Fabozzi Bmas8 Ppt Ch20ge

8/18/2019 Fabozzi Bmas8 Ppt Ch20ge

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Global Edition

Chapter 20

Corporate BondCredit Analysis


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© 2013 Pearson Education

Learning Objectives

After reading this chapter, you ill understand

the major areas of bond credit analysis: covenants, collateral,and ability to pay

the reason why covenants must be analyzed

what factors are considered in evaluating the ability of an issuerto satisfy its obligations what factors are considered in assessing a company’s business

risk why an analysis of a company must be looked at relative to the

industry in which it operates

the reasons corporate governance risk is important and how itcan be mitigated

key financial ratios the relationship between corporate bond credit analysis and

common stock analysis


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Overvie of Bond Credit Analysis

In the analysis of the default risk of a corporatebond issuer and specific bond issues, there arethree areas that are analyzed by bond creditanalysts.

These three areas are:. the protections afforded to bondholders that are

provided by covenants limiting management’sdiscretion

!. the collateral available for the bondholder should

the issuer fail to make the re"uired payments

#. the ability of an issuer to make the contractualpayments to bondholders


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Overvie of Bond Credit Analysis$continued%

Analysis of Covenants &n analysis of the indenture is part of a credit review of a

corporation’s 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 analyzed carefully. There are two general types of covenants.

i. &ffirmative covenants call upon the corporation to makepromises to do certain things.

ii. 'egative covenants, also called restrictive covenants, re"uirethat the borrower not take certain actions.

There are an infinite variety of restrictions that can be placedon borrowers in the form of negative covenants.


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Analysis of Covenants

(ome of the more common restrictive covenants includevarious limitations on the company’s ability to incur debt.

)ondholders may want to include limits on the absolutedollar amount of debt that may be outstanding or mayre"uire some type of fi*ed charge coverage ratio test.

The two most common tests are the maintenance test andthe debt incurrence test.

The maintenance test re"uires the borrower’s ratio ofearnings available for interest or fi*ed charges to be at least

a certain minimum figure on each re"uired reporting date$such as "uarterly or annually% for a certain precedingperiod.



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The debt incurrence test only comes into play whenthe company wishes to do additional borrowing.

In order to take on additional debt, the re"uired

interest or fi*ed charge coverage figure adjusted forthe new debt must be at a certain minimum level forthe re"uired period prior to the financing.

+ebt incurrence tests are generally considered lessstringent than maintenance provisions.

There could also be cash flow tests $or cash flowre"uirements% and working capital maintenanceprovisions.



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(ome indentures may prohibit subsidiaries fromborrowing from all other companies e*cept the parent.

estricted subsidiaries are those considered to be

consolidated for financial test purposes- unrestrictedsubsidiaries $often foreign and certain specialpurposecompanies% are those e*cluded from the covenantsgoverning the parent.

/ften, subsidiaries are classified as unrestricted in

order to allow them to finance themselves throughoutside sources of funds.




Analysis of Collateral

& corporate debt obligation can be secured or unsecured.

In the case of the li"uidation of a corporation, proceedsfrom a bankruptcy are distributed to creditors based on

the absolute priority rule. 0hat is typically observed is that the corporation’s

unsecured creditors may receive distributions for theentire amount of their claim and common stockholdersmay receive some distribution, while secured creditors

may receive only a portion of their claim. The claim position of a secured creditor is important in

terms of the negotiation process.




Assessing an !ssuer"s Ability to #ay

The ability of an issuer to generate cash flow goesconsiderably beyond the calculation and analysis ofa myriad of financial ratios and cash flow measures

that can be used as a basic assessment of acompany’s financial risk.

&n evaluation of an issuer’s ability to pay involvesanalysis of

i. business riskii. corporate governance risk

iii. financial risk




Analysis of Business $is%

)usiness risk is defined as the risk associated withoperating cash flows.

/perating cash flows are not certain because therevenues and the e*penditures comprising the cash

flows are uncertain.

&n analysis of industry trends is important because itis only within the conte*t of an industry that companyanalysis is valid. Industry consideration should be

considered in a global conte*t. The need for many companies to become globally

competitive increases as the barriers to internationaltrade are broken down.



Analysis of Business $is%$continued%

It has been suggested that the following areas willprovide a credit analyst with a sufficient framework toproperly interpret a company’s economic prospects:

. economic cyclicality

!. growth prospects#. research and development e*penses

1. competition

2. sources of supply

3. degree of regulation

4. labor

These general areas encompass most of the areasthat the rating agencies have identified for assessingbusiness risk.



