1、Chapter 21 Corporate Bond Credit Analysis Learning ObjectivesAfter reading this chapter, you will understandvthe major areas of bond credit analysis: covenants, collateral, and ability to payvthe reason why covenants must be analyzedvwhat factors are considered in evaluating the ability of an issuer
2、 to satisfy its obligationsvwhat factors are considered in assessing a companys business riskvwhy an analysis of a company must be looked at relative to the industry in which it operatesvthe reasons corporate governance risk is important and how it can be mitigatedvkey financial ratiosvthe relations
3、hip between corporate bond credit analysis and common stock analysisOverview of Bond Credit Analysisv In the analysis of the default risk of a corporate bond issuer and specific bond issues, there are three areas that are analyzed by bond credit analysts.v These three areas are:1. the protections af
4、forded to bondholders that are provided by covenants limiting managements discretion2. the collateral available for the bondholder should the issuer fail to make the required payments3. the ability of an issuer to make the contractual payments to bondholdersOverview of Bond Credit Analysis (continue
5、d)v Analysis of CovenantsAn analysis of the indenture is part of a credit review of a corporations bond issue.The indenture provisions establish rules for several important areas of operation for corporate management.These provisions are safeguards for the bondholder.Indenture provisions should be a
6、nalyzed carefully.There are two general types of covenants.i.Affirmative covenants call upon the corporation to make promises to do certain things.ii.Negative covenants, also called restrictive covenants, require that the borrower not take certain actions.There are an infinite variety of restriction
7、s that can be placed on borrowers in the form of negative covenants.Overview of Bond Credit Analysis (continued)vAnalysis of Covenants Some of the more common restrictive covenants include various limitations on the companys ability to incur debt. Bondholders may want to include limits on the absolu
8、te dollar amount of debt that may be outstanding or may require some type of fixed charge coverage ratio test. The two most common tests are the maintenance test and the debt incurrence test. The maintenance test requires the borrowers ratio of earnings available for interest or fixed charges to be
9、at least a certain minimum figure on each required reporting date (such as quarterly or annually) for a certain preceding period.Overview of Bond Credit Analysis (continued)vAnalysis of Covenants The debt incurrence test only comes into play when the company wishes to do additional borrowing. In ord
10、er to take on additional debt, the required interest or fixed charge coverage figure adjusted for the new debt must be at a certain minimum level for the required period prior to the financing. Debt incurrence tests are generally considered less stringent than maintenance provisions. There could als
11、o be cash flow tests (or cash flow requirements) and working capital maintenance provisions.Overview of Bond Credit Analysis (continued)vAnalysis of Covenants Some indentures may prohibit subsidiaries from borrowing from all other companies except the parent. Restricted subsidiaries are those consid
12、ered to be consolidated for financial test purposes; unrestricted subsidiaries (often foreign and certain special-purpose companies) are those excluded from the covenants governing the parent. Often, subsidiaries are classified as unrestricted in order to allow them to finance themselves through out
13、side sources of funds.Overview of Bond Credit Analysis (continued)vAnalysis of Collateral A corporate debt obligation can be secured or unsecured. In the case of the liquidation of a corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. What is typ
14、ically observed is that the corporations unsecured creditors may receive distributions for the entire amount of their claim and common stockholders may receive some distribution, while secured creditors may receive only a portion of their claim. The claim position of a secured creditor is important
15、in terms of the negotiation process.Overview of Bond Credit Analysis (continued)vAssessing an Issuers Ability to Pay The ability of an issuer to generate cash flow goes considerably beyond the calculation and analysis of a myriad of financial ratios and cash flow measures that can be used as a basic
16、 assessment of a companys financial risk. An evaluation of an issuers ability to pay involves analysis ofi. business riskii. corporate governance riskiii.financial riskAnalysis of Business Riskv Business risk is defined as the risk associated with operating cash flows.v Operating cash flows are not
17、certain because the revenues and the expenditures comprising the cash flows are uncertain.v An analysis of industry trends is important because it is only within the context of an industry that company analysis is valid. Industry consideration should be considered in a global context.v The need for
