1. Kuliah 7

2.  General Principles of Credit Analysis

3. General Principles of Credit Analysis Credit Analysis for Corporate Bond Credit Risk Seniority Ranking Credit Rating Yield Spread Element of Credit Analysis capacity Collateral Covenants Character Credit Analysis for High Yield Bonds Sovereign Bonds Municipal Bonds

4. Default Risk Risk that borrower will not repay the obligation Credit Spread Risk Risk that credit spread will increase, resulting the value to decrease Downgrade Risk Risk of being downgraded by rating agencies

5. Default Risk Probability Borrower fails to pay interest and repay principal when due Loss Severity Value an investor will lose if issuer default. Can be stated as a monetary value of percentage Recovery Rate Percentage of bond’s an investor will receive if issuer default. 1- Loss Severity

6. Secured Debt First Lien or First Mortgage Senior Secured Debt Junior Secured Debt Unsecured Debt Senior Unsecured Debt Senior Subordinated Debt Subordinated Debt Junior Subordinated Debt

7. Credit rating agencies (S&P’s, Moody’s, and Fitch) assess only Default risk Credit rating reflects probability of default Rating watch Short Term Projection (3 months) Rating outlook longer term projection (6- 24 months)

8. Credit rating agencies (S&P’s, Moody’s, and Fitch) assign ratings to categories of bonds with similar credit risk Corporate Family Rating (Issuer Credit Ratings) Corporate Credit Rating (Issue-specific ratings) Notching (different rating assignment to bonds same issuer)

9. Rating Scale

10. Four Risk of Credit Rating Credit rating are dinamyc Rating Agencies are not perfect Event risk is difficult to assess Credit rating lag market price

11. Spread Risk (Risk Premium) Credit Risk Liquidity Risk Factors affected Credit cycle Economic conditions Financial market performance Broker-dealer capital General market demand and supply

12. Capacity Ability of an issuer to repay its obligation Collateral Quality and value of assets pledged to secure debt Covenant Restriction contained in the lending agreement. It helps to prevent transfer of wealth from debt holders to equity holders Character Management’s capability, credibility and commitment to repay debt

13. Industry Structure Industry Fundamental Company Fundamental

14. Porter’s five forces Industry Structure Industry cyclicality Industry Growth Prospect Industry Published Statistic Industry Fundamentals Competitive Position Operating History Management’s strategy and execution Ratios and ratio analysis Company Fundamentals

15. Traditional Ratios Profitability Ratios ROEROA Profit Margin Asset Turnover Debt and Coverage Analysis Short Term Solvency Ratios Capitali- zation Ratios Coverage Tests Cash Flow Analysis Cash Flow Measu- res Cash Flow Ratios

16. Short Term Solvency ratios Capitalization Ratios

17. Coverage Test

18. Cash Flow Measures

19. Example Example: PT. ABC’s credit quality has declined relative to rating’s guideline for A- rating. Downgrade is likely

20. Traditional Ratios Traditional ratios is not sufficient to identify companies encountering financial difficulties Traditional ratios may show some down trends but provide no clues to company’s impending bankruptcy Cash Flow Analysis Study of cash flows from operations can reveal that company operations were causing an increase drain on cash rather than providing cash

21. Issue to consider Intangible Assets. Depreciation Equity market Capitalization Human and intellectual capital

22. Purpose Covenants are created to protect interest of bondholders Failure to comply covenants : Technical Default Types of Covenant Affirmative covenants: require debtor to do certain things Negative covenants: prohibit debtor from doing certain things (ie. No additional borrowing, limitation on dividend payment, stock repurchase)

23. Quality of Management In assessing quality of management, the following should be considered: Soundness of Strategy Track record Accounting Policies and Tax Strategies Fraud and malfeasance record Prior treatment of bondholders

24. High Yield Bonds Issuers usually employ holding company structure Debt borrowed at parent level, while funds to pay obligation are obtained from operating subsidiaries Hence, subsidiaries’ financial ratios and debt covenants need to be examined Are there restrictions on dividend payments ? Are intercompany loans permitted? Are there restrictions on asset sale? High yields bonds is usually subordinated to bank loan. Priority of payment need to considered

25. Sovereign Debt 2 factors considered by rating agencies when evaluating Sovereign Debt Economic risk: ability of a national government to meet its debt obligation (eg. budget, tax collection, public debt burden, inflation, BOP, external debt, etc) Political risk: willingness of a national government to meet its debt obligation (eg. political stability, security issues, succession, etc)

26. Sovereign Debt 2 rating assigned to each government, because defaults on foreign currency debt historically greater than local currency debt Local currency debt rating - consider policies that foster or impede timely debt service (eg. tax discipline, budgetary record, monetary policy, inflation, debt service record, government debt burden) Foreign currency debt rating - focus on BOP, Trade balance, structure of external balance sheet.

27. Municipal Bonds Tax-backed Bond issued by municipalities and secured by tax revenue Revenue Bond secured by revenue generated by projects/ enterprises finance by the bond

28. Tax backed Bonds Analysis Issuer’s debt structure: debt per resident in tax jurisdiction Budgetary policy: indicate degree of financial and political discipline Tax revenue availability: tax collection rate Socioeconomic environment: trend in local employment level Revenue Bonds Analysis Analyzing the credit risk of Revenue bond are the same as for a Corporate bond Debt Service Coverage Ratio (DSCR) ratio of the project’s net revenue to the required interest and principal payments Covenants that ensure revenues are not directed for other purposes

29. Comparison For Corporate Issuer two Most important factors are capacity and CG structure For ABS the most important factor is an assessment of collateral credit quality For Municipal Bonds very similar with Corporate Issuer. The differencies is that revenue bonds have rate covenant and priority of revenue claim clause For Sovereign Issuer two Most important factors are ability to pay (economic risk) and willingness to pay (political risk)