Fundamentals of

Credit Analysis
Special Considerations of
High Yield Credit Analysis
 Moody's S&P Fitch
Aaa AAA AAA
Aa1 AA+ AA+
Aa2 AA AA
Aa3 AA− AA−
A1 A+ A+
Investment Grade Bonds
A2 A A
A3 A− A−
Baa1 BBB+ BBB+
Baa2 BBB BBB
Baa3 BBB− BBB−
Ba1 BB+ BB+
Ba2 BB BB
Ba3 BB− BB−
B1 B+ B+
B2 B B
B3 B− B− High Yield Bonds
Caa CCC CCC
Ca CC CC “Junk bonds”
C C C
C D D

Special Considerations of High Yield Credit Analysis

 High Yield Bonds
Reasons for Non-Investment Grade Ratings Investment Grade Bonds

Highly leveraged capital structure Low confidence in management

Weak or limited operating history Unclear competitive advantages

Low or negative free cash flow Large off-balance-sheet liabilities

Highly cyclical business Declining industry

Special Considerations of High Yield Credit Analysis

 High Yield Bonds vs Investment Grade Bonds

Higher risk of default

Focus on recovery analysis

More in-depth analysis

Special Considerations

Special Considerations of High Yield Credit Analysis

 Special Considerations
in analysis of high yield bonds issuers

Corporate Structure

Liquidity Financial Projections

Issuer

High Yield Bonds

Bank Debt
Second Lien
Debt
Senior Unsecured Covenants
Subordinated
Structure
Preferred Stock

Special Considerations of High Yield Credit Analysis

 Liquidity
availability of cash

Com
pan
inve y un
stig der
atio
n

e s s ion
t R e c
Wors y e a rs
Limited access to in 39
additional borrowings
High Yield Issuer
More expensive!

Special Considerations of High Yield Credit Analysis

 Liquidity
availability of cash

Dry up liquidity
Com
of debt markets inve
pan
y un
stig der
atio
n

e s s ion
t R e c
Wors y e a rs
in 39

High Yield Issuer

Privately Owned

Equity Market

Special Considerations of High Yield Credit Analysis

 Liquidity
6 sources of liquidity to analyse
(in order from strongest to weakest)

Customers
Banks
3 Operating cash flow (CFO)
Sales→Receivables→Cash 4 Bank credit
May require covenants
Balance Sheet
Liabilities Assets
Current Cash
Liabilities
Current
2 Working capital Assets
Examine its use in company 5
Equity Shareholders
Long-term
cash-conversion cycle
Assets
High Yield Issuer issuance

SALE
Unreliable source if issuer is private
or market condition is poor
1 Cash on 6 Asset sales
balance sheet Highly uncertain potential value and
actual time of closing

Special Considerations of High Yield Credit Analysis

 Liquidity
Too risky to
lend

I may
Customers have to Banks
Operating cash flow (CFO) default!
Bank credit Don’t dilute
my stake
Balance Sheet
Liabilities due soon! Liabilities Assets
Cash
Current Current
Liabilities
Working capital Assets
Long-term Equity Shareholders
Assets High Yield Issuer issuance
Cash on
balance sheet

Special Considerations of High Yield Credit Analysis

 Financial Projections

Forecast Future Earnings and Cash Flow

Stress
Project changes in capital expenditures scenarios
and working capital

Special Considerations of High Yield Credit Analysis

 Debt Structure

Secured
Highest seniority
Bank Debt

Second Lien

Unsecured
Senior Unsecured

Subordinated Convertible to common shares

Highest loss severity
Equity
Preferred Stock

Special Considerations of High Yield Credit Analysis

 Debt Structure
Secured
Highest seniority
Bank Debt
Top Heavy
Less capacity to have further
Second Lien
borrowings from banks

More likely to default

Unsecured
Senior Unsecured Lower recovery rates for
Subordinated unsecured debt holders
Highest loss severity
Equity
Preferred Stock

