Presentation on theme: "Session 8 General Principles of Credit Analysis"— Presentation transcript:
1Session 8 General Principles of Credit Analysis Fixed Income AnalysisSession 8General Principles of Credit Analysis
2General Principles of Credit Analysis by Frank J. Fabozzi PowerPoint Slides byDavid S. Krause, Ph.D., Marquette UniversityCopyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.
3Chapter 15 General Principles of Credit Analysis Major learning outcomes:Elements of fixed income credit risk, including:The risk that the issuer will default on its obligationsThe 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 ratingsTraditional credit analysisCredit scoring modelsCredit risk models
4Key Learning OutcomesDistinguish 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.
5Key Learning OutcomesEvaluate 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.
6Key Learning OutcomesDescribe 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.
7Key Learning OutcomesDiscuss 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.
8Key Learning OutcomesContrast 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.
9Credit AnalysisThe risk that the issuer will default on its obligations is called credit riskThe 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 orDowngrade risk – lowering of the credit rating
10Credit AnalysisThe 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 ratingsTraditional credit analysisCredit scoring models
11Credit or Bond RatingsA 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 potentialBond 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 categoryThere are a total of 20 classes or grades
12Credit 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.
13Why 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 instrumentsOnce 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.
14Corporate 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.
15Moody’s Rating Suggestions For issues on:Suggestion:Downgrade watchReduce current rating by 2 notches (i.e. a Baa2 reduction would go to Ba1)Upgrade watchIncrease current rating by 2 notchesNegative outlookReduce current rating by one rating notchStable outlookKeep current ratingPositive outlookIncrease current rating by one rating notch
17The 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.
18Ratings ChangeCredit “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 monthsRating 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).
19The Yield SpreadA 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.
21Default RiskIf 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.
22Evaluating default risk: Bond ratings Investment GradeJunk BondsMoody’sAaa Aa A BaaBa B Caa CS & PAAA AA A BBBBB B CCC DBond ratings are designed to reflect the probability of a bond issue going into default.
23Financial Factors Affecting Default Risk and Ratings Financial performanceDebt ratioCoverage (TIE) ratioCurrent ratioBond contract provisionsSecured vs. unsecured debtSenior vs. subordinated debtGuarantee and sinking fund provisionsDebt maturity
24Business Factors Affecting Default Risk Earnings stabilityRegulatory environmentPotential antitrust or product liabilitiesPension liabilitiesPotential labor problemsAccounting policiesManagement strength and experience
25Default 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.
28Effectiveness 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.
30Traditional Credit Analysis Capacity – ability to repayCollateral – assets pledged to secure debt, quality and value of unpledged assetsCovenants – terms and conditions of the lending agreementCharacter – Ethical reputation, business qualifications, operating record of the board of directors and management
31Capacity: Factors Examined by Credit Analysts Industry trendsRegulatory environmentBasic operating and competitive positionFinancial position and liquidityCapital structureParent / holding company agreementsSpecial event risk
38Credit Scoring ModelsCredit 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 toDecide 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 areProvide a rigorous, objective method for using financial data to screen the credit of loan applicants.Reduces lenders’ time and cost of making loan decisions.
39Altman’s Z-Score Model This 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 equationwhereZ = 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
40Altman’s Z-Score Model (continued) 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 assign to non-bankrupt group and approve loanIf Z < assign to bankrupt group and deny loan.
41Altman Zeta ModelZeta 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