CFA Level I - Fixed Income: Fundamentals of Credit Analysis

CFA Level I Fixed Income
Fundamentals of Credit Analysis
Presented by: Arif Irfanullah

www.arifirfanullah.com
www.arifirfanullah.com 1
Contents
1. Introduction
2. Credit Risk
3. Capital Structure, Seniority Ranking and Recovery Rates
4. Rating Agencies, Credit Rating And Their Role in Debt
Markets
5. Traditional Credit Analysis
6. Credit Risk vs. Return
7. Special Considerations of High Yield, Sovereign and
Municipal Credit Analysis
2. Credit Risk
Credit risk has two components
Default risk (or default probability)
Loss severity (or loss given default)
Expected loss =
Spread risk is another form of credit risk
Credit migration (or downgrade risk)
Market liquidity risk Example 1
3. Capital Structure, Seniority Ranking And Recovery Rates
3.1 Capital Structure
3.2 Seniority Ranking
Example 2
3.3 Recovery Rates
Pari passu (on an equal footing)
Recovery rates vary by seniority ranking
Vary by industry
Depend on when they occur in a credit cycle
High variability
Priority of claims: not always absolute

Example 3
4. Rating Agencies
Moodys, S&P and Fitch play a dominant role
4.1 Credit Ratings
6
4.2 Issuer vs. Issue Rating
Notching
Structural subordination
4.3 Risks in Relying on Agency Ratings
1. Credit ratings can be very dynamic
2. Rating agencies are not infallible
3. Idiosyncratic or event risk is difficult to capture
4. Ratings lag market pricing of credit
Example 4
5. Traditional Credit Analysis: Corporate Debt Securities
5.1 Credit Analysis vs. Equity Analysis
5.2 The Four Cs of Credit Analysis
Capacity
Collateral
Covenants
Character
Capacity
Industry structure
Power of suppliers
Power of buyers/customers
Barriers to entry
Substitution risk
Level of competition
Degree of operating leverage
Industry fundamentals
Cyclical vs non-cyclical
Growth prospects
Published industry statistics
Company fundamentals
Competitive position
Track record/operating history
Managements strategy and execution
Ratios and ratio analysis (next slide)

Example 5
Profitability and Cash Flow Measures
EBITDA
Funds from operations (FFO)
Free cash flow after dividends
Leverage ratios
Debt/capital
Debt/EBITDA
FFO/Debt
Coverage ratios
EBITDA/interest expense
EBIT/interest expense
Issuer liquidity
Cash on balance sheet
Net working capital
Operating cash flow
Committed bank lines
Debt coming due and committed capital

expenditures in next couple of years
Example 6
Collateral
Covenants
Character
Example 7
6. Credit Risk vs. Return: Yields and Spreads
Yield on corporate bond = Real risk-free interest rate + Expected inflation +
Maturity premium + Liquidity premium + Credit spread
Yield spread = Liquidity premium + Credit spread
Spreads on corporate bonds are impacted by:
Credit cycle
Broader economic conditions
Financial market performance overall, including equities
Broker-dealers willingness to provide sufficient capital for market listing
General market supply and demand
Example 8
Return impact (without convexity adjustment)
Return impact (with convexity adjustment)
Example 9
7. Special Considerations of High-Yield, Sovereign, and
Municipal Credit Analysis
7.1 High Yield
Bonds rated below BBB-

Also called Junk Bonds or non-investment grade bonds
Possible reasons for Junk Bond status
Special considerations:
Greater focus on liquidity and cash Corporate structure

flow
Covenant analysis
Detailed financial projections
Equity-like approach to high-yield

Debt structure analysis
Example 10 www.arifirfanullah.com 19
7.2 Sovereign Debt
Historically viewed as risk-free
Best able to service debt if a sovereign runs twin surpluses
Two key issues: ability to pay and willingness to pay
Credit rating agencies distinguish between local currency debt and foreign currency debt
Review simplistic framework presented in the curriculum (adapted from S&Ps methodology)
Political and economic Flexibility and performance
profile profile
Effectiveness, stability and predictability

External liquidity and international
of policy making institutions
investment positions
Fiscal performance, flexibility and debt

Perceived commitment to honor debts
burden
Monetary flexibility
Economic structure and growth prospects
Example 11
7.3 Municipal Debt
Debt issued by state, provincial and local governments
Generally refers to US municipal bonds
General obligation bonds
GO bonds are unsecured and issued with full faith and credit of issuing government
Credit analysis: employment, per capita income, per capita debt
Over-reliance on one or two types of tax revenue (ex: capital gains or sales tax) can signal credit risk
Revenue bonds
Credit analysis similar to corporate bonds
Look at debt service coverage ratio: how much revenue to cover debt service payments

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CFA Level I Fixed Income

Fundamentals of Credit Analysis

Presented by: Arif Irfanullah

Default risk (or default probability)

Loss severity (or loss given default)

Spread risk is another form of credit risk

Credit migration (or downgrade risk)

Market liquidity risk Example 1

3.1 Capital Structure

3.2 Seniority Ranking

Pari passu (on an equal footing)

Recovery rates vary by seniority ranking

Depend on when they occur in a credit cycle

Priority of claims: not always absolute

4.1 Credit Ratings

1. Credit ratings can be very dynamic

2. Rating agencies are not infallible

3. Idiosyncratic or event risk is difficult to capture

4. Ratings lag market pricing of credit

5.2 The Four Cs of Credit Analysis

Degree of operating leverage

Published industry statistics

Track record/operating history

Managements strategy and execution

Ratios and ratio analysis (next slide)

Funds from operations (FFO)

Free cash flow after dividends

Cash on balance sheet

Net working capital

Operating cash flow

Committed bank lines

Debt coming due and committed capital

Yield spread = Liquidity premium + Credit spread

Spreads on corporate bonds are impacted by:

Broader economic conditions

Financial market performance overall, including equities

Broker-dealers willingness to provide sufficient capital for market listing

General market supply and demand

Return impact (with convexity adjustment)

7.1 High Yield

Bonds rated below BBB-

Possible reasons for Junk Bond status

Greater focus on liquidity and cash Corporate structure

Equity-like approach to high-yield

Historically viewed as risk-free

Best able to service debt if a sovereign runs twin surpluses

Two key issues: ability to pay and willingness to pay

Effectiveness, stability and predictability

Fiscal performance, flexibility and debt

Debt issued by state, provincial and local governments

Generally refers to US municipal bonds

General obligation bonds

Credit analysis: employment, per capita income, per capita debt

Credit analysis similar to corporate bonds

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