1. Global Edition Chapter 20 Corporate Bond Credit Analysis

2. © 2013 Pearson Education Learning Objectives After reading this chapter, you will 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 issuer to 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 it can be mitigated  key financial ratios  the relationship between corporate bond credit analysis and common stock analysis

3. © 2013 Pearson Education Overview of Bond Credit Analysis  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.  These three areas are: 1.the protections afforded to bondholders that are provided by covenants limiting management’s discretion 2.the collateral available for the bondholder should the issuer fail to make the required payments 3.the ability of an issuer to make the contractual payments to bondholders

4. © 2013 Pearson Education Overview of Bond Credit Analysis (continued)  Analysis of Covenants  An 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.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 restrictions that can be placed on borrowers in the form of negative covenants.

5. © 2013 Pearson Education  Analysis of Covenants  Some of the more common restrictive covenants include various limitations on the company’s ability to incur debt.  Bondholders may want to include limits on the absolute 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 borrower’s ratio of earnings available for interest or fixed charges to be 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)

6. © 2013 Pearson Education  Analysis of Covenants  The debt incurrence test only comes into play when the company wishes to do additional borrowing.  In order 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 also be cash flow tests (or cash flow requirements) and working capital maintenance provisions. Overview of Bond Credit Analysis (continued)

7. © 2013 Pearson Education  Analysis of Covenants  Some indentures may prohibit subsidiaries from borrowing from all other companies except the parent.  Restricted subsidiaries are those considered 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 outside sources of funds. Overview of Bond Credit Analysis (continued)

8. © 2013 Pearson Education  Analysis 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 typically observed is that the corporation’s 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 in terms of the negotiation process. Overview of Bond Credit Analysis (continued)

9. © 2013 Pearson Education  Assessing an Issuer’s 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 assessment of a company’s financial risk.  An evaluation of an issuer’s ability to pay involves analysis of i.business risk ii.corporate governance risk iii.financial risk Overview of Bond Credit Analysis (continued)

10. © 2013 Pearson Education Analysis of Business Risk  Business risk is defined as the risk associated with operating cash flows.  Operating cash flows are not certain because the revenues and the expenditures comprising the cash flows are uncertain.  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.  The need for many companies to become globally competitive increases as the barriers to international trade are broken down.

11. © 2013 Pearson Education Analysis of Business Risk (continued)  It has been suggested that the following areas will provide a credit analyst with a sufficient framework to properly interpret a company’s economic prospects: 1.economic cyclicality 2.growth prospects 3.research and development expenses 4.competition 5.sources of supply 6.degree of regulation 7.labor  These general areas encompass most of the areas that the rating agencies have identified for assessing business risk.

12. © 2013 Pearson Education  One of the first areas of analysis is investigating how closely the industry follows gross domestic product (GDP) growth.  This is done in order to understand the industry’s economic cyclicality.  Related to the analysis of economic cyclicality are the growth prospects of the industry.  This requires an analysis as to whether the industry’s growth is projected to increase and thereafter be maintained at a high level or is it expected to decline.  To assess the growth prospects, a credit analyst will have to investigate the dependence on research and development (R&D) expenditures for maintaining or expanding the company’s market position. Analysis of Business Risk (continued)

13. © 2013 Pearson Education  With respect to regulation, the concern should not be with its existence or absence in an industry per se.  Rather, the focus with respect to regulation should be on the direction of regulation and its potential impact on the current and prospective profitability of the company.  Regulation also encompasses government intervention in non–U.S. operations of a company  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. Analysis of Business Risk (continued)

14. © 2013 Pearson Education Corporate Governance Risk  Corporate governance issues involve 1.the ownership structure of the corporation 2.the practices followed by management 3.policies for financial disclosure  The eagerness of corporate management to present favorable results to shareholders and the market has been a major factor in several 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.  The underlying economic theory regarding many of the corporate governance issues is the principal-agency relationship between the senior 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 of the corporation.

15. © 2013 Pearson Education  There are mechanisms that can mitigate the likelihood that management will act in its own self- interest.  The mechanisms fall into two general categories.  The first mechanism is to more strongly align the interests of management with those of shareholders.  This can be accomplished by granting management an economically meaningful equity interest in the company.  Also, manager compensation can be linked to the performance of the company’s common stock. Corporate Governance Risk (continued)

16. © 2013 Pearson Education  The second mechanism (that can mitigate the likelihood that management will act in its own self-interest) is by means of the company’s 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 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 board members. Corporate Governance Risk (continued)

17. © 2013 Pearson Education  Several organizations have developed services that assess corporate governance and express their view in the form of a rating.  Generally, these ratings are made public at the option of the company requesting an evaluation.  One such service is offered by S&P, which produces a Corporate Governance Score based on a review of both publicly available information, interviews with senior management and directors, and confidential information that S&P may have available from its credit rating of the corporation’s debt. Corporate Governance Risk (continued)

18. © 2013 Pearson Education  In addition to corporate governance, credit analysts look at the quality of management in assessing a corporation’s ability to pay.  In assessing management quality, Moody’s tries to understand the business strategies and policies formulated by management.  The factors Moody’s considers are: 1.strategic direction 2.financial philosophy 3.conservatism 4.track record 5.succession planning 6.control systems Corporate Governance Risk (continued)

19. © 2013 Pearson Education Financial Risk  Having achieved an understanding of a corporation’s business risk and corporate governance risk, the analyst is ready to move on to assessing financial risk.  This involves traditional ratio analysis and other factors affecting the firm’s financing.  Some of the more important financial ratios are: interest coverage, leverage, cash flow, net assets, and working capital.  Once these ratios are calculated, it is necessary to analyze their absolute levels relative to those of the industry.

