Module 8: Credit Underwriting & Investment Decisions

What is the first thing you want to know about a new issuer?

How it makes money: its customers, volumes, prices, costs, competition, and how demand changes in a downturn.

I'd start by understanding how the company makes money, what it sells, who its customers are, and what drives its revenue and costs. I'd also look at competition and the cyclicality of the business. As a bondholder, that helps me assess how sustainable its earnings and cash flow are, particularly during downturns, and whether it can reliably meet its debt obligations.

Sales grew 10%. What do you want to know before calling that healthy?

Whether it came from more customers, higher prices, or acquisitions—and whether margins and cash flow improved.

I'd want to understand what drove that growth. Was it higher sales volumes, price increases, or acquisitions? I'd also look at whether EBITDA margins and free cash flow improved, because as a bondholder, I care about whether that growth is sustainable and actually strengthens the company's ability to repay debt.

A retailer raises prices while customer traffic falls. What worries you?

Price increases may be masking weaker demand. I would test whether customers can keep absorbing higher prices.

I'd worry that higher prices are hiding weaker demand. If customers keep leaving, the retailer may have to offer discounts, hurting margins and cash flow.

I'd worry that higher prices are masking weaker underlying demand. Even if prices offset falling traffic today, customers may eventually resist further increases or switch to competitors. That could force the retailer to offer discounts, putting pressure on margins and cash flow.

The company reports higher adjusted EBITDA. What would you check?

I would reconcile it to reported earnings and cash flow, then question one-time addbacks and projected savings.

I'd compare adjusted EBITDA with reported EBITDA and cash flow, and look closely at management's adjustments. I'd want to make sure the expenses they're adding back are actually one-time and that any projected cost savings are realistic, rather than overstating sustainable earnings.

An acquisition boosts EBITDA. What matters for credit?

Whether the extra cash covers integration costs and added debt, not just whether reported earnings rise.

Easy to memorize: Added EBITDA → Added debt → Added cash costs (integration costs).

I'd look at how much additional debt the company took on and whether the acquired business generates enough cash to cover the higher interest and integration costs. Just because EBITDA increases doesn't necessarily mean the company's credit quality improves.

Two companies have 5x leverage. Are they equally risky?

No. I would compare cash-flow stability, fixed costs, capex, liquidity, and the timing of debt maturities.

No because even with the same leverage, the company with more reliable cash flow and less refinancing pressure is generally less risky. I'd compare their free cash flow, liquidity, interest coverage, debt maturities, and business cyclicality.

A company has unusually high margins this year. Should you use them forever?

No. I would separate temporary benefits from the margin it could sustain under normal conditions.

I wouldn't assume those margins last forever. I'd look at what drove the increase and compare it with normalized margins in past cycles and peers. For forecasts, I'd use a sustainable level, not the peak.

EBITDA grows 10%, but debt grows 30%. What is your concern?

Leverage may worsen despite higher earnings. I would calculate the ratios and ask how the new debt was used.

I'd worry that leverage is increasing because debt is growing faster than EBITDA. I'd want to understand why debt increased and whether the company generates enough cash flow to support the additional debt and interest expense.

Why does converting EBITDA into cash matter to a bondholder?

Cash, not EBITDA, pays interest and principal. I want to know what remains after taxes, working capital, and capex.

EBITDA isn't actual cash flow. I'd subtract cash interest, taxes, CapEx, and working capital needs to understand free cash flow. As a bondholder, I care because that tells me how much cash the company has available to repay debt and maintain liquidity.

Operating cash flow improves because inventory falls. How do you judge it?

I would check if the inventory reduction can continue or if it is a one-time boost to cash.

I'd want to understand why inventory fell, whether it was higher sales or better inventory management. Lower inventory frees up cash, but I'd want to know whether that improvement is sustainable or just a one-time benefit.

Management forecasts strong growth. How would you test that?

I would compare it with volumes, pricing, margins, competitors, and what the company has delivered before.

