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Global Edition

Chapter 20
Corporate Bond
Credit Analysis

Learning Objectives
After reading this chapter, you will understand
 the major areas of bond credit analysis: covenants, collateral,
and ability to pay
 the reason why covenants must be analyzed
 what factors are considered in evaluating the ability of an issuer
to satisfy its obligations
 what factors are considered in assessing a company’s business
 why an analysis of a company must be looked at relative to the
industry in which it operates
 the reasons corporate governance risk is important and how it
can be mitigated
 key financial ratios
 the relationship between corporate bond credit analysis and
common stock analysis
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Overview of Bond Credit Analysis
 In the analysis of the default risk of a corporate
bond issuer and specific bond issues, there are
three areas that are analyzed by bond credit
 These three areas are:
1. the protections afforded to bondholders that are
provided by covenants limiting management’s
2. the collateral available for the bondholder should
the issuer fail to make the required payments
3. the ability of an issuer to make the contractual
payments to bondholders

© 2013 Pearson Education

 The indenture provisions establish rules for several important areas of operation for corporate management. ii. require that the borrower not take certain actions.  Indenture provisions should be analyzed carefully. © 2013 Pearson Education . Affirmative covenants call upon the corporation to make promises to do certain things. Negative covenants.  There are an infinite variety of restrictions that can be placed on borrowers in the form of negative covenants.  These provisions are safeguards for the bondholder. also called restrictive covenants.  There are two general types of covenants. i.Overview of Bond Credit Analysis (continued)  Analysis of Covenants  An analysis of the indenture is part of a credit review of a corporation’s bond issue.

Overview of Bond Credit Analysis (continued)  Analysis of Covenants     Some of the more common restrictive covenants include various limitations on the company’s ability to incur debt. The two most common tests are the maintenance test and the debt incurrence test. The maintenance test requires the borrower’s ratio of earnings available for interest or fixed charges to be at least a certain minimum figure on each required reporting date (such as quarterly or annually) for a certain preceding period. © 2013 Pearson Education . Bondholders may want to include limits on the absolute dollar amount of debt that may be outstanding or may require some type of fixed charge coverage ratio test.

the required interest or fixed charge coverage figure adjusted for the new debt must be at a certain minimum level for the required period prior to the financing.  In order to take on additional debt.  Debt incurrence tests are generally considered less stringent than maintenance provisions.Overview of Bond Credit Analysis (continued)  Analysis of Covenants  The debt incurrence test only comes into play when the company wishes to do additional borrowing.  There could also be cash flow tests (or cash flow requirements) and working capital maintenance provisions. © 2013 Pearson Education .

© 2013 Pearson Education .Overview of Bond Credit Analysis (continued)  Analysis of Covenants  Some indentures may prohibit subsidiaries from borrowing from all other companies except the parent.  Often.  Restricted subsidiaries are those considered to be consolidated for financial test purposes. subsidiaries are classified as unrestricted in order to allow them to finance themselves through outside sources of funds. unrestricted subsidiaries (often foreign and certain special-purpose companies) are those excluded from the covenants governing the parent.

 What is typically observed is that the corporation’s unsecured creditors may receive distributions for the entire amount of their claim and common stockholders may receive some distribution.  In the case of the liquidation of a corporation. proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule.  The claim position of a secured creditor is important in terms of the negotiation process.Overview of Bond Credit Analysis (continued)  Analysis of Collateral  A corporate debt obligation can be secured or unsecured. © 2013 Pearson Education . while secured creditors may receive only a portion of their claim.

 An evaluation of an issuer’s ability to pay involves analysis of i. corporate governance risk iii.Overview of Bond Credit Analysis (continued)  Assessing an Issuer’s Ability to Pay  The ability of an issuer to generate cash flow goes considerably beyond the calculation and analysis of a myriad of financial ratios and cash flow measures that can be used as a basic assessment of a company’s financial risk. financial risk © 2013 Pearson Education . business risk ii.

 The need for many companies to become globally competitive increases as the barriers to international trade are broken down. © 2013 Pearson Education .Analysis of Business Risk  Business risk is defined as the risk associated with operating cash flows.  Operating cash flows are not certain because the revenues and the expenditures comprising the cash flows are uncertain.  An analysis of industry trends is important because it is only within the context of an industry that company analysis is valid. Industry consideration should be considered in a global context.

research and development expenses 4. © 2013 Pearson Education . sources of supply 6. competition 5. growth prospects 3. labor  These general areas encompass most of the areas that the rating agencies have identified for assessing business risk.Analysis of Business Risk (continued)  It has been suggested that the following areas will provide a credit analyst with a sufficient framework to properly interpret a company’s economic prospects: 1. economic cyclicality 2. degree of regulation 7.

a credit analyst will have to investigate the dependence on research and development (R&D) expenditures for maintaining or expanding the company’s market position.  To assess the growth prospects.Analysis of Business Risk (continued)  One of the first areas of analysis is investigating how closely the industry follows gross domestic product (GDP) growth. © 2013 Pearson Education .  This is done in order to understand the industry’s economic cyclicality.  This requires an analysis as to whether the industry’s growth is projected to increase and thereafter be maintained at a high level or is it expected to decline.  Related to the analysis of economic cyclicality are the growth prospects of the industry.

