to-Interest Expense

EBIT is EBITDA less the depreciation and amortisation charge. It may be more
commonly used because EBIT comes “closest” to the interest expense as an income
statement.

EBIT-to-Interest Expense = EBIT/Total Interest Expense

● A higher ratio indicates a higher ability to pay interest expenses by using EBIT
● A lower ratio indicates a lower ability to pay interest expense by using EBIT

It is important to compare all of these ratios against companies in the same industry
and of the same company over a period of time.

As an analyst, it is most important to look for any sign which shows that the company
has the capacity to repay current debt and to deleverage.
Issuer Liquidity

It is also important to look at the following factors relative to the size of the company:

● Cash and cash equivalent balances: Cash is the most liquid asset and it
provides the best assurance that expenses and interest obligations can be
paid.
● Net working capital: It is important that the operating current assets of a
company exceed or at least equal the operating current liabilities of a
company. If current obligations exceed the liquidity position of a company,
then the payables may not be met sufficiently.
● Operating cash flow (CFO): Besides EBITDA, the operating cash flow is also
an important factor to consider. The CFO may be projected into future periods
to assess the risk of a lower-than-expected CFO.
● Committed bank lines: Committed lines of credit that have not been tapped
yet are a potential source of short-term liquidity when the company needs
financing.
● Debt that will mature and capital expenditures: These two factors must be
analysed together to assess if the company can repay their debt and
simultaneously fulfil capital expenditure commitments.
Questions

Use the following information for questions 1 to 5.

Details (Rs. crore) FY20 FY21

Revenue from Operations 5,600.00 7,600.00

EBITDA 952.00 1,596.00

Depreciation and Amortization 112.00 152.00

EBIT 840.00 1,444.00

Finance Costs 164.80 103.00

EBT 675.20 1,341.00

Taxes 168.80 335.25

Net Income 506.40 1,005.75

Other Non-Cash Charges 84.00 114.00

Working Capital Increase 347.00 780.00

Cash Flow From Operations 355.40 491.75

Funds From Operations ? ?

Capital Expenditures 200.00 350.00

 FCF Before Dividends ? ?

Cash Dividends Paid 50.00 50.00

FCF After Dividends ? ?

Total Short-Term Debt 780.00 900.00

Total Long-Term Debt 1,280.00 1,250.00

Total Shareholder's Equity 3,000.00 3,110.76

Market Value of Total Debt 2,163.00 2,300.50

Market Value of Total Equity 10,500.00 10,887.66

Total Capital ? ?

1. Calculate the FFO for both the periods

A. FY20: 618.40, FY21: 1,157.75

B. FY20: 702.40, FY21: 1,271.75

C. FY20: 355.40, FY21: 491.75

2. Calculate the FCF Before Dividends-to-Debt ratio for FY21 (in percentage terms).

A. 6.59%

B. 42.87%
C. 11.34%

3. Interpret the change in the debt-to-capital ratio.

A. The debt-to-capital ratio for both periods is c. 0.69 and there is no significant
change in the ratio.

B. The debt-to-capital ratio for both periods is c. 0.17 and there is no significant
change in the ratio.

C. The debt-to-capital ratio for both periods is c. 0.41 and there is no significant
change in the ratio.

4. Which of the following is most likely an appropriate coverage ratio to assess the
interest-paying ability of the company?

A. FCF-to-Debt ratio

B. Debt-to-EBITDA ratio

C. EBIT-to-Interest Expense Ratio

5. Interpret the change Debt-to-EBITDA ratio of FY21.

A. The total debt of the company is c. 1.35 times its EBITDA and the financial
leverage risk has increased since the previous year, based on this measure

B. The total debt of the company is c. 0.74 times its EBITDA and the financial
leverage risk has increased since the previous year, based on this measure

C. The total debt of the company is c. 1.35 times its EBITDA and the financial
leverage risk has decreased since the previous year, based on this measure

Answers

1. B is correct.

FFO = Net Income + Depreciation and Amortisation + Other Non-Cash Charges

FFO in FY20 = 506.40 + 112.00 + 84.00 = 702.40

FFO in FY21 = 1,005.75 + 152.00 + 114.00 = 1,271.75

A is incorrect because it does not add other non-cash charges.

C is incorrect because this is the cash flow from operations. You may also think
about the FFO as the CFO plus working capital changes.

