Investments & Securities Chapter 20 Corporate Bond Credit Analysis Summary Since The Credit Rating Companies

CHAPTER 20

CORPORATE BOND CREDIT ANALYSIS

CHAPTER SUMMARY

Since the credit rating companies (Moody’s Investors Service, Standard & Poor’s, and Fitch

Ratings) have well-developed methodologies for analyzing the default risk of a corporate bond,

we will describe factors that they consider in this chapter. The framework for analysis that we

describe in this chapter is referred as “traditional credit analysis.” Available online at

www.pearsonhighered.com/fabozzi is the appendix to this chapter, which is a report on Lear

Corporation.

OVERVIEW OF CORPORATE 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 analysts. These are: (1) the protections afforded to

Analysis of Covenants

An analysis of the indenture is part of a credit review of a corporation’s bond issue. The

indenture provisions establish rules for several important areas of operation for corporate

management. These provisions are safeguards for the bondholder. Indenture provisions should be

or annually) for a certain preceding period.

The debt incurrence test only comes into play when the company wishes to do additional

borrowing. In order to take on additional debt, 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. Debt incurrence tests are generally considered less stringent than maintenance

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Some indentures may prohibit subsidiaries from borrowing from all other companies except the

parent. Restricted subsidiaries are those considered to be consolidated for financial test purposes;

unrestricted subsidiaries (often foreign and certain special-purpose companies) are those

excluded from the covenants governing the parent.

Analysis of Collateral

A corporate debt obligation can be secured or unsecured. In the case of the liquidation of a

corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute

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. An evaluation of an issuer’s ability to pay involves

analysis of business risk, corporate governance risk and financial risk

ANALYSIS OF BUSINESS RISK

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: economic cyclicality, growth

prospects, research and development expenses, competition, sources of supply, degree of

regulation, and labor. These general areas encompass most of the areas that the rating agencies

have identified for assessing business risk.

potential impact on the current and prospective profitability of the company. Regulation also

encompasses government intervention in non–U.S. operations of a company.

CORPORATE GOVERNANCE RISK

Corporate governance issues involve (1) the ownership structure of the corporation,(2) the

practices followed by management, and (3) policies for financial disclosure. The underlying

economic theory regarding many of the corporate governance issues is the principal-agency

The second category of mechanism is by means of the company’s internal corporate control

systems, which can provide a way for effectively monitoring the performance and decision-making

behavior of management. 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, the structure

FINANCIAL RISK

Having achieved an understanding of a corporation’s business risk and corporate governance

risk, the analyst is ready to move on to assessing financial risk. This involves traditional ratio

analysis and other factors affecting the firm’s financing. Some of the more important financial

ratios are: interest coverage, leverage, cash flow, net assets, and working capital. Once these

ratios are calculated, it is necessary to analyze their absolute levels relative to those of the

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Before performing an analysis of the financial statement, the analyst must determine if the

industry in which the company operates has any special accounting practices, such as those in the

insurance industry. If so, an analyst should become familiar with industry practices.

Interest Coverage

An interest coverage ratio measures the number of times interest charges are covered on a pretax

basis. Typically, interest coverage ratios that are used and published are pretax as opposed to

after-tax because interest payments are a pretax expense. Pretax interest coverage ratio is

calculated by dividing pretax income plus interest charges by total interest charges. The higher

this ratio, the lower the credit risk, all other factors the same. A calculation of simple pretax

interest coverage would be misleading if there are fixed obligations other than interest that are

significant. In this case, a more appropriate coverage ratio would include these other fixed

obligations, and the resulting ratio is called a fixed charge coverage ratio.

Leverage

While there is no one definition for leverage, 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.e., a company with a high leverage ratio), the margin of safety must be analyzed. The margin

Cash Flow

The statement of cash flows is required to be published in financial statements along with the

income statement and balance sheet. The statement of cash flows is a summary over a period of

time of a company’s cash flows broken out by operating, investing, and financing activities.

Analysts reformat this information, combining it with information from the income statement to

obtain what they view as a better description of the company’s activities.

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As stated by S&P, prefinancing cash flow “represents the extent to which company cash flow

from all internal sources have been sufficient to cover all internal needs.”

Cash flow measures can then be used to calculate various cash flow ratios. The ratio used often

depends on the type of company being analyzed.

Net Assets

A fourth important ratio is net assets to total debt. In the analysis of this ratio, consideration

should be given to the liquidation value of the assets. Liquidation value will often differ

CORPORATE BOND CREDIT ANALYSIS AND EQUITY ANALYSIS

The analysis of business risk, corporate governance risk, and financial risk involves the same

type of analysis that a common stock analyst would undertake. Many fixed income portfolio

managers strongly believe that corporate bond analysis, particularly high-yield bond analysis,

KEY POINTS

• Corporate bond credit analysis involves an assessment of bondholder protections set forth in

the bond indenture, the collateral available for the bondholder should the issuer fail to make

the required payments, and the capacity of an issuer to fulfill its payment obligations.