/ne of the first areas of analysis is investigating howclosely the industry follows gross domestic product$5+6% growth.

This is done in order to understand the industry’s

economic cyclicality. elated to the analysis of economic cyclicality are thegrowth prospects of the industry.

This re"uires an analysis as to whether the industry’sgrowth is projected to increase and thereafter be

maintained at a high level or is it e*pected to decline. To assess the growth prospects, a credit analyst will

have to investigate the dependence on research anddevelopment $7+% e*penditures for maintaining ore*panding the company’s market position.




0ith respect to regulation, the concern should not bewith its e*istence or absence in an industry per se.

ather, the focus with respect to regulation should beon the direction of regulation and its potential impacton the current and prospective profitability of thecompany.

egulation also encompasses government interventionin non89.(. operations of a company

& key component in the cost structure of an industry is

labor. In analyzing the labor situation, the credit analyst wille*amine if the industry is heavily unionized.

In nonunionized companies, the credit analyst will lookat the prospect of potential unionization.



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Corporate Governance $is%

orporate governance issues involve. the ownership structure of the corporation!. the practices followed by management#. policies for financial disclosure

The eagerness of corporate management to present favorableresults to shareholders and the market has been a major factor inseveral of the corporate scandals in recent years.

hief e*ecutive officers, chief financial officers, and the board ofdirectors are being held directly accountable for disclosures infinancial statements and other corporate decisions.

The underlying economic theory regarding many of the corporate

governance issues is the principalagency relationship between thesenior managers and the shareholders of corporations. The agent, a corporation’s senior management, is charged with the

responsibility of acting on behalf of the principal, the shareholders ofthe corporation.


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There are mechanisms that can mitigate thelikelihood that management will act in its own selfinterest.

The mechanisms fall into two general categories.

The first mechanism is to more strongly align theinterests of management with those of shareholders.

This can be accomplished by granting managementan economically meaningful e"uity interest in thecompany.

&lso, manager compensation can be linked to theperformance of the company’s common stock.

Corporate Governance $is% $continued%


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The second mechanism $that can mitigate the likelihoodthat management will act in its own selfinterest% is bymeans of the company’s internal corporate controlsystems, which can provide a way for effectivelymonitoring the performance and decisionmaking behavior

of management. 0hat has been clear in corporate scandals is that there

was a breakdown of the internal corporate control systemsthat lead to corporate difficulties and the destruction ofshareholder wealth.

)ecause of the important role played by the board ofdirectors, the structure and composition of the board arecritical for effective corporate governance.

The key is to remove the influence of the ;/ and seniormanagement on board members.



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(everal organizations have developed services thatassess corporate governance and e*press their viewin the form of a rating.

5enerally, these ratings are made public at the

option of the company re"uesting an evaluation. /ne such service is offered by (76, which produces

a orporate 5overnance (core based on a review ofboth publicly available information, interviews withsenior management and directors, and confidentialinformation that (76 may have available from itscredit rating of the corporation’s debt.



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In addition to corporate governance, credit analystslook at the quality of management in assessing acorporation’s ability to pay.

In assessing management quality ,


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&inancial $is%

=aving achieved an understanding of acorporation’s business risk and corporategovernance risk, the analyst is ready to move on toassessing financial risk.

This involves traditional ratio analysis and otherfactors affecting the firm’s financing.

(ome of the more important financial ratios are:interest coverage, leverage, cash flow , net assets,and working capital .

/nce these ratios are calculated, it is necessary toanalyze their absolute levels relative to those of theindustry.


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&inancial $is% $continued%

)efore performing an analysis of the financial statement, theanalyst must determine if the industry in which the companyoperates has any special accounting practices, such as those inthe insurance industry.

If so, an analyst should become familiar with industry practices.


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!nterest Coverage

&n interest coverage ratio measures the number of timesinterest charges are covered on a preta* basis.

Typically, interest coverage ratios that are used and publishedare preta* as opposed to afterta* because interest payments

are a preta* e*pense. 6reta* interest coverage ratio is calculated by dividing preta*

income plus interest charges by total interest charges. The higher this ratio, the lower the credit risk, all other factors

the same. & calculation of simple preta* interest coverage would be

misleading if there are fi*ed obligations other than interest thatare significant.