2. A is correct.

FCF Before Dividends = FFO - Working Capital Increases - Capital Expenditures

FCF Before Dividends in FY21 = 1,271.75 - 780.00 - 350.00 = 141.75

Total Debt = Total Short-Term Debt + Total Long-Term Debt

Total Debt in FY21 = 900.00 + 1,250.00 = 2,150.00

FCF Before Dividends / Total Debt = 141.75 / 2,150.00 = 0.0659 or 6.59%

B is incorrect because it does not subtract working capital changes in the FFO
formula.

C is incorrect because it considers only long-term debt.

3. C is correct.

Debt-to-Capital Ratio = Total Debt / Total Capital

This uses the book value of debt and equity so,

Total Capital for FY20 = 780.00 + 1,280.00 + 3,000.00 = 5,060.00

Total Capital for FY21 = 900.00 + 1,250.00 + 3,110.76 = 5,260.76

A is incorrect because this is the total debt-to-equity ratio.

B is incorrect because it uses the market value of capital, not the book value of
capital.
4. C is correct. EBITDA and EBIT may be compared to the interest expense (finance
costs) to assess the interest coverage (i.e., the ability to make interest payments). A
and B are both leverage ratios.

5. C is correct. The ratio has decreased from 2.16 to 1.35. This indicates that the
financial leverage risk has decreased since the previous year, based on this
measure.

LOS 44.i: Describe factors that influence the level and volatility of yield
spreads.

The following diagram shows the building blocks of the yield on an option-free
corporate bond:

INSERT R44_LOSi_1

So we can see that the yield spread is a function of the liquidity premium and
credit risk premium (credit spread).

It can also be said that the yield spread is the difference in YTM between the YTM
of a corporate bond (option-free) and the YTM of a sovereign bond of that country.
The two bonds must have the same maturity.

This is affected by five main factors:

Credit Cycle

The credit cycle is in tandem with the business cycle in the overall economy. For
instance, when the credit cycle is at its peak, there is bullish sentiment and low credit
risk.

● Yield spreads tighten when the credit cycle improves.

● Yield spreads widen when the credit cycle deteriorates.

Economic Conditions

This is just like the credit cycle but takes into account the overall economy.

● Yield spreads tighten when the economic conditions improve.

● Yield spreads widen when the economic conditions deteriorate.
Financial Market Performance

A booming financial market indicates positive sentiment for the future. Equity
markets typically price in the future business cycle, economic conditions and
sentiment. So, if we can see equity market performance as a function of current and
future financial conditions then:

● Yield spreads tighten when the markets are booming.

● Yield spreads widen when the markets are performing poorly.

Broker-Dealer Capital

This can be linked to liquidity and availability of capital provided by brokers and
dealers. Corporate bonds typically trade over-the-counter and so broker-dealers are
the market makers for these transactions. They require capital to make markets and
to facilitate transactions.

● Yield spreads tighten when there is sufficient market-making capital.

● Yield spreads widen when there is a lack of market-making capital.

Demand and Supply

This also has to do with liquidity. Lack of supply relative to demand means there is
lack of liquidity in the market and so a dealer may have to sell the bonds below
market price. This adds to the liquidity risk premium. Conversely, more demand than
supply implies there is liquidity to take the buying position in the bond.

● Yield spreads tighten when there is ample demand and sufficient supply.
● Yield spreads widen when there is a lack of supply relative to demand.

Credit Quality of the Issue and Financial Performance of the Issuer

An issue quality of lower investment grade is likely to be more volatile and have a
higher yield spread for several reasons. Consider a low quality issue compared to a
higher quality issue:

● The required return is higher, implying a higher yield spread.

● The liquidity for these issues is lower, implying a higher yield spread.
● The ratings uncertainty increases the price volatility of these issues.
 ● A higher bid-ask spread implies that these issues are more volatile and less
liquid.
● Significantly poor financial performance relative to expected financial
performance suggests there could be a higher yield spread.

Yield Spreads and Price

Recall from the previous reading that the change in a bond’s price due to a change
in the credit spread is calculated as:

%Δ Bond Value = –ModDur(ΔSpread) + ½ x Convexity(ΔSpread) 2

So, the bond price may change due to:

● Change in duration or convexity.

● Change in credit spread.

For instance, an increase in duration or convexity makes a bond more sensitive to

changes in the spread. Additionally, if the spread increases then the bond price
usually decreases and vice versa. The increase in credit spread may be attributed to
greater credit risk, thereby making the bond less attractive and less valuable.