20. © 2013 Pearson Education Financial Risk (continued)  Before 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.  Moreover, the analyst must review the accounting policies to determine whether management is employing liberal or conservative policies in applying generally accepted accounting principles (GAAP).  Since historical data are analyzed, the analyst should recognize that companies adjust prior years’ results to accommodate discontinued operations and changes in accounting that can hide unfavorable trends.  This can be done by assessing the trends for the company’s unadjusted and adjusted results.

21. © 2013 Pearson Education  Interest Coverage  An interest coverage ratio measures the number of times interest charges are covered on a pretax 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, 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 resulting ratio is called a fixed charge coverage ratio. Financial Risk (continued)

22. © 2013 Pearson Education  Leverage  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 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 meet its fixed obligations.  Recognition must be given to the company’s operating leases. Financial Risk (continued)

23. © 2013 Pearson Education  Cash Flow  The statement of cash flows is required 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 company’s cash flows broken out by operating, investing, and financing activities. Analysts reformat this information, combining it with information from the income statement to obtain what they view as a better description of the company’s activities. Financial Risk (continued)

24. © 2013 Pearson Education  Cash 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).  Operating cash flow is funds from operations reduced by changes in the investment in working capital (current assets less current liabilities).  Subtracting capital expenditures gives what S&P defines as free operating cash flow.  It is from this cash flow that dividends and acquisitions can be made.  Deducting cash dividends from free operating cash flow gives discretionary cash flow.  Adjusting discretionary cash flow for managerial discretionary decisions for acquisition of other companies, the disposal of assets (e.g., lines of business or subsidiaries), and other sources or uses of cash gives prefinancing cash flow. Financial Risk (continued)

25. © 2013 Pearson Education  Net Assets  A fourth important ratio is net assets to total debt.  In the analysis of this ratio, consideration should be given to the liquidation value of the assets.  Liquidation value will often differ dramatically from the value stated on the balance sheet.  Consideration should be given to several other financial variables including intangible assets, pension liabilities, and the age and condition of the plant. Financial Risk (continued)

26. © 2013 Pearson Education  Working Capital  Working capital is defined as current assets less current liabilities.  Working capital is considered a primary measure of a company’s financial flexibility.  Other such measures include the current ratio (current assets divided by current liabilities) and the acid test (cash, marketable securities, and receivables divided by current liabilities).  The stronger the company’s liquidity measures, the better it can weather a downturn in business and reduction in cash flow. Financial Risk (continued)

27. © 2013 Pearson Education Corporate Bond Credit Analysis and Equity Analysis  The analysis of business risk, corporate governance risk, and financial risk involves the same type of analysis that a common stock analyst would undertake.  Many fixed income portfolio managers strongly believe that corporate bond analysis, particularly high-yield bond analysis, should be viewed from an equity analyst’s perspective.

28. © 2013 Pearson Education Corporate Bond Credit Analysis and Equity Analysis (continued)  Stephen F. Esser (“High-Yield Bond Analysis: The Equity Perspective,” in Ashwinpaul C. Sondhi (ed.), Credit Analysis of Nontraditional Debt Securities (Charlottesville, VA: Association for Investment Management and Research, 1995), p. 54) writes : “For those who work with investing in high-yield bonds, whether issued by public or private companies, dynamic, equity-oriented analysis is invaluable. If analysts think about whether they would want to buy a particular high-yield company’s stock and what will happen to the future equity value of that company, they have a useful approach because, as equity values go up, so does the equity cushion beneath the company’s debt. All else being equal, the bonds then become better credits and should go up in value relative to competing bond investments.”

29. © 2013 Pearson Education Key Points ● Corporate bond credit analysis involves an assessment of bondholder protections set forth in the bond indenture, the collateral available for the bondholder should the issuer fail to make the required payments, and the capacity of an issuer to fulfill its payment obligations. ● Covenants contained in the bond indenture set forth limitations on management and, as a result, provide safeguard provisions for bondholders. While collateral analysis is important, there is a question of what a secured position means in the case of a reorganization if the absolute priority rule is not followed in a reorganization. ● In assessing the ability of an issuer to service its debt, analysts look at a myriad of financial ratios as well as qualitative factors such as the issuer’s business risk and corporate government risk.

30. © 2013 Pearson Education Key Points (continued) ● In assessing the ability of an issuer to service its debt, analysts assess the issuer’s business risk, corporate governance risk, and financial risk. Business risk is the risk associated with operating cash flows. In assessing business risk, some of the main factors considered are industry characteristics and trends, the company’s market and competitive positions, management characteristics, and national political and regulatory environment. ● Corporate governance risk involves assessing (1) the ownership structure of the corporation, (2) the practices followed by management, and (3) policies for financial disclosure. ● Assessing financial risk involves traditional ratio analysis and other factors affecting the firm’s financing. The more important financial ratios analyzed are interest coverage, leverage, cash flow, net assets, and working capital. ● Some fixed income portfolio managers strongly believe that corporate bond analysis should be viewed from an equity analyst’s perspective. This is particularly the case in analyzing high-yield bonds.