18、many companies to become globally competitive increases as the barriers to international trade are broken down.Analysis of Business Risk (continued)v It has been suggested that the following areas will provide a credit analyst with a sufficient framework to properly interpret a companys economic pro
19、spects:1.economic cyclicality2.growth prospects3.research and development petition5.sources of supply6.degree of regulation7.laborv These general areas encompass most of the areas that the rating agencies have identified for assessing business risk.Analysis of Business Risk (continued)v One of the f
20、irst areas of analysis is investigating how closely the industry follows gross domestic product (GDP) growth.v This is done in order to understand the industrys economic cyclicality.v Related to the analysis of economic cyclicality are the growth prospects of the industry.v This requires an analysis
21、 as to whether the industrys growth is projected to increase and thereafter be maintained at a high level or is it expected to decline.v To assess the growth prospects, a credit analyst will have to investigate the dependence on research and development (R&D) expenditures for maintaining or expandin
22、g the companys market position.Analysis of Business Risk (continued)v Competition is based on a variety of factors and depends on the nature of the industry.v The basis for competition determines which factors are analyzed for a given company.v With respect to pricing, the credit analyst will look a
23、t the market structure of an industry (e.g., unregulated monopoly, oligopoly, etc.) because of its implications on pricing flexibility.v Moreover, market structure is important if it bears on one of the other industry factors: sources of supply.v With respect to regulation, the focus should be on th
24、e direction of regulation and its potential impact on the current and prospective profitability of the company.Analysis of Business Risk (continued)v With respect to its analysis of a companys global risk, there is a particular risk to the company that the government may change the rules through suc
25、h items as1.import/export restrictions2.direct intervention in service quality or levels3.redefining boundaries of competition4.altering existing barriers to entry5.changing subsidies6.changing antitrust legislation7.changing the percentage of foreign ownership participation8.changing terms to conce
26、ssion contracts for utilitiesv A key component in the cost structure of an industry is labor.In analyzing the labor situation, the credit analyst will examine if the industry is heavily unionized.In nonunionized companies, the credit analyst will look at the prospect of potential unionization.Corpor
27、ate Governance RiskvCorporate governance issues involve1.the ownership structure of the corporation2.the practices followed by management3.policies for financial disclosureThe eagerness of corporate management to present favorable results to shareholders and the market has been a major factor in sev
28、eral of the corporate scandals in recent years.Chief executive officers, chief financial officers, and the board of directors are being held directly accountable for disclosures in financial statements and other corporate decisions.vThe underlying economic theory regarding many of the corporate gove
29、rnance issues is the principal-agency relationship between the senior managers and the shareholders of corporations.The agent, a corporations senior management, is charged with the responsibility of acting on behalf of the principal, the shareholders of the corporation.Corporate Governance Risk (con
30、tinued)v There are mechanisms that can mitigate the likelihood that management will act in its own self-interest.v The mechanisms fall into two general categories.v The first mechanism is to more strongly align the interests of management with those of shareholders. This can be accomplished by grant
31、ing management an economically meaningful equity interest in the company. Also, manager compensation can be linked to the performance of the companys common stock.Corporate Governance Risk (continued)v The second mechanism (that can mitigate the likelihood that management will act in its own self-in
32、terest) is by means of the companys internal corporate control systems, which can provide a way for effectively monitoring the performance and decision-making behavior of management.What has been clear in corporate scandals is that there was a breakdown of the internal corporate control systems that
33、 lead to corporate difficulties and the destruction of shareholder wealth.Because of the important role played by the board of directors, the structure and composition of the board are critical for effective corporate governance.The key is to remove the influence of the CEO and senior management on
