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.