Lecture 7 - RSM430

What is the role of a credit agency?

• To access the credit quality of an issuer and access the probability of continued interest/principal payments to investors

• issuers require 2 credit ratings to sell bonds in the bond market.

What 4 things do credit ratings drive?

1) Cost of borrowing

• credit spread determines credit spread

2) Covenant Patterns

• types of covenants required by lenders are determined by credit ratings

3) investor universe

• institutional vs retail, investment-grade vs junk.

4) issue size

• credit ratings drive investor universe, which drive issue size as larger universe means you can issue more.

Do credit agencies provide real-time evaluations?

No, they can only adjust their evaluation every quarter when earnings are released.

What are high-yield/junk bonds?

• below BBB- rating

• follow a call schedule instead of make whole provison.

How do agencies elvaluate credit ratings

They consider

1) general risk profile

• country risk, industry cyclicality, economic environment

2) financial risk profile

• look at earnings/coverage/ CF ratios

• consider financial flexibility, which is a companies ability to raise CF outside the bond market

3) industry-specific risks

• ex: are there barriers to entry?

Evaluating financial risk profile

• calculate ratios using yearly earnings or LTM.

• focuses on cashflow adequacy to service debt.

Total Debt

ST debt + LT debt (includes bank loans)

Types of ST Debt Credit Faciliities

1) revolving credit facility

• max 3 years

• provides working capital funding for general purposes

• company can draw/repay without notice

2) commercial papers

• usually 1-3 months, max 1 year

• a type of ST corporate loans.

Financial Covenants for ST Debt

bank loans in general usually require maintaince ratios, in which companies are required to maintain certain measures/ratios during each reporting period.

interest rate on ST Debt

floating rate (LIBOR) + credit spread

Raking in capital structure / recovery waterfall

1) Senior secured claims

2) senior unsecured claims

3) subordinate claims

4) equity

secured claims have some sort of collateral/pledge.

recovery rates depend on where you are in the waterfal.

Point of bankruptcy

When EBITDA ≤ (interest + amortizing debt principal + maintenance CAPEX)

Bond covenants

restrict issuers activity to protect invesotrs

Not meeting these actions could be considered an event of DEFAULT.

Positive Covenants

• actions that the company must comply by / promise to maintain

• example: paying taxes, following laws

Negative Covenants

• limit harmful actions that the company could take to protect investors

• example: restrict dividend payments, asset sales, additional debt.

3 basic investment grade covenants

1) negative pledge

2) cross default

3) cross acceleration

Negative Pledge

• limits companies ability to raise new debt higher priority.

• in place to keep assets available for unsecured lenders and max money available in case of default.

• PERMITTED Carveout: stated amount of debt that can be above limit, which is usually bank loans.

Cross Default

• if a borrower defaults on one bond, they default on them all.

Cross acceleration

accelerates repayment

4 Other major restrictive covenants

1) limitedness of indebtness

2) limitations on restrictive payments

3) limitations on asset sales

4) change of control put option

limitedness of indebtedness

• caps amount of potential new debt company can take on in future based on certain ratios.

• can be maintainence test or incurance test

maintainence test

Maintain compliance for each reporting period

incurrance test

Compliance checked when a relevant action occurs like issuing new debt.

limitation on restricted payments

limits cash leakages like dividends.

limitations on asset sales

limits asset leakages — proceeds from sales must first go towards reinvestment or debt repayment.

change of control put option

Limits merger activity and protects investors from significant change in ownership or weakening of credit rating.