• Covenants contained in the bond indenture set forth limitations on management and, as a

result, provide safeguard provisions for bondholders. While collateral analysis is important,

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operating cash flows. In assessing business risk, some of the main factors considered are

industry characteristics and trends, the company’s market and competitive positions,

management characteristics, and national political and regulatory environment.

• Corporate governance risk involves assessing (1) the ownership structure of the corporation,

(2) the practices followed by management, and (3) policies for financial disclosure.

• Assessing financial risk involves traditional ratio analysis and other factors affecting the

firm’s financing. The more important financial ratios analyzed are interest coverage, leverage,

ANSWERS TO QUESTIONS FOR CHAPTER 20

(Questions are in bold print followed by answers.)

1. Answer the below questions.

(a) What is the difference between a positive and negative covenant?

There are two general types of covenants. Positive (or affirmative) covenants call upon the

corporation to make promises to take certain actions. Negative (or restrictive) covenants differ

because they require that the borrower not take certain actions. There are an infinite variety of

restrictions that can be placed on borrowers in the form of restrictive covenants. More details are

given below on these restrictive covenants.

(b) What is the purpose of the analysis of covenants in assessing the credit risk of an issuer?

2. Answer the below questions.

(a) What is a maintenance test?

(b) Explain whether or not a company would conduct a debt incurrence test if it does not

wish to acquire additional borrowing.

It is not likely to have the debt incurrence test. The debt incurrence test only comes into play

when the company wishes to do additional borrowing. In order to take on additional debt, the

3. Some credit analysts place less emphasis on collateral compared to covenants and business

risk. Explain why.

Some analysts place less emphasis on collateral compared to covenants and business risk due the

observation that bankruptcy often only allows secured creditors to receive part of their claim in

terms of assets pledged by a borrower to secure a loan. Thus, the both covenants found in the

indenture and also the business risk (under which the company operates) takes on added

significance. More details are given below.

The question is then, what does a “secured position” mean in the case of a reorganization if the

absolute priority rule is not followed in a reorganization? The claim position of a secured

creditor is important in terms of the negotiation process. However, because absolute priority is

not followed and the final distribution in a reorganization depends on the bargaining ability of

the parties, some analysts place less emphasis on collateral compared to covenants and business

risk.

4. Why do credit analysts begin with an analysis of the industry in assessing the business

risk of a corporate issuer?

An analysis of the industry (and its trends) is important for credit analysts because it is only

within the context of an industry that company analysis is valid. All proper analysts have to take

into consider both some standard and how that standard changes over time or might be

influenced by global competition. For example, suppose that the growth rate for a company over

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consider the automobile industry. For this industry, it is not sufficient for a company to examine

its competitive position in its industry but also investigate its competitive position from a global

perspective.

5. What is the purpose of a credit analyst investigating the market structure of an industry

(e.g., unregulated monopoly, oligopoly, etc.)?

A credit analyst will look at the market structure of an industry (e.g., unregulated monopoly,

oligopoly, etc.) because of its implications regarding factors such as price, supply, product

quality, distribution capabilities, image, product differentiation, or service. With respect to

6. What should be the focus of an analyst with respect to the regulation of an industry?

7. In analyzing the labor situation in an industry in which a corporate issue operates, what

should the credit analyst examine?

8. Based on the relationship between the senior managers and the shareholders of

corporations, explain why we have agency costs?

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incentives so as to maximize stockholder value. This cannot be done without cost; the costs of

monitoring the agent’s behavior is called agency costs.

9. With respect to corporate governance, what are the mechanisms that can mitigate the

likelihood that management will act in its own self-interest?

The mechanisms (that can mitigate the likelihood that management will act in its own

self-interest) fall into two general categories. The first category involves strongly aligning the

interests of management with those of shareholders. This can be accomplished by granting

management an economically meaningful equity interest in the company. Also, manager

compensation can be linked to the performance of the company’s long–run common stock price.

The second category involves the company’s internal corporate control systems, which can

provide a way for effectively monitoring the performance and decision-making behavior of

10. Answer the below questions.

(a) What are corporate governance ratings?

Corporate governance ratings refer to the ratings received by corporation in regard to their

adherence to the standards and codes of best practice for effective corporate governance. The

standards of best practice that have become widely accepted as a benchmark to rate companies

on corporate govern are those set forth by the Organization of Economic Cooperation and

(b) Are corporate governance ratings reported to the investing public?

Several organizations have developed services that assess corporate governance and express their

view in the form of a rating. Generally, these ratings are made public at the option of the

(c) What factors are considered by services that assign corporate governance ratings?

For a look at the factors considered by services that assign corporate governance ratings,

consider S&P’s Corporate Governance Score. This score is based on information attained both

privately and publicly and includes interviews with managers and knowledge attained from its

credit rating of the corporation’s debt. The score takes into consider the following factors. First is

the ownership structure and external influences. This factor includes the transparency of

ownership structure and the concentration and influence of ownership and external stakeholders.