Questions

1. The economy is just beginning to recover from a recession. Yield spreads for BB+
corporate rated bonds (over government bonds of similar maturity) are most likely to

A. Remain the same

B. Contract

C. Widen

2. Yield spreads most likely widen for corporate bonds when

A. Broker-dealer capital becomes limited

B. The demand for corporate bonds significantly beings to exceed the supply of
corporate bonds

C. Financial markets are on an upward trend

3. Yield spreads most likely tighten for corporate bonds when

A. The credit cycle improves

B. Liquidity is scarce

C. The economic cycle is moving into a recessionary phase

Answers

1. B is correct. The yield for such bonds is likely to decrease as the economy
recovers from a recession. A decrease in the yield lowers the credit spread.

2. A is correct. Limited capital indicates that supply is less than demand. The
equilibrium price decreases, so the yield increases. When the yield on corporate
bonds increases, the spread increases too. B is incorrect because this indicates that
the equilibrium price should increase. An increase in the price and a decrease in the
yield indicates that the yield spread tightens. C is incorrect because when financial
markets are performing well, the price of bonds is likely to increase. This decreases
the yield and decreases the spread.

3. A is correct. When the credit cycle improves, there is more availability of funds.
Yields are likely to reduce in this scenario, so the spread tightens. B is incorrect
because this is the opposite of option A. When liquidity is scarce, yield spreads are
likely to expand due to an increase in the liquidity risk premium. C is incorrect
because a recessionary phase is most likely linked to increasing corporate bond
yields.

LOS 44.j: Explain special considerations when evaluating the credit of high
yield, sovereign, and non-sovereign government debt issuers and issues.

High Yield Debt

High yield, junk bonds or non-investment grade corporate bonds must be given more
attention because of their higher credit risk. There is an increased loss severity for
such debt. They are rated below BBB/Baa3 and the future prospects of credit
upgrades or downgrades must be analysed carefully.
Common reasons for low ratings may include:

● High leverage.
● Poor track record or lack of track record of operating history.
● Negative, low or unsustainable free cash flow.
● More volatility of earnings compared to the general business cycle.
● Companies in a declining industry.
● Poor quality of management.
● Poor or unclear competitive advantage.
● High proportion of off-balance sheet liabilities (like asset-backed securities or
risky CDOs).

Which are the key factors to assess?

Liquidity

The firm should have solid operating cash flow and free cash flow in order to
make interest and principal payments. The higher the operating cash flow and free
cash flow (relative to the level of debt), the lower the chance of default.

Access to funding and sources of short-term financing are a key factor in assessing
liquidity. Recall the importance of working capital management and sources of short-
term funding from the corporate finance readings.

An analyst may look at the following items to assess liquidity and sources of liquidity
(the higher the better):

● Balance sheet cash.

● Working capital.
● Operating cash flow (CFO).
● Bank credit.
● Equity issued.
● Sales of assets.

Note that high yield issuers may also be privately listed and may not have access to
equity markets to raise capital. Liquidity is also a crucial factor for companies that
depend on short-term financing to fund long-term assets.

Financial Projections
A company is likely to be lowly rated because of their poor historical and current
financial position. But this does not mean that they will stay in this position forever.
The analyst must make the financial projections as accurate as possible to know if
there are prospects for a ratings upgrade.

On the other hand, the analyst must also stress test certain variables to assess how
they will affect the debt repayments. For example, interest rates are a key factor for
banking and financial services companies. When interest rates decrease, it is likely
that the bank’s revenue will decrease if they are very dependent on interest income
from loans. It is important to analyse how a change in key variables such as this will
affect the ability of the company to repay debt.

Debt Structure

The capital structure plays an important role but even the sources of debt funding,
terms of debt funding and level of sustainable debt must be put in the spotlight.

High yield issuers may have several levels of seniority on the debt that they have
issued. Each level of seniority will have different levels of loss severity, depending
on the assets that are backing these issues. So, if a company has senior secured
debt but a lot of subordinated debt too, then it is not practical to apply the same level
of loss severity for both of these categories - the secured debt will have a lower level
of loss severity.

There will also be a huge difference in the recovery rate for each level of debt. So,
the analyst will have to assess the debt structure of each level of debt and also the
recovery rate for each level.

Companies that take on a lot of secured bank debt are said to be top-heavy. Since
they have already taken on so much secured funding from banks, the capacity to
borrow more secured debt reduces in times of financial distress. Think about it this
way: the assets of a company cannot be sufficient enough to cover all the additional
secured debt. Such companies also have lower recovery rates for unsecured issues
because secured debt gets first priority.