 In nonunionized companies. the focus with respect to regulation should be on the direction of regulation and its potential impact on the current and prospective profitability of the company.  Rather. operations of a company  A key component in the cost structure of an industry is labor. the concern should not be with its existence or absence in an industry per se. the credit analyst will examine if the industry is heavily unionized. the credit analyst will look at the prospect of potential unionization.  In analyzing the labor situation.Analysis of Business Risk (continued)  With respect to regulation.  Regulation also encompasses government intervention in non–U.S. © 2013 Pearson Education .

    Corporate governance issues involve the ownership structure of the corporation the practices followed by management policies for financial disclosure The eagerness of corporate management to present favorable results to shareholders and the market has been a major factor in several of the corporate scandals in recent years. and the board of directors are being held directly accountable for disclosures in financial statements and other corporate decisions. The agent. a corporation’s senior management. 3. 2. © 2013 Pearson Education . Chief executive officers. is charged with the responsibility of acting on behalf of the principal. the shareholders of the corporation.Corporate Governance Risk  1. chief financial officers. The underlying economic theory regarding many of the corporate governance issues is the principal-agency relationship between the senior managers and the shareholders of corporations.

Corporate Governance Risk (continued)  There are mechanisms that can mitigate the likelihood that management will act in its own selfinterest.  The first mechanism is to more strongly align the interests of management with those of shareholders. © 2013 Pearson Education .  The mechanisms fall into two general categories. manager compensation can be linked to the performance of the company’s common stock.  This can be accomplished by granting management an economically meaningful equity interest in the company.  Also.

Corporate Governance Risk (continued)  The second mechanism (that can mitigate the likelihood that management will act in its own self-interest) is by means of the company’s internal corporate control systems.  The key is to remove the influence of the CEO and senior management on board members. which can provide a way for effectively monitoring the performance and decision-making behavior of management. © 2013 Pearson Education . the structure and composition of the board are critical for effective corporate governance.  What has been clear in corporate scandals is that there was a breakdown of the internal corporate control systems that lead to corporate difficulties and the destruction of shareholder wealth.  Because of the important role played by the board of directors.

 Generally. © 2013 Pearson Education . these ratings are made public at the option of the company requesting an evaluation. and confidential information that S&P may have available from its credit rating of the corporation’s debt. which produces a Corporate Governance Score based on a review of both publicly available information.Corporate Governance Risk (continued)  Several organizations have developed services that assess corporate governance and express their view in the form of a rating.  One such service is offered by S&P. interviews with senior management and directors.

Corporate Governance Risk (continued)  In addition to corporate governance. financial philosophy 3. conservatism 4. strategic direction 2. succession planning 6. credit analysts look at the quality of management in assessing a corporation’s ability to pay.  In assessing management quality. control systems © 2013 Pearson Education . Moody’s tries to understand the business strategies and policies formulated by management. track record 5.  The factors Moody’s considers are: 1.

 This involves traditional ratio analysis and other factors affecting the firm’s financing. cash flow. net assets.  Some of the more important financial ratios are: interest coverage. © 2013 Pearson Education . leverage.  Once these ratios are calculated. it is necessary to analyze their absolute levels relative to those of the industry. the analyst is ready to move on to assessing financial risk. and working capital.Financial Risk  Having achieved an understanding of a corporation’s business risk and corporate governance risk.

the analyst should recognize that companies adjust prior years’ results to accommodate discontinued operations and changes in accounting that can hide unfavorable trends. Moreover. an analyst should become familiar with industry practices.Financial Risk (continued)      Before performing an analysis of the financial statement. If so. the analyst must determine if the industry in which the company operates has any special accounting practices. the analyst must review the accounting policies to determine whether management is employing liberal or conservative policies in applying generally accepted accounting principles (GAAP). such as those in the insurance industry. This can be done by assessing the trends for the company’s unadjusted and adjusted results. © 2013 Pearson Education . Since historical data are analyzed.

Pretax interest coverage ratio is calculated by dividing pretax income plus interest charges by total interest charges.Financial Risk (continued)  Interest Coverage  An interest coverage ratio measures the number of times interest charges are covered on a pretax basis. the lower the credit risk. Typically. A calculation of simple pretax interest coverage would be misleading if there are fixed obligations other than interest that are significant. and the resulting ratio is called a fixed charge coverage ratio. a more appropriate coverage ratio would include these other fixed obligations.     • © 2013 Pearson Education . all other factors the same. In this case. The higher this ratio. interest coverage ratios that are used and published are pretax as opposed to after-tax because interest payments are a pretax expense.