I'd look at what's driving management's growth forecast, whether that's higher volumes, pricing, or margins. Then I'd compare those assumptions against historical performance, competitors, and management's track record to see if they're realistic.

Which year of earnings best represents normal conditions?

I would adjust for unusual demand, acquisitions, one-time costs, and margins before choosing a sustainable base.

I'd look at historical earnings and adjust for unusual demand, acquisitions, one-time items, or unusually high margins. The goal is to find a sustainable earnings level that reflects normal business conditions, rather than relying on an unusually strong or weak year.

A business has little debt but weak and shrinking cash flow. Is it safe?

Not automatically. I would test whether cash could turn negative and what obligations come due before it recovers.

I wouldn't automatically call it safe. I'd want to understand why cash flow is shrinking and whether it could turn negative. Then I'd look at upcoming debt maturities and liquidity to see whether the company can meet its obligations before cash flow recovers.

After reading the statements, what is your initial credit question?

Can this business generate enough cash through a downturn to meet its debt obligations without relying on a rescue?

I'd want to understand whether the company generates enough cash flow to meet its debt obligations, especially during a downturn. I'd look at free cash flow, liquidity, leverage, and upcoming maturities to see whether it can survive without needing outside financing.

What is the purpose of a downside case in credit?

To see how a realistic setback affects earnings, cash, debt service, liquidity, and the chance of default.

I'd use a downside case to understand how a downturn affects EBITDA, free cash flow, and liquidity. The main question is whether the company can still meet its debt obligations and avoid default when conditions get worse.

Demand falls 10%. Why might EBITDA fall more than 10%?

Some expenses are fixed, so the lost sales may reduce profit faster than revenue.

If demand falls 10%, EBITDA could fall even more because of operating leverage. Some costs, like rent and salaries, are fixed and don't decrease with sales, so the revenue decline has a larger impact on earnings.

Debt is $500M. EBITDA falls from $100M to $75M. New leverage?

It rises from 5.0x to about 6.7x, because debt stays $500M while earnings fall.

If EBITDA is falling because of a temporary issue, the company might recover. But if demand is weakening permanently or costs are structurally higher, leverage could remain elevated, increasing refinancing and default risk.

Interest is $40M. EBITDA falls from $100M to $60M. Coverage?

Interest coverage falls from 2.5× to 1.5×, meaning the company has a much smaller earnings cushion to cover interest payments. I'd want to understand why EBITDA declined and whether that weakness is temporary or structural.

A company is EBITDA-positive but burns cash. Why does that matter?

It may need to use cash or borrow more to fund interest, working capital, and required investment.

Even with positive EBITDA, a company could burn cash because of interest, taxes, working capital, CapEx, and other cash expenses. I'd want to understand what's driving that cash burn and whether the company has enough liquidity to meet its obligations without borrowing more.

Can the company simply cut all capex during a recession?

Not necessarily. A company can cut or delay growth CapEx during a recession, but maintenance CapEx is still needed to keep existing operations running. Cutting too much maintenance spending could hurt the business over time.

Inventory rises while sales fall. What happens to cash?

Cash is tied up in unsold goods, which can worsen liquidity and lead to discounts which will worsen margins.

Cash decreases because more money is tied up in unsold inventory while sales are falling. If inventory builds up too much, the company may need to discount products to sell them, which would hurt margins and put further pressure on cash flow and liquidity.

One customer accounts for 30% of sales. What would you stress?

I would model losing or repricing that customer and test the effect on margins, cash flow, and debt service.

I'd stress customer concentration risk by modeling what happens if that customer leaves or negotiates lower prices. Losing that customer could reduce revenue by up to 30%, putting pressure on margins, EBITDA, and free cash flow. I'd then assess whether the company has enough liquidity to continue meeting its debt obligations.

Cash is $40M, revolver availability $60M, cash burn $70M, and debt due $80M. Gap?