Corporate Structure
Companies may use a holding company structure. In this case, a parent company
will own several other subsidiary companies. For example, there are many non-
banking financial holding companies in India. They include the likes of Tata
Investment Corporation, JSW Holdings, and Aditya Birla Capital. These companies
will invest in their respective subsidiaries (among other companies) and earn a part
of the dividends that the subsidiaries will pay out to their shareholders.

So, it is important to see the subsidiaries’ performance too since they are a source
of income for the parent company and will indirectly determine the financial health of
the parent company too.

The parent company’s credit rating will most likely differ from that of the subsidiaries.
Since they may invest in a diverse range of companies, the risk may be reduced
as the risk is not concentrated in one sector. Also, even if one subsidiary company
defaults or does not pay dividends that year then the parent company still has other
companies to rely on.

An intermediate holding company structure may occur when the company does
not own 100% of the subsidiary. This is most likely a result of mergers and
acquisitions or buyouts. They may hold a stake in the subsidiary that is less than
50% and so they cannot fully “own” the subsidiary company from an accounting
perspective. However, they will still receive dividends from the subsidiary.

It is therefore important to analyse the leverage ratios at each level and additionally
on a consolidated basis.

Covenants

There are a few covenants that are specifically scrutinised in high-yield debt.

Change of Control Put

“Change of control” implies that the company has been acquired. The “put” is simply
a put option. So a “change of control put” will require the bond issuers (the company)
to buy back the debt from the borrowers (the investors of the high-yield debt) in the
event of an acquisition.

The put price is usually at par value or slightly higher.

Note that this condition may be in the covenants only if the acquisition will result in a
ratings downgrade to “below investment grade”. For instance, investors of high-
yield debt would not mind if the acquisition improves the financial position and credit
rating of the company if it is acquired. This covenant is therefore beneficial to
investors in case the acquisition worsens the credit rating of the company.

Restricted Payments

This is a restriction on the amount of cash that can be paid to equity holders.
Suppose the company pays a lot of dividends in one year as a special dividend. The
cash flow of the company in the next year or so will be lower than if it was if this
dividend was not paid.

Limitations on Liens

Imagine you are an investor in the company’s unsecured debt. Would you prefer that
there is a limitation on the amount of secured debt a company can raise?

Yes, you would prefer that because in the event of a default, secured debt gets
paid first. So suppose there are Rs. 100 crore up for grabs after default proceedings
have taken place. If the company has more secured debt than unsecured debt then it
is likely that secured debt holders will get a higher proportion of this Rs. 100 crore.
This will leave less money for unsecured debt holders.

A limitation on liens may prevent this from happening and then unsecured debt
holders will have a higher recovery rate in the event of a default.

Restricted vs. Unrestricted Subsidiaries

Cash flows and assets of restricted subsidiaries can be used to pay interest and
principal on the debt of the parent company. This is beneficial for debt holders of a
holding company (the parent company) since their debt repayment is in line with that
of the subsidiaries.

Suppose JSW Holdings has claimed JSW Steel as a restricted subsidiary. As soon
as JSW Steel gets some cash inflow, this can be immediately used by JSW Holdings
to pay the debt obligation of JSW Holdings.
If JSW Steel was an unrestricted subsidiary, JSW Holdings would have to earn a
dividend from JSW Steel so that they can show some cash inflow to repay the debt
obligations.

Restricted subsidiaries will usually be companies that have a high asset base and
cash flows. However, tax and regulatory laws may affect the restricted or
unrestricted status of a subsidiary. The restriction status will be found in the bond’s
indenture.

Bank Covenants

These are usually stricter than bond covenants. If a company borrows from a bank
and violates some covenants then the bank can restrict additional funding until the
violation is corrected.

Banks also have the power to ask for full repayment of a loan faster than usual. This
will force a default because the company cannot make such payments so soon.

Risk and Leverage

The risk factor of high yield bonds have certain aspects of equities too in terms of the
downside risk that they bear. These bonds are riskier than investment grade
corporate bonds and are significantly more risky than sovereign bonds. They have
higher price volatility and higher spread volatility. They are also more closely
correlated with equity markets. So, the analysis of high-yield bonds can also use
some techniques that are used in equities.

Enterprise value (EV) may be used to understand a firm’s potential for leverage or
the damage on company value if it is bought out. EV is essentially the market value
of debt and equity minus cash-on-hand. The EV is used in assessing multiples
(ratios) like EV-to-EBITDA and Debt-to-EV in high-yield analysis. A larger difference
in these ratios implies that the company has greater equity value compared to the
debt that they have issued.