> In this case, a more appropriate coverage ratio would includethese other fi*ed obligations, and the resulting ratio is called afi*ed charge coverage ratio.



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Leverage

0hile there is no one definition for leverage, the most commonone is the ratio of longterm debt to total capitalization.

If there is a higher level of debt then a higher percentage ofoperating income must be used to satisfy fi*ed obligations.

In analyzing a highly leveraged company $i.e., a company with ahigh leverage ratio%, the margin of safety must be analyzed.

The margin of safety is defined as the percentage by whichoperating income could decline and still be sufficient to allow thecompany to meet its fi*ed obligations.

ecognition must be given to the company’s operating leases.



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Cash &lo

The statement of cash flows is re"uired to bepublished in financial statements along with theincome statement and balance sheet.

The statement of cash flows is a summary over aperiod of time of a company’s cash flows broken outby operating, investing, and financing activities.

&nalysts reformat this information, combining it withinformation from the income statement to obtain

what they view as a better description of thecompany’s activities.



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Cash &lo

(76 calculates what it refers to as funds from operations $definedas net income adjusted for depreciation and other noncash debitsand credits%.

Operating cash flow is funds from operations reduced by changes inthe investment in working capital $current assets less currentliabilities%.

(ubtracting capital e*penditures gives what (76 defines as freeoperating cash flow .

It is from this cash flow that dividends and ac"uisitions can bemade.

+educting cash dividends from free operating cash flow gives

discretionary cash flow. &djusting discretionary cash flow for managerial discretionary

decisions for ac"uisition of other companies, the disposal of assets$e.g., lines of business or subsidiaries%, and other sources or uses ofcash gives prefinancing cash flow .



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'et Assets

& fourth important ratio is net assets to total debt .

In the analysis of this ratio, consideration should begiven to the li"uidation value of the assets.

Liquidation value will often differ dramatically fromthe value stated on the balance sheet.

onsideration should be given to several other

financial variables including intangible assets,pension liabilities, and the age and condition of theplant.



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(or%ing Capital

Working capital is defined as current assets lesscurrent liabilities.

0orking capital is considered a primary measure of

a company’s financial fle*ibility. /ther such measures include the current ratio

$current assets divided by current liabilities% and theacid test $cash, marketable securities, andreceivables divided by current liabilities%.

The stronger the company’s li"uidity measures, thebetter it can weather a downturn in business andreduction in cash flow.



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Corporate Bond Credit Analysisand E)uity Analysis

The analysis of business risk, corporate governancerisk, and financial risk involves the same type ofanalysis that a common stock analyst wouldundertake.


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Corporate Bond Credit Analysisand E)uity Analysis $continued%

*tephen &+ Esser $?=igh@ield )ond &nalysis: The ;"uity6erspective,A in &shwinpaul . (ondhi $ed.%, Credit Analysisof Nontraditional ebt !ecurities $harlottesville, B&:&ssociation for Investment


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ey #oints

● orporate bond credit analysis involves an assessment ofbondholder protections set forth in the bond indenture, thecollateral available for the bondholder should the issuer fail tomake the re"uired payments, and the capacity of an issuer tofulfill its payment obligations.

●

ovenants contained in the bond indenture set forth limitationson management and, as a result, provide safeguard provisionsfor bondholders. 0hile collateral analysis is important, there is a"uestion of what a secured position means in the case of areorganization if the absolute priority rule is not followed in areorganization.

●

In assessing the ability of an issuer to service its debt, analystslook at a myriad of financial ratios as well as "ualitative factorssuch as the issuer’s business risk and corporate government risk.


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ey #oints $continued%

● In assessing the ability of an issuer to service its debt, analysts assessthe issuer’s business risk, corporate governance risk, and financialrisk. )usiness risk is the risk associated with operating cash flows. Inassessing business risk, some of the main factors considered areindustry characteristics and trends, the company’s market andcompetitive positions, management characteristics, and national

political and regulatory environment.● orporate governance risk involves assessing $% the ownership

structure of the corporation, $!% the practices followed bymanagement, and $#% policies for financial disclosure.

● &ssessing financial risk involves traditional ratio analysis and otherfactors affecting the firm’s financing. The more important financial

ratios analyzed are interest coverage, leverage, cash flow, net assets,and working capital.

● (ome fi*ed income portfolio managers strongly believe that corporatebond analysis should be viewed from an e"uity analyst’s perspective.This is particularly the case in analyzing highyield bonds.

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Fabozzi Bmas8 Ppt Ch20ge