Fixed Income Analysis Session 8 General Principles of Credit Analysis.

Fixed Income Analysis

Session 8 General Principles of Credit Analysis

General Principles of Credit Analysis

by Frank J. Fabozzi

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PowerPoint Slides byDavid S. Krause, Ph.D., Marquette University

Chapter 15General Principles of Credit Analysis

• Major learning outcomes:– Elements of fixed income credit risk, including:

• The risk that the issuer will default on its obligations• The risk that the bond’s value will decline or the return will be

worse than benchmark investments.

– The four general approaches to gauging credit risk:• Credit ratings• Traditional credit analysis• Credit scoring models• Credit risk models

Key Learning Outcomes

• Distinguish among default risk, credit spread risk, and downgrade risk.

• Describe the meaning of credit ratings, rating watches, and rating outlooks.

• Explain how credit analysis encompasses assessing the borrower’s character (including the quality of management) and capacity to repay (including sources of liquidity), and the issue’s underlying collateral and covenants.

• Compute the key ratios used by credit analysts to assess the ability of a company to satisfy its debt obligations and explain the limitations of these ratios.

Key Learning Outcomes

• Evaluate the credit quality of an issuer of a corporate bond, given such data as key financial ratios for the issuer and the industry.

• Evaluate the credit quality of an asset-backed, non-agency mortgage-backed security, municipal bond, or sovereign bond, given information about the issuer.

• Describe corporate governance ratings.

• Discuss why and how cash flow from operations is used to assess the ability of an issuer to service its debt obligations and to assess the financial flexibility of a company.

Key Learning Outcomes

• Describe the various covenants and discuss their importance in assessing credit risk for both investment grade and non-investment grade companies.

• Explain the typical elements of the debt structure of a high-yield issuer, the interrelationships among these elements, and the impact of these elements on the risk position of the lender.

• Explain the importance of the corporate structure of a high-yield issuer that has a holding company.

• Explain why some investors advocate using an equity perspective when analyzing the creditworthiness of high-yield issues.

Key Learning Outcomes

• Discuss the factors considered by rating agencies in rating asset-backed securities (i.e., collateral credit quality, seller/servicer quality, cash flow stress and payment structure, and legal structure).

• Explain how the creditworthiness of municipal bonds is assessed, and contrast the analysis of tax-backed debt with the analysis of revenue obligations.

• Discuss the key economic and political risks considered by Standard & Poor’s in assigning sovereign ratings.

• Explain why two ratings are assigned to each national government and discuss the key factors emphasized by Standard & Poor’s for each rating.

Key Learning Outcomes

• Contrast the credit analysis required for corporate bonds with that required for: (1) asset-backed securities, (2) municipal securities, and (3) sovereign debt.

• Describe what a credit scoring model is and its limitations in predicting corporate bankruptcy.

• Explain structural and reduced form credit risk models and compare these two types of models.

Credit Analysis• The risk that the issuer will default on its

obligations is called credit risk

• The risk the bond’s value will decline or the return will be worse than benchmark investments is either:

• Credit spread risk - higher than expected or increased credit spread during the life of the bond or

• Downgrade risk – lowering of the credit rating

Credit Analysis• The credit analysis of an entity (firm,

municipality, or government body) involves the analysis of various past, present, and future quantitative and qualitative factors.

• The three topics covered in the chapter include:– Credit ratings– Traditional credit analysis– Credit scoring models

Credit or Bond Ratings• A credit or bond rating is the formal opinion given by a rating

agency (Moody’s, Standard & Poor’s, Fitch Ratings, etc.) on the amount of default risk a bond or the issuing entity possesses.

• A credit or bond rating is an evaluation of the possibility of default by a bond issuer, based on an in-depth analysis of the issuer's financial condition and profit potential

• Bond ratings start at AAA (being the highest investment quality) and end at D (in payment default)– These may be modified by plus or minus to show relative

standing within the category– There are a total of 20 classes or grades

Credit or Bond Rating Process• Ratings occur because the bond issuing entity requests the

rating(s) firm to issue a specific credit rating.