A $50M gap: $100M of potential sources minus $150M of needs, before restrictions and minimum cash.

The company has $100 million in available liquidity against $150 million in cash needs, leaving a $50 million funding gap. I'd check whether all that liquidity is actually accessible and how management plans to close the gap, whether through refinancing, asset sales, or raising additional capital.

When is a company facing a liquidity problem?

When usable cash and funding are not enough to meet payments when they come due—not just when EBITDA turns negative.

A company faces a liquidity problem when it doesn't have enough cash or accessible funding to meet its obligations as they come due. Even if it's profitable or owns valuable assets, that doesn't necessarily mean it has enough cash available to make those payments.

Why can refinancing become difficult even before a default?

Lenders may demand higher yields or refuse new funding if earnings, leverage, or market conditions deteriorate.

Weaker credit + Tighter markets → Higher borrowing costs or no refinancing.

Refinancing can become difficult if a company's earnings, cash flow, or leverage deteriorate, making lenders less confident in its ability to repay debt. They may demand higher interest rates or refuse to lend altogether. I'd also look at broader credit market conditions, since tighter lending markets can make refinancing harder even for otherwise healthy companies.

What should change together in a recession forecast?

Demand, pricing, margins, working capital, capex, interest costs, and liquidity—not just EBITDA.

I'd start by understanding how cyclical the business is and how much operating leverage it has. Then I'd stress demand, pricing, margins, working capital, and CapEx together to see how a recession affects EBITDA, free cash flow, and liquidity, and ultimately the company's ability to meet its debt obligations.

How would you choose a realistic downside rather than a random one?

I'd start by understanding the company's business model and cyclicality, then look at how it and comparable companies performed during past downturns. I'd use those historical examples to build realistic assumptions for revenue, margins, and cash flow, rather than choosing random percentages.

How do you tell whether a company can survive your downside?

I would track cash and available borrowing over time, interest payments, required capex, and each maturity.

I'd first look at how the downside affects EBITDA, free cash flow, and liquidity. Then I'd track cash and available funding over time to see whether the company can cover interest payments, necessary CapEx, and upcoming debt maturities without running out of liquidity.

Before saying buy or pass, which bond details do you need?

Issuer and guarantors, ranking, maturity, coupon, call terms, price, yield, and creditor protections.

I'd first look at the bond's maturity, coupon, price, yield, call terms, and where it sits in the capital structure, including guarantees and creditor protections. Then I'd compare it with similar bonds to determine whether I'm being adequately compensated for the risk I am taking.

Can a strong company still issue an unattractive bond?

Yes. The bond could be priced too richly or have weak terms, so the return may not justify its risks.

Absolutely. Even if the company is financially strong, the bond could be trading at too high a price, offering too little yield, or have unfavorable call terms and weak creditor protections. I'd compare it with similar bonds to see whether the return actually justifies the risk.

Bond A yields 9%; a comparable bond yields 7%. Is A cheap?

Not automatically. I would compare credit quality, maturity, security, liquidity, and call features.

Not necessarily. Even though Bond A offers a higher yield, I'd compare credit quality, maturity, seniority, call terms, and liquidity to understand why it's yielding more. Then I'd determine whether that extra yield adequately compensates me for the additional risk.

Why compare credit spreads rather than just headline yields?

Treasury rates and maturities affect yields too. Spreads help isolate the extra compensation for credit risk.

I'd compare credit spreads because headline yields are also affected by Treasury rates and maturities. Credit spreads help isolate the additional compensation I'm receiving for taking credit risk, making it easier to compare bonds.

A bond trades at 110. What additional risk would you check?

I would check call terms and yield to worst. An early redemption could limit my return.

I'd focus on call risk because the bond is trading above par. If the company calls it early, I could lose part of the premium I paid. So I'd check the call terms and yield-to-worst to understand my potential return."

YTM is 9%, but yield to worst is 6%. Which matters more?

