Principles of Credit Analysis

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.