For example, a firm with a low Debt/EV multiple implies that the debt portion of the
EV is low and the company may have more scope for raising debt capital. The aim
here is to assess the market value of equity relative to the market value of debt. If
there is more market value of equity relative to debt then it is more likely that the
company has a better credit rating than a comparable company with a high
proportion of debt.

If a high yield company is not private then comparable public company data can
be used to estimate EV.

Sovereign Debt

Even debt that is issued by governments will have varying ratings depending on a
few key factors.

Institutional Assessment

The analyst may look at how effective the government is in enforcing successful
policies. These could include internal policies to promote the economy, trade policy,
regulations, etc. The level of corruption and how the government deals with
corruption is also an important criteria.

The government must also have adequate systems and the correct attitude towards
debt payments. For example, if a government has continually resorted to printing
more currency to repay debt, it reflects poorly on the attitude towards debt payment
as this is not sustainable.

Economic Assessment

This includes an evaluation of how the company has grown over a period of time and
how this has benefitted debt payments. GDP growth, GDP per capita and the
sources of economic growth are important factors to consider.

External Assessment

This assessment is regarding the foreign reserves, the amount of debt that they have
raised from other countries or institutions and the status of its currency in the global
markets.

For example, the U.S. dollar has held a high status in global currency markets over
the past few decades. Any currency that holds a reserve currency status (like the
U.S. dollar has recently) will always be a safer bet than other currencies. But it is
important to see how this status will change over time.

Fiscal Assessment
This assessment is regarding the fiscal revenue and expenditure of the government.
For example, taxes are a fiscal revenue and expenditure on public projects like
highway construction is a fiscal expenditure. So, the analyst must look at how well
the government is able to raise money or cut expenditures so that they can service
the debt payments.

It is also important to see the debt as a percentage of GDP. Countries will have
different levels of debt and different levels of GDP. This measure allows analysts to
compare each country regardless of size.

Fun Fact: Japan and Greece are notorious for having high debt-to-GDP ratios.
These countries have had a level of debt that is equal to their GDP and sometimes in
multiples of 1.5 to 2 times.

Monetary Assessment

This is an assessment of the use of monetary policy to attain economic objectives in

a country. But this power to use monetary policy may be reduced if a country is part
of a monetary union. For example, the European Central Bank dictates interest
rates for the Euro area. So, countries that participate in the euro currency may not
have flexibility to move interest rates as they wish.

This power may also be reduced when the country wants to use a target exchange
rate.

These are two examples of a tradeoff that countries must make when it comes to
monetary policy.

Local Currency and Foreign Currency

Ratings agencies will assign every national government with these two types of
ratings.

Local Currency

If a country defaults on its debt, it can simply print more currency to make the
payments. We have seen in previous readings that while this is theoretically a good
idea, it can cause hyperinflation.
Even if the country runs a risk of hyperinflation by printing more currency, it can at
least change the fiscal policy. Increasing taxes or decreasing fiscal expenditures
will give them a higher chance to repay debt.

Foreign Currency

A country cannot print another country’s currency. So in the event of a default, they
will have to borrow the foreign currency in the open market. This immediately puts
the foriegn currency denominated debt at foreign exchange risk.

For these reasons, local currency debt will have a higher rating than debt that is
denominated in a foreign currency. If the RBI issues a 10-year government bond that
pays in INR and another 10-year government bond that pays in U.S. dollars, then the
INR-denominated bond will have a better rating.

Which factors can trigger sovereign debt default?

● War: War and war-like situations can significantly increase government

expenditure. They will then have less money to spend on repaying debt.
● Political instability: This threatens economic growth and can affect debt
payments. Poor quality and ineffective government administration can lead to
misallocation of the country’s financial and non-financial resources. This will
affect growth, taxes and government revenue.
● Currency devaluation: Consider a country like India that almost always
imports more than it exports in a given fiscal year. If the Indian rupee
depreciates against an average basket of currencies, the imports become
more expensive. This increases the trade deficit and the government may
have less rupees to repay debt.
Similarly, if exports reduce or the traded value of exports reduces then the
trade deficit will worsen and it will have a negative impact on the ability to
repay debt.
● Access to debt markets: This is specifically important to assess in an
economic stress scenario. For instance, the IMF may be more willing to lend
to the U.S. rather than to Venezuela during a global recession. The track
record of debt payments and ability to repay in the future may play an
important role in determining which countries have better access to sovereign
funding.
Non-Sovereign Government Bonds

Debt that is issued by cities, states, provinces and counties is part of the non-
sovereign government bond category.