I would focus on yield to worst for a callable bond, while checking the actual call schedule and scenarios.

I'd focus on yield-to-worst because an early call could reduce my return from 9% to 6%. I'd also check the call terms to understand how likely that is.

The issuer reports steady EBITDA, but its bond price falls. Why?

Market rates or credit spreads may have risen, or investors may be worried about future risk or liquidity.

Even if EBITDA is steady, the bond price could fall because Treasury yields rise or credit spreads widen. Investors might also be concerned about future cash flow, liquidity, or refinancing risk that isn't showing up in EBITDA yet.

One-year default probability is 5%, with 40% recovery. Simple expected principal loss?

About 3%: 5% default probability times 60% loss given default. It is not a full return forecast.

I'd calculate expected loss by multiplying the probability of default by the loss given default. Since recovery is 40%, the loss given default is 60%. Multiplying that by the 5% default probability gives me a 3% expected principal loss.

The easiest way to remember it:

Default probability = Chance I lose money from default.

Loss given default = How much principal I lose if default happens.

Expected loss = Chance × Amount lost.

A bond trades at 90 and your stressed recovery is 60. What does that tell you?

There could be 30 points of principal downside in that outcome, before coupons, timing, and other scenarios.

If the bond trades at 90 and my stressed recovery is 60, that means I could lose 30 points of principal in a downside scenario, or roughly 33% of my investment. I'd use that to assess whether the bond's yield adequately compensates me for that downside risk."

The bond yields 12%, but a large maturity is approaching. Buy?

Only if the yield and price compensate for refinancing, default, and recovery risk. I would check liquidity first.

"Not necessarily. I'd first look at whether the company has enough cash flow and liquidity to meet the upcoming maturity or refinance it. If refinancing is uncertain, I'd assess the default and recovery risks to see whether that 12% yield is enough compensation for the risk I'm taking."

Why is a first-lien bond not automatically a good investment?

Collateral may be worth less than the debt, and even a well-protected bond can be too expensive.

A first-lien bond isn't automatically a good investment because the collateral might not be worth enough to cover the debt in a default. I'd also look at its price, yield, and creditor protections, and compare it with similar bonds to see whether I'm getting paid enough for the risk.

Same issuer: 2029 bond yields 7%, 2033 yields 9%. Which do you favor?

I would compare maturity risk, ranking, calls, duration, and price. The higher yield alone does not decide it.

I wouldn't decide based on yield alone. The 2033 bond offers more yield, but it generally has greater duration and longer-term credit risk. I'd compare their prices, where it sits in cap stack, and call terms to see whether the extra 2% adequately compensates me for those risks.

How do you compare a bond with a peer bond fairly?

I would match business risk, maturity, seniority, callability, and liquidity before comparing spreads.

I'd first make sure the bonds are from comparable companies in the same industry, with similar credit quality. Then I'd compare their maturity, seniority, call terms, and liquidity to make sure they're good comparables before looking at their credit spreads to see which offers better value.

You like the issuer, but no bond price is provided. Can you recommend buying?

I can give a preliminary credit view, but a buy decision needs a specific security and price.

Not necessarily. Even if I like the issuer and its financials, I still need to understand the specific bond's price, yield, and terms. At the end of the day, high-yield investing is about whether I'm getting paid enough for the risk I'm taking, so I can't make a buy recommendation without that information.

What could make an undervalued bond move closer to fair value?

A refinancing, stronger cash flow, lower leverage, or improved market confidence—but the catalyst is not guaranteed.

An undervalued bond could move closer to fair value if the company's credit quality improves through stronger free cash flow, lower leverage, or a successful refinancing. That could increase investor confidence, tighten credit spreads, and push the bond's price higher.

Give me your credit view in 30 seconds. What do you say?

I'd start with my recommendation and the bond's price. Then I'd briefly explain the company's business, earnings, and free cash flow, along with the main debt and liquidity risks. Finally, I'd explain whether the bond's yield compensates me enough for those risks.