• The bond rating cost is paid by the issuing entity.– The request is made because without one, it would be difficult for the

entity to issue the bond.

• The rating applies to the specific bond being issued, not the entity requesting the rating.– Ratings may also be provided for firms that have no specific public debt

outstanding, but are parties to various private financial transactions.

Why Bond Ratings?• Ratings provide an insight in the default probability / likelihood

of individual firms or governmental institutions (municipal bonds).

• Ratings are taken as prime ingredient in fixing appropriate interest rate on loans, bonds, and other fixed income instruments

• Once a credit rating is assigned to an obligation, the rating agency will monitor the credit quality of the issuer and can reassign a different rating to its bonds.

Corporate Bond Credit Ratings

• A corporation usually subscribes to several bond rating agencies for a credit evaluation of a new bond issue.

• Each contracted rating agency will then provide a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition.– The best known rating agencies in the U.S. are Moody’s

Investors Services and Standard & Poor’s Corporation.– Rating agencies in the U.S. also include Duff and Phelps;

Fitch Investors Service; and McCarthy, Crisanti, and Maffei.

Moody’s Rating SuggestionsFor issues on: Suggestion:

Downgrade watch Reduce current rating by 2 notches (i.e. a Baa2 reduction would go to Ba1)

Upgrade watch Increase current rating by 2 notches

Negative outlook Reduce current rating by one rating notch

Stable outlook Keep current rating

Positive outlook Increase current rating by one rating notch

S&P Business and Financial Risk Profile

The Importance of Corporate Bond Credit Ratings

• Only a few institutional investors have the resources and expertise necessary to evaluate correctly the credit quality of a particular bond.

• Many financial institutions have prudent investment guidelines stipulating that only securities with a certain level of investment safety may be included in their portfolios.

• The bond ratings are vitally important to many firms.

Ratings Change• Credit “upgrades” occurs when there is an improvement in the credit

quality of an issue. A “downgrade” occurs when there is a deterioration in the issuer’s credit quality.

• Typically, before a rating change occurs the rating agency will announce in advance that it is reviewing the issue for upgrade or downgrade potential:– The issue is referred as being on a “rating or credit watch”– A decision is usually announced within 3 months

• Rating agencies will issue “outlooks.” A rating outlook is a projection of whether an issue is likely to be upgraded, downgraded, or remain stable over the long-run (6 months to 2 years into the future).

The Yield Spread

• A bond’s credit rating helps determine its yield spread.

• The yield spread is the extra return (increased yield to maturity) that investors demand for buying a bond with a lower credit rating (and higher risk).

• Yield spreads are often quoted in basis points over Treasury notes and bonds. That is,– A 5-year Aaa/AAA yield spread equal to 59 means the

YTM on this bond is 59 basis points (0.59%) greater than a 5-year U.S. Treasury notes.

U.S. Investment Grade Corporate BondsHistorical Spreads 1995 – 2005

Source: Lehman Brothers

0

100

200

300

400

500

600

700

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Sp

read

in

Bas

is P

oin

ts

All AA 10 Yr All A 10 Yr All BBB 10 Yr All BB 10 Yr

Default Risk

• If an issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return.

• Credit rating are influenced by the issuer’s financial strength and the terms of the bond contract - they are the assessment of the amount of default risk associated with a bond issue.

Evaluating default risk: Bond ratings

• Bond ratings are designed to reflect the probability of a bond issue going into default.

