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Fixed Income Analysis Session 8 General Principles of Credit Analysis.

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1 Fixed Income Analysis Session 8 General Principles of Credit Analysis

2 General Principles of Credit Analysis by Frank J. Fabozzi Copyright 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. PowerPoint Slides by David S. Krause, Ph.D., Marquette University

3 Chapter 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 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

4 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.

5 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.

6 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.

7 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.

8 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.

9 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

10 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

11 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

12 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.

13 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.

14 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.

15 Moody’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 notches Negative outlookReduce current rating by one rating notch Stable outlookKeep current rating Positive outlookIncrease current rating by one rating notch

16 S&P Business and Financial Risk Profile

17 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.

18 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).

19 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.

20 U.S. Investment Grade Corporate Bonds Historical Spreads 1995 – 2005 Source: Lehman Brothers

21 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.

22 Evaluating default risk: Bond ratings Bond ratings are designed to reflect the probability of a bond issue going into default. Investment GradeJunk Bonds Moody’s Aaa Aa A BaaBa B Caa C S & P AAA AA A BBBBB B CCC D

23 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

24 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

25 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.

26 Measuring Default Risk

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28 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.

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30 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

31 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

32 The Key S&P Ratios

33 S&P Financial Risk Ratios

34 S&P Method for Measuring Firm Cash Flow

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

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

37 Cash Flow / Total Debt

38 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

39 Altman’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 equation where Z = 0 if firm becomes bankrupt and = 1 if firm does not. X 1 =Working Capital / Total Assets X 2 =Retained Earnings / Total Assets X 3 =EBIT / Total Assets X 4 =Market Value of Equity / Book Value Long-Term Debt X 5 =Sales / Total Assets

40 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 loan If Z < assign to bankrupt group and deny loan. Altman’s Z-Score Model (continued)

41 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

42 Altman’s Zeta Credit Risk score

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