What three questions would you research before making a decision?

What drives sustainable earnings, how much cash is needed to run the business, and what could block debt repayment?

The three things I'd want to understand are what's driving the company's earnings and whether they're sustainable, how much free cash flow it can generate after its operating needs, and what risks could prevent it from meeting its debt obligations.

Memorize: Sustainable earnings → Free cash flow → Debt repayment risks.

I think you are underestimating demand. How do you respond?

I would test that against customer data and a stronger-demand case, then see whether my credit view changes.

I'd first ask what's driving their view and compare it with the assumptions and data I used in my analysis. Then I'd test a stronger-demand scenario to see how it affects EBITDA, free cash flow, and my credit recommendation. If the evidence supports their argument, I'd be willing to change my view.

What is the strongest argument against your own buy recommendation?

I would name the assumption most likely to fail, quantify the downside, and explain what would change my mind.

I'd look at the weakest assumption behind my recommendation and what could happen if I'm wrong. For example, if I'm expecting earnings to recover but demand keeps falling, I'd assess how that affects free cash flow, liquidity, and the company's ability to repay debt. I'd also explain what would make me change my recommendation.

What would make you change your investment recommendation?

A meaningful change in cash flow, liquidity, debt terms, recovery, or bond price relative to the risk.

I'd change my recommendation if my assumptions proved wrong, like if free cash flow or liquidity deteriorated, or if refinancing risk increased. I'd also reconsider if the bond started trading too rich and I was no longer getting paid enough for the risk I'm taking.

Management says liquidity is strong. Would you rely on that?

I would verify unrestricted cash, available revolver capacity, upcoming payments, and cash needs myself.

Not necessarily. I'd want to do my own analysis by looking at the company's unrestricted cash, available revolver capacity, upcoming debt maturities, and other cash needs to see whether its liquidity is actually as strong as management claims.

You do not know the answer to a specific credit question. What do you say?

I would say what I know, explain what I can infer, and identify the information needed to decide.

I'm not entirely sure, but here's how I'd think about it. I'd start with what I know, explain what I can reasonably conclude from that, and identify what additional information I'd need to give a more confident answer.

You notice that your leverage calculation was wrong. What do you do?

I would correct it clearly, recalculate the downside, and update my conclusion if the mistake matters.

I'd acknowledge the mistake and correct the leverage calculation. Then I'd reassess how the corrected number affects my downside analysis and whether it changes my investment recommendation.

Why can a bondholder worry even when shareholders like the company?

Equity benefits from upside, while a bond has limited upside and can lose heavily if repayment fails.

Shareholders care more about the company's upside because they benefit if its value increases. Bondholders have limited upside since they're mainly entitled to interest and principal repayment, but they can still lose a lot if the company defaults. That's why I'd focus more on downside risk and the company's ability to repay debt.

Your bond rallies and its yield falls. Do you still hold it?

I would reassess the remaining return against its risks and alternatives, rather than rely on my entry thesis.

Not necessarily. If the bond rallies and its yield falls, I'd reassess its relative value to see whether I'm still getting paid enough for the risk I'm taking. I'd compare it with other investment opportunities and decide whether it makes more sense to hold or sell.

A senior analyst challenges your recommendation. What makes a strong defense?

Clear evidence, transparent assumptions, a realistic downside, and a willingness to change my view.

I'd first understand their concern and explain the evidence and assumptions behind my recommendation. Then I'd test their argument against my downside analysis to see if it changes my view. If they're right, I'd be willing to adjust my recommendation.

After all the analysis, you still lack key bond terms. What is your call?

I would give a conditional issuer view and explain what terms and price I need before recommending a trade.

I'd first acknowledge that I'm missing some key bond terms. Based on the information I have, I'd give my preliminary credit view, but I wouldn't make a final buy recommendation until I understand the bond's price, seniority, and creditor protections. I'd also explain how those details could change my recommendation.