Recognition must be given to the company’s operating leases.. The margin of safety is defined as the percentage by which operating income could decline and still be sufficient to allow the company to meet its fixed obligations. the margin of safety must be analyzed.Financial Risk (continued)  Leverage  While there is no one definition for leverage.e. the most common one is the ratio of long-term debt to total capitalization. If there is a higher level of debt then a higher percentage of operating income must be used to satisfy fixed obligations. In analyzing a highly leveraged company (i.     © 2013 Pearson Education . a company with a high leverage ratio).

© 2013 Pearson Education .  Analysts reformat this information. investing.  The statement of cash flows is a summary over a period of time of a company’s cash flows broken out by operating. and financing activities. combining it with information from the income statement to obtain what they view as a better description of the company’s activities.Financial Risk (continued)  Cash Flow  The statement of cash flows is required to be published in financial statements along with the income statement and balance sheet.

lines of business or subsidiaries). Operating cash flow is funds from operations reduced by changes in the investment in working capital (current assets less current liabilities). the disposal of assets (e. Subtracting capital expenditures gives what S&P defines as free operating cash flow..g. Deducting cash dividends from free operating cash flow gives discretionary cash flow.      © 2013 Pearson Education . Adjusting discretionary cash flow for managerial discretionary decisions for acquisition of other companies. It is from this cash flow that dividends and acquisitions can be made. and other sources or uses of cash gives prefinancing cash flow.Financial Risk (continued)  Cash Flow  S&P calculates what it refers to as funds from operations (defined as net income adjusted for depreciation and other noncash debits and credits).

 In the analysis of this ratio.Financial Risk (continued)  Net Assets  A fourth important ratio is net assets to total debt.  Liquidation value will often differ dramatically from the value stated on the balance sheet.  Consideration should be given to several other financial variables including intangible assets. © 2013 Pearson Education . and the age and condition of the plant. pension liabilities. consideration should be given to the liquidation value of the assets.

Financial Risk (continued)  Working Capital  Working capital is defined as current assets less current liabilities.  Working capital is considered a primary measure of a company’s financial flexibility. and receivables divided by current liabilities).  Other such measures include the current ratio (current assets divided by current liabilities) and the acid test (cash. the better it can weather a downturn in business and reduction in cash flow.  The stronger the company’s liquidity measures. © 2013 Pearson Education . marketable securities.

should be viewed from an equity analyst’s perspective. © 2013 Pearson Education . and financial risk involves the same type of analysis that a common stock analyst would undertake.Corporate Bond Credit Analysis and Equity Analysis  The analysis of business risk.  Many fixed income portfolio managers strongly believe that corporate bond analysis. particularly high-yield bond analysis. corporate governance risk.

p. Esser (“High-Yield Bond Analysis: The Equity Perspective. All else being equal. the bonds then become better credits and should go up in value relative to competing bond investments. Credit Analysis of Nontraditional Debt Securities (Charlottesville.” in Ashwinpaul C. VA: Association for Investment Management and Research. dynamic. Sondhi (ed. so does the equity cushion beneath the company’s debt.” © 2013 Pearson Education . equity-oriented analysis is invaluable. 1995). as equity values go up.).Corporate Bond Credit Analysis and Equity Analysis (continued)  Stephen F. they have a useful approach because. If analysts think about whether they would want to buy a particular high-yield company’s stock and what will happen to the future equity value of that company. whether issued by public or private companies. 54) writes: “For those who work with investing in high-yield bonds.

© 2013 Pearson Education . as a result. In assessing the ability of an issuer to service its debt.Key Points ● ● ● Corporate bond credit analysis involves an assessment of bondholder protections set forth in the bond indenture. provide safeguard provisions for bondholders. the collateral available for the bondholder should the issuer fail to make the required payments. there is a question of what a secured position means in the case of a reorganization if the absolute priority rule is not followed in a reorganization. analysts look at a myriad of financial ratios as well as qualitative factors such as the issuer’s business risk and corporate government risk. Covenants contained in the bond indenture set forth limitations on management and. and the capacity of an issuer to fulfill its payment obligations. While collateral analysis is important.

Key Points (continued) ● ● ● ● In assessing the ability of an issuer to service its debt. and national political and regulatory environment. Assessing financial risk involves traditional ratio analysis and other factors affecting the firm’s financing. Some fixed income portfolio managers strongly believe that corporate bond analysis should be viewed from an equity analyst’s perspective. This is particularly the case in analyzing high-yield bonds. and financial risk. In assessing business risk. and working capital. some of the main factors considered are industry characteristics and trends. corporate governance risk. the company’s market and competitive positions. Business risk is the risk associated with operating cash flows. cash flow. leverage. management characteristics. analysts assess the issuer’s business risk. net assets. The more important financial ratios analyzed are interest coverage. (2) the practices followed by management. Corporate governance risk involves assessing (1) the ownership structure of the corporation. and (3) policies for financial disclosure. © 2013 Pearson Education .