Corporate DebtInstruments and Credit Analysis

Chapter 20All Pages

Corporate Debt InstrumentsCorporate Debt

Securities

Corporate BondsMedium-TermNotes (MTNs)

Commercial Paper

Directly-Placed Dealer PlacedSecured BondsUnsecured Bonds

(Debenture Bonds)Credit-Enhanced

Bond

guaranteed by aThird Party

guaranteed by aBank Letter of Credit

Mortgage Debt

Collateral TrustBonds

secured by real propertyor personal property

secured byfinancial assets

Moody's S&P Fitch Brief Definition Investment Grade: High Credit Worthiness Aaa AAA AAA Gilt edge, prime, maximum safety Aa1 AA+ AA+ Aa2 AA AA Very high grade, high quality Aa3 AA– AA– A1 A+ A+ A2 A A Upper medium grade A3 A– A– Baa1 BBB+ BBB+ Baa2 BBB BBB Lower medium grade Baa3 BBB2 BBB2 Distinctly Speculative: Low Creditworthiness Ba1 BB+ BB+ Ba2 BB BB Low grade, speculative Ba3 BB– BB– B1 B+ B+ B2 B B Highly speculative B3 B– B–2 Predominantly Speculative: Substantial Risk or in Default

CCC+ Caa CCC CCC Substantial risk, in poor standing

CCC– Ca CC CC May be in default, extremely speculative C C C Even more speculative than those above

CI CI = Income bonds; no interest is being paid DDD Default DD

D D

Credit analysis for corporate bonds

Trading Strategy Strategy – find bonds whose credit rating is too low (yield spread to Treasury is too

high) Buy Corp Bond with view that the market corrects to agree

with your position Make profits from the tightening credit spread

Can also play corporate bond spreads overall Example: Buy IBM bonds & Sell Dell bonds

Spread trades involve going long the underpriced security and/or short the overpriced security Shorting can be done through Credit Default Swaps (CDS)

Areas analyzed by bond credit analystsPage 445

I - Bond covenants Protections to Bond Holders

II - Collateral analysis What assets are available should issuer fail

III - Ability to make payments (financial situation) Cash Flow generation

Part I - Covenant analysis pg. 445-447

Credit analysis involves close scrutiny of the indenture for each bond issue

Covenants can be strong or weak and involve loopholes

Meant to protect lenders (Bond Investors) Two types

Affirmative (what they WILL do) Negative (or Restrictive – what they CAN’T do)

Example – Limit ability to issue more debt

Part II - Collateral analysis pg. 446

Secured versus unsecured debt Absolute priority rule puts secured first Often unsecured creditors are made whole

first in reorganization Secured debtholders have stronger

bargaining position in chapter 11 reorg Sometimes Secured Debt holders end up holding

debt in the newly re-emerging entity

Part III - Assessing issuers ability to paypg. 446-456 Business risk

Governance risk

Financial risk

Business risk analysisPg. 447-450 Risk associated with operating cash flows Revenue (adjusted for accruals)-cash expenses-

taxes What could effect this?

Macro-economic risk Overall economic slowdown

Industry risk – very important Industry Growth Rates (relative to GDP) Cyclical or not Industry structure (different from most?)

Competitors/competitive position R&D Barriers to entry Price takers or makers – ability to pass along costs?

Governance riskPg. 450-453 Ownership structure

Managers and shareholders aligned Board strength

Independent boards (bigger is better) Audit committee strength

Financial disclosure policies Aggressive versus conservative accounting

policies Shareholders rights

Financial riskPg. 453-456

Look at ratios (versus industry) Interest coverage ratio or pretax interest coverage

EBITDA/interest expense High is good (indicates lower credit risk)

Leverage Ratio LT Debt/ market capitalization LT Debt/EBITDA (Text Example w/ Lear Corp)

Cash Flow Very important for high risk borrowers (below invest. grade) Operating cash, free cash*, discretionary cash

* Most Commonly used

Financial Risk ContinuedNet assets and working capital – pg. 455-456 Ratio of Net Assets to Total Debt

Liquidation Value of assets should be considered Liquidity of the assets is important (page 456 top)

Working Capital (Current Assets minus Current Liab) Primary measure of company’s financial flexibility

Current ratio (current assets/current liabilities) Acid test (takes out inventories from current assets)

Receivables quality is important High liquidity is better than low