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(the lowest score). In addition to corporate governance, credit analysts look at the quality of

management in assessing a corporation’s ability to pay. Moody’s notes the following regarding

the quality of management:

Although difficult to quantify, management quality is one of the most important factors

supporting an issuer’s credit strength. When the unexpected occurs, it is a management’s ability

to react appropriately that will sustain the company’s performance. Assessment of management’s

plans in comparison with those of their industry peers can also provide important insights into

the company’s ability to compete, how likely it is to use debt capacity, its treatment of its

subsidiaries, its relationship with regulators, and its position vis-à-vis all fundamentals affecting

the company’s long-term credit strength.

In assessing management quality, Moody’s tries to understand the business strategies and

policies formulated by management. The factors Moody’s considers are: strategic direction,

financial philosophy, conservatism, track record, succession planning, and control systems.

11. Explain what a credit analyst should do in preparation for an analysis of the financial

statements.

Before performing an analysis of the financial statement, the credit analyst must determine if the

12. Answer the below questions.

(a) What is the purpose of an interest coverage ratio?

(b) What does an interest coverage ratio of 2.8 × mean?

If a company has a pretax interest ratio that is 2.8×, it means it does not need to borrow or use

cash flow or proceeds from the sale of assets to meet its interest payments. It has a cushion of

(c) Discuss whether the interest coverage ratios would be typically computed on a pretax

basis or after-tax basis.

Interest coverage ratios are typically computed on a pretax basis because interest payments are a

pretax expense. Because interest payments lower a company’s taxes there is no need to adjust the

(d) Are there any differences between a fixed charge coverage ratio and an interest

coverage ratio?

A fixed charge coverage ratio would be materially different from an interest coverage ratio

calculation of simple pretax interest coverage if there are fixed obligations other than interest that

13. Answer the below questions.

(a) What is the purpose of a leverage ratio?

The purpose of a leverage ratio is to determine what proportion of a firm’s financing is

composed of debt. While there is no one definition for leverage, the most common one is the

(b) What measures are used in a leverage ratio for total capitalization?

In calculating a leverage ratio for total capitalization, it is common to use the company’s

(c) What is the margin of safety measure?

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 degree of leverage and

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In computing a margin of safety, recognition must be given to other factors to make sure the

margin of safety is accurately calculated. For example, one must see if the company has

operating leases. Such leases represent an alternative to financing assets with borrowed funds.

The existence of material operating leases can therefore understate a company’s leverage causing

the margin of safety to be overestimated. Thus, operating leases should be capitalized to give a

true measure of leverage.

Two other factors should be considered: the maturity structure of the debt and bank lines of

credit. With respect to the first, the one would want to know the percentage of debt that is

coming due within the next five years and how that debt will be refinanced. For the latter, a

company’s bank lines of credit often constitute a significant portion of its total debt.

14. Why do analysts investigate the bank lines of credit that a corporation has?

15. Answer each of the below questions.

(a) Explain the meaning of funds from operation.

Funds from operation are the net income adjusted for depreciation and other noncash debits and

(b) Explain the meaning of operating cash flow.

Operating cash flow is funds from operations reduced by changes in the investment in working

(c) Explain the meaning of free operating cash flow.

(d) Explain the meaning of discretionary cash flow.

The discretionary cash flow is free operating cash flow minus cash dividends. If the company

pays dividends, the discretionary cash flow will reveal how much cash is available to spend on

16. In the analysis of net assets, what factors should be considered?

In the analysis of net assets (and any financial ratio involving net assets such as “net assets to

total debt”), consideration should be given to the liquidation value of the assets. Liquidation

value will often differ dramatically from the net asset value stated on the balance sheet. If the

liquidation value per share for a company is less than the current share price, then it usually

17. Answer the below questions.

(a) “Working capital is a liquidity measure, and it can never be a negative number.”

Explain whether you agree or disagree with the above statements.

One would disagree with the statement.

Working capital is considered a primary measure of a company’s financial flexibility. It is

defined as current assets less current liabilities. Whenever the amount of current assets is less

than that of current liabilities, the working capital would be a negative number, and it implies

(b) Why is an analysis of working capital important?

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capital (such as accounts receivable, accounts payable and so forth) should be assessed. For

example, although accounts receivable are considered to be liquid, an increase in the average

day’s receivables (which is accounts receivable divided by annual sales on credit times 365) that

are outstanding may be an indication that a higher level of working capital is needed for the

efficient running of the operation. In addition, companies frequently have account receivable

financing, some with recourse provisions. In this scenario, comparisons among companies in the

same industry may be distorted.

18. Why do analysts of high-yield corporate bonds feel that the analysis should be viewed

from an equity analyst’s perspective?

For high-yield bonds, the analysis of business risk, corporate governance risk, and financial risk

all involve the same type of analysis that a common stock analyst would undertake. Thus, many

fixed income portfolio managers strongly believe that corporate bond analysis, particularly