Municipal bonds (munis) are popular in the U.S. and interest on these bonds are
most likely exempt from national income taxes. They also have lower default rates
and higher credit quality than corporate bonds.

But they are still non-sovereign and cannot use interest rates or monetary policy to
affect the bond payments and value. Instead, municipalities must control their
operating budget and assess their revenue from taxes to pay back debt. The local
economy of the municipality is the key focus rather than the national economy. They
can also have other long-term obligations like pension payments. These must be
factored into the analysis too and how this will affect debt repayment.

General obligation (GO) bonds, however, are unsecured bonds. These are still
backed by government authorities and their taxing power.

Revenue bonds are issued for specific projects, such as airports, toll bridges,
hospitals, and power generation facilities. The investors of revenue bonds will be
repaid from the income generated from these specific projects. These typically hold
higher credit risk than GO bonds because the projects are concentrated in one
business sector or area.

It is therefore important to see the economic factors that are surrounding the specific
project or municipality in order to assess the credibility of the bond. Job creation,
income growth, quality of the tax base, demographics and overall desirability of the
area must all be considered.

It is also important to see where the taxes are coming from. Stable taxes are much
more desirable than unstable taxes like capital gains tax.

Many of the considerations in sovereign bonds can also be used for non-sovereign
bonds but at the local level rather than the country level.

Questions

1. An improvement in a high yield issuer’s short-term liquidity position is least likely

to
A. Increase its creditworthiness

B. Decrease its credit spread

C. Increase its credit spread

2. Which of the following is most likely to decrease the recovery rate for unsecured
debt in the event of a default?

A. Pledging too many assets against secured debt

B. Pledging too few assets against secured debt

C. A lower loss severity for unsecured debt

3. Assessing the performance of a partially-owned subsidiary is most likely important

because

A. It directly affects the credit rating of the parent company

B. The analyst must know the potential income from dividends

C. The parent owns the assets of that company

4. The parent company can most likely immediately claim the cash flows from which
of the following types of subsidiaries?

A. Restricted subsidiaries

B. Unrestricted subsidiaries

C. Both, restricted and unrestricted subsidiaries

5. Other things held constant, which of the following companies is most likely to have
the highest credit rating?

A. A company with a high debt-to-EV multiple

B. A company with a high debt-to-EBITDA multiple

C. A company with a high equity-to-EV multiple

6. Which of the following is most likely a red flag in the analysis of sovereign debt?

A. A strengthening currency relative to a basket of global currencies

B. A high GDP-to-debt ratio

C. An indebted country that is increasing fiscal expenditures

Answers

1. C is correct. The better the liquidity position, the lower the chances of a default,
hence an improvement in the creditworthiness. An improvement in creditworthiness
is likely to decrease the credit spread.

2. A is correct. If too many assets have already been pledged against secured debt,
then the senior debt holders will receive most of the recovered amount. This leaves
less for the lower categories of seniority. C is incorrect because a lower loss severity
means a higher recovery rate.

3. B is correct. Dividends from subsidiaries are a cash inflow and can improve the
liquidity position of the parent company. It is important to assess the dividends
because they are an income source. A is incorrect because the performance of a
partially-owned subsidiary may not dictate the credit rating of a parent company. The
parent and the subsidiary may have two different credit ratings altogether. C is
incorrect because the parent does not technically own the assets of a partially-
owned subsidiary.

4. A is correct. The cash inflow from a restricted subsidiary can immediately be used
to pay off the debt obligations of a parent company. B and C are incorrect because
the unrestricted subsidiary would have to pay a dividend for the parent company to
receive cash from the subsidiary.

5. C is correct. A high equity-to-EV multiple suggests that the equity portion of EV is

high which implies a low debt-to-EV multiple. This suggests that the company has
additional capacity to take on debt. B is incorrect because a low debt-to-EBITDA
multiple is preferred. For instance, a high EBITDA relative to debt suggests that the
company can fulfil its debt obligations sooner.

6. C is correct. Increasing fiscal expenditures leaves less room for servicing debt
obligations. A is incorrect because a strengthening currency makes it easier to pay
off local debt and foreign debt. B is incorrect because a high GDP relative to debt is
a good sign.