Special Considerations of High Yield Credit Analysis

 Debt Structure
HeavyTop LightTop

EBITDA $70 $30

Cash $130 $20

More capacity to borrow from banks
More top heavy than LightTop ➡Lower probability of default
Secured
Bank Debt 860/70 = 12.3x 100/30 = 3.3x
$860 $100
Secured debt leverage = Secured debt/EBITDA
Second Lien

Unsecured
1080/70 = 15.4x 310/30 = 10.3x
Senior Unsecured $220 Secured unsecured leverage = (Secured+Snr Unsecured)/EBITDA $210
Subordinated $70 1150/70 = 16.4x 390/30 = 13.0x $80
Total debt leverage = Total debt/EBITDA

1020/70 = 14.5x 340/30 = 12.3x

Net leverage = (Total debt - cash)/EBITDA

Special Considerations of High Yield Credit Analysis

 Corporate Structure
Holding company structure

Parent
Bondholders

Parent
BondsCompany
by Parent

Parent receives 2nd Structural Subordination

dividends from
subsidiaries as
primary source Subsidiary
Bonds Y
by Sub
of income
1st

Subsidiary Bondholders
Special Considerations of High Yield Credit Analysis
 Corporate Structure
Holding company structure Structural Subordination

Parent Bonds by Sub

Bondholders
Multiple cash flows from
diverse subsidiaries can
Bonds by Parent (subordinated)
improve parent’s credit rating
Parent Company

Subsidiary X Subsidiary Z

Subsidiary Y

Subsidiary Bondholders
Special Considerations of High Yield Credit Analysis
 Covenants
Change of control put
Right to require issuer to buy back bonds
in the event of an acquisition
Protect lenders from being exposed to a
weaker, more indebted borrower as a
result of the acquisition
Restricted payments
Protect lenders by limiting how much
cash can be paid out to shareholders
Restricted amount can grow with
increased retained earnings or cash flow
Special Considerations of High Yield Credit Analysis
Limitation on liens
Put limits on how much secured debt the
issuer can have
Increases the recovery amount
available to unsecured debt holders in
the event of default
Restricted/Unrestricted subsidiary
Unrestricted - structural subordination
Subsidiary’s bondholders have priority on
the subsidiary’s cash flows and assets
Restricted - pari passu
Subsidiary’s cash flows and assets can
be used to service parent’s debts
 Covenants

Bondholders Banks

Bond covenants Bank covenants

Typically more restrictive
Can block additional loans until
violation is corrected
Can trigger a default if violation is
High Yield Issuer
not resolved, accelerating full
repayment of loan

Special Considerations of High Yield Credit Analysis

 Special Considerations
in analysis of high yield bonds issuers

Corporate Structure

Liquidity Financial Projections

Issuer

High Yield Bonds

Bank Debt
Second Lien
Debt
Senior Unsecured Covenants
Subordinated
Structure
Preferred Stock

Special Considerations of High Yield Credit Analysis

 Enterprise Value
to analyse
Investment-grade Bonds High Yield Bonds Equity

Highly influenced by Influenced by interest

interest rate changes rate changes

Influenced by Highly influenced by

economic growth economic growth

Historical Returns

Special Considerations of High Yield Credit Analysis

 Enterprise Value
to analyse
High Yield Bonds
Enterprise value is a measure of what a business is worth before any takeover premium

I want to
EV take over this
company
=

Total Debt Total Debt Net cash to

+ take over
company
Equity Market
Capitalisation
Equity Market
- Capitalisation
Cash Cash

Special Considerations of High Yield Credit Analysis

 Enterprise Value
to analyse
High Yield Bonds
indicate a firm’s potential for additional leverage

Total Debt Net cash to

takeEV
over
company
EV Total Debt
-
EBITDA EBITDA Equity Market
Capitalisation
Cash

Special Considerations of High Yield Credit Analysis

 Enterprise Value
to analyse
High Yield Bonds
indicate a firm’s potential for additional leverage

Total Debt
Net cash to
Wider difference takeEV
over
EV Total Debt company
→Greater equity vs debt -
→Less credit risk EBITDA EBITDA Equity Market
Capitalisation

Cash

Special Considerations of High Yield Credit Analysis

prepnuggets.com