Credit Risk to Investors: Three Types

• Default Risk: The risk that a borrower fails to make an interest or principal payment on schedule.
• Credit Spread Risk: The risk that market conditions change in a manner that causes the yield spread of a fixed income security to widen against its benchmark yield.
• Downgrade Risk: This is the risk that the value of a fixed income security will decrease because the borrower’s credit worthiness has been downgraded by a credit rating agency, such as Moody’s.

Corporate Credit Analysis and the “Four C’s of Credit”

The “four C’s of credit” provide an analytical framework evaluating the credit quality of a company.

• Character: This is an interpretation of managerial ability.  Does the company have a sound strategy?  Is the company financially conservative?  Does leadership respond effectively to a changing business environment?  Etc.

• **Capacity:**This is an evaluation of the company’s ability to generate sufficient cash flows to service debt on time.

  • In analyzing “capacity”, an analyst will look at profitability ratios, liquidity ratios and solvency ratios (including interest coverage ratios).
  • Discretionary Cash Flow = Cash Flow from Ops – CapEx – Cash Dividend
  • Analysts will also want to look for off-balance sheet financing techniques, such as the use of operating leases, and also understand the frequency and application of short term debt financing.

• Collateral: This is an evaluation of the quality of a company’s assets.  Are the assets sufficiently valuable and liquid enough to serve as borrowing collateral?  Can the assets be sold in order to return funds in the event of default?

• **Covenants:**The analyst will need to ensure that the bond indenture contains terms that will facilitate debt payment.

  • Affirmative covenants: Borrower promises to lenders.
  • Negative covenants: Constrain borrow activities.
  • Common tests included in bond covenants include:
    • Maintenance test: Specifies minimum interest coverage ratios.
    • Working capital requirements: Specify minimum levels of working capital.
    • Cash flow test: Specify minimum cash flow levels.
    • Debt incurrence test: Restricts a company from issuing new debt unless interest coverage exceeds a specified level.
    • Restricted subsidiaries are subsidiaries must be consolidated with the parent for the above covenant tests.