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S & P AAA AA A BBB BB B CCC D

Financial Factors Affecting Default Risk and Ratings

• Financial performance– Debt ratio– Coverage (TIE) ratio– Current ratio

• Bond contract provisions– Secured vs. unsecured debt– Senior vs. subordinated debt– Guarantee and sinking fund provisions– Debt maturity

Business Factors Affecting Default Risk

• Earnings stability• Regulatory environment• Potential antitrust or product liabilities• Pension liabilities• Potential labor problems• Accounting policies• Management strength and experience

Default Rate and Default Loss Rate

• The bond rating agencies will report the percentage of bonds of a given rating (and sector) that have defaulted during a period of time – default rate.

• The agencies also measure the financial magnitude of the potential losses related to default – default loss rate.

Measuring Default Risk

Measuring Default Risk

Effectiveness of Ratings• Studies have shown that ratings (including watches

and outlooks) provide a high degree of accuracy in predicting financial difficulties of an issuer.

– Issues that had a negative rating outlook at the beginning of the year had a one-year default rate that was 4 times greater than issues that had a positive rating outlook.

Traditional Credit Analysis

• Capacity – ability to repay• Collateral – assets pledged to secure debt,

quality and value of unpledged assets• Covenants – terms and conditions of the

lending agreement• Character – Ethical reputation, business

qualifications, operating record of the board of directors and management

Capacity: Factors Examined by Credit Analysts

• Industry trends• Regulatory environment• Basic operating and competitive position• Financial position and liquidity• Capital structure• Parent / holding company agreements• Special event risk

The Key S&P Ratios

S&P Financial Risk Ratios

S&P Method for Measuring Firm Cash Flow

Median Financial Ratios (S&P) by Credit Rating - Industrials

Median Financial Ratios (S&P) by Credit Rating – Utilities

Cash Flow / Total Debt

-0.3

-0.2

-0.10

0.1

0.2

0.30.4

0.5

0.6

5 4 3 2 1

Years before failure

Nonfailedfirms

Failed firms

• Credit scoring models use historical data on loan defaults or business bankruptcies to predict the likelihood of default for new loan applicants. The models’ results can be used to» Decide whether a loan request should be approved.» Decide the terms of a loan: maximum amount lent (credit

limit) and interest rate (credit spread).

• The benefits of credit scoring models are» Provide a rigorous, objective method for using financial

data to screen the credit of loan applicants.» Reduces lenders’ time and cost of making loan decisions.

Credit Scoring Models

Altman’s Z-Score ModelThis uses a statistical technique, Multiple Discriminate Analysis

(also could use logit or probit analysis) to classify firms into those likely to become bankrupt or non-bankrupt over a given future horizon.

Past financial data on firm financial ratios and bankruptcies were used to estimate the regression equation

where Z = 0 if firm becomes bankrupt and = 1 if firm does not.X1=Working Capital / Total AssetsX2=Retained Earnings / Total AssetsX3=EBIT / Total AssetsX4=Market Value of Equity / Book Value Long-Term DebtX5=Sales / Total Assets

1 2 3 4 51.2 1.4 3.3 0.6 1.0Z X X X X X

• The higher is Z, the lower is the firm’s estimated risk of bankruptcy.

• For a given Type I error (classifying firm as not bankrupt when it is) and a given Type II error (classifying a firm as bankrupt when it is not), a critical value of Z could be used to approve or deny a loan. For example: If Z 2.675 assign to non-bankrupt group and approve loan If Z < 2.675 assign to bankrupt group and deny loan.

Altman’s Z-Score Model (continued)

Altman Zeta Model

• Zeta Credit Risk rating is a multivariate model created by Altman which includes 7 financial ratios measuring: – Profitability, financial leverage, liquidity, earnings

stability, etc.• It is an upgrade of the original Z-score model

Altman’s Zeta Credit Risk score

-4

-3

-2

-1

0

1

2

3

4

5

5 4 3 2 1

Years prior to bankruptcy

Nonbankruptfirms

Bankruptfirms

Altman’s Zeta Credit Risk score

0

2

4

6

8

10

12

14

16

Score

Nu

mb

er

of

firm

s

Bankrupt Zone

Nonbankrupt Zone