34、board members.Corporate Governance Risk (continued)v Several organizations have developed services that assess corporate governance and express their view in the form of a rating.v Their ratings take into consideration four key elements evaluated by S&P:1. the ownership structure and external influe
35、nces2. shareholder rights and stakeholder relations3. transparency, disclosure, and audit4. board structure and effectivenessv See Overhead 21-19 for more information on these four elements.Standard & Poors, Corporate Governance Evaluations & Scores1. Ownership structure and external influences Tran
36、sparency of ownership structure Concentration and influence of ownership and external stakeholders3. Transparency, disclosure, and audit Content of public disclosure Timing of and access to public disclosure Audit process2. Shareholder rights and stakeholder relations Shareholder meeting and voting
37、procedures Ownership rights and takeover defenses Stakeholder relations4. Board structure and effectiveness Board structure and independence Role and effectiveness of the board Director and senior executive compensationCorporate Governance Risk (continued)v In addition to corporate governance, credi
38、t analysts look at the quality of management in assessing a corporations ability to pay.v In assessing management quality, Moodys tries to understand the business strategies and policies formulated by management.v The factors Moodys considers are:1. strategic direction2. financial philosophy3. conse
39、rvatism4. track record5. succession planning6. control systems Financial Riskv Having achieved an understanding of a corporations business risk and corporate governance risk, the analyst is ready to move on to assessing financial risk.v This involves traditional ratio analysis and other factors affe
40、cting the firms financing.v Some of the more important financial ratios are: interest coverage, leverage, cash flow, net assets, and working capital.v Once these ratios are calculated, it is necessary to analyze their absolute levels relative to those of the industry. Financial Risk (continued)vBefo
41、re performing an analysis of the financial statement, the analyst must determine if the industry in which the company operates has any special accounting practices, such as those in the insurance industry.If so, an analyst should become familiar with industry practices.vMoreover, the analyst must re
42、view the accounting policies to determine whether management is employing liberal or conservative policies in applying generally accepted accounting principles (GAAP).vSince historical data are analyzed, the analyst should recognize that companies adjust prior years results to accommodate discontinu
43、ed operations and changes in accounting that can hide unfavorable trends.This can be done by assessing the trends for the companys unadjusted and adjusted results. Financial Risk (continued)v Interest CoverageAn interest coverage ratio measures the number of times interest charges are covered on a p
44、retax basis.Typically, interest coverage ratios that are used and published are pretax as opposed to after-tax because interest payments are a pretax expense.Pretax interest coverage ratio is calculated by dividing pretax income plus interest charges by total interest charges.The higher this ratio,
45、the lower the credit risk, all other factors the same.A calculation of simple pretax interest coverage would be misleading if there are fixed obligations other than interest that are significant.In this case, a more appropriate coverage ratio would include these other fixed obligations, and the resu
46、lting ratio is called a fixed charge coverage ratio. Financial Risk (continued)vLeverage While there is no one definition for leverage, the most common one is the ratio of long-term debt to total capitalization. If there is a higher level of debt then a higher percentage of operating income must be
47、used to satisfy fixed obligations. In analyzing a highly leveraged company (i.e., a company with a high leverage ratio), the margin of safety must be analyzed.The margin of safety is defined as the percentage by which operating income could decline and still be sufficient to allow the company to mee
48、t its fixed obligations. Recognition must be given to the companys operating leases. Financial Risk (continued)vCash FlowCash flow analysis is the single most critical aspect of all credit rating decisions.It takes on added importance for speculative-grade issuers.The statement of cash flows is requ
49、ired to be published in financial statements along with the income statement and balance sheet.The statement of cash flows is a summary over a period of time of a companys cash flows broken out by operating, investing, and financing activities.Analysts reformat this information, combining it with in
50、formation from the income statement to obtain what they view as a better description of the companys activities. Financial Risk (continued)vCash Flow S&P calculates what it refers to as funds from operations (defined as net income adjusted for depreciation and other noncash debits and credits). Oper
