fixed income 16: Credit Analysis for Corporate Issuers

7 qualitative facors affecting credit for corporations

1. Business model.

2. Industry and Competition.

3. Business risk.

4. Corporate governance.

5. Accounting quality.

6. Collateral quality.

Why is a company's business model important in credit analysis?

determines the stability and predictability of cash flows available to service debt.

• Strong business models → stable cash flows → reduce default risk.

• strong = stable cash flows, low business risk, and limited competition.

How does industry competition affect creditworthiness?

Greater competition increases business risk and can reduce future cash flows.

• Competitive pressure can reduce profits.

• Market disruption can weaken credit quality.

What is business risk?

uncertainty associated with a firm's future operating performance and cash flows.

Why is corporate governance important for credit analysts?

Management decisions affect bondholder protection and future credit quality.

Positive signs:

• Conservative financing.

• Responsible debt usage.

• Compliance with covenants.

• Transparent communication.

• Strong treatment of bondholders.

Why do credit analysts evaluate accounting policies?

Aggressive accounting can hide true financial risk.

6 warning sings in accounting policies

• Off-balance-sheet financing.

• Premature revenue recognition.

• Excessive capitalization of expenses.

• Frequent auditor changes.

• Frequent CFO changes.

• Fraud concerns.

Quantitative Top-Down Analysis factors

1. macroeconomic cycle: GDP growth cyclicality

2. size of the industry: potential market share

3. event risk: potential external shocks and scenario analysis

Quantitative Bottom-Up Analysis factors

1. balance sheet - Liquidity leverage, profitability

2. Income statement - Revenue growth, operating profit

3. Cash Flow statement - Debt service coverage, Interest coverage

Key Quantitative Factors for high credit quality

• Strong operating profits and recurring revenues

• Low levels of leverage and less reliance on debt in the capital structure

• High coverage of debt service payments with periodic income

• High levels of liquidity to meet short-term debt payments

what is Funds from operations (FFO)

Net income from continuing operations

• plus depreciation, amortization, deferred taxes, and other non-cash charges.

What is Retained Cash Flow (RCF)?

Operating cash flow minus dividends paid.

• conservative measure as accounts for all dividends paid

EBIT margin formula

Operating income / revenue

• profitability measure

EBIT to interest expense

Operating income / Interest expense

• measures coverage

Debt to EBITA

Debt / EBITA

• measures leverage

RCF to Net DEbt

RCF/(Debt - Cash and Marketable securities)

• measures leverage

Typical seniority order (highest to lowest)?

1. First lien/Mortgage - Debt with first claim on pledged collateral.

2. Senior secured (Second lien) - Debt with a secondary claim on collateral after first-lien

3. Junior secured

4. Senior unsecured

5. Senior subordinated

6. Subordinated

7. Junior subordinated

8. Equity

What does pari passu mean?

Equal ranking and equal treatment.

3 features of recovery rates

1. vary widely by industry,

2. vary depending on when they occur in the cycle, and

3. represent averages across industries and companies.

What is an issuer rating?

Rating of the issuer's overall creditworthiness.

aka corporate family ratings (CFRs),

• probability of default of the issuer’s senior unsecured debt.

What is an issue rating?

Rating of a specific debt instrument.

aka corporate credit ratings (CCRs).

Why can issue ratings differ from issuer ratings?

Different recovery prospects due to collateral, seniority, and subordination.

What is notching?

Adjusting issue ratings above or below issuer ratings based on recovery expectations.

Structural subordination occurs when?

Debt exists at both holding company and operating subsidiary levels.

Why is subsidiary debt often stronger than parent debt?

Subsidiary cash flows service subsidiary debt before being upstreamed to the parent.