Global Edition

Chapter 20
Corporate Bond
Credit Analysis

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 companys 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
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 managements
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

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
corporations 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.

2013 Pearson Education

Overview of Bond Credit Analysis

(continued)

Analysis of Covenants

Some of the more common restrictive covenants include

various limitations on the companys 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 borrowers 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.

2013 Pearson Education

Overview of Bond Credit Analysis

(continued)

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.

2013 Pearson Education

Overview of Bond Credit Analysis

(continued)

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.

2013 Pearson Education

Overview of Bond Credit Analysis

(continued)

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 corporations
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.

2013 Pearson Education

Overview of Bond Credit Analysis

(continued)

Assessing an Issuers 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
companys financial risk.
An evaluation of an issuers ability to pay involves
analysis of
i. business risk
ii. corporate governance risk
iii. financial risk

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.
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 companys 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.
2013 Pearson Education

Analysis of Business Risk

(continued)

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 industrys
economic cyclicality.
Related to the analysis of economic cyclicality are the
growth prospects of the industry.
This requires an analysis as to whether the industrys
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 companys market position.
2013 Pearson Education

Analysis of Business Risk

(continued)

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 nonU.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.
2013 Pearson Education

Corporate Governance Risk

1.
2.
3.

Corporate governance issues involve

the ownership structure of the corporation
the practices followed by management
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 corporations senior management, is charged with the
responsibility of acting on behalf of the principal, the shareholders of
the corporation.

2013 Pearson Education

Corporate Governance Risk

(continued)
There are mechanisms that can mitigate the
likelihood that management will act in its own selfinterest.
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 companys common stock.

2013 Pearson Education

Corporate Governance Risk

(continued)
The second mechanism (that can mitigate the likelihood
that management will act in its own self-interest) is by
means of the companys 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.
2013 Pearson Education

Corporate Governance Risk

(continued)
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 corporations debt.

2013 Pearson Education

Corporate Governance Risk

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

Financial Risk
Having achieved an understanding of a
corporations 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 firms 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.
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 companys
unadjusted and adjusted results.

2013 Pearson Education

Financial Risk (continued)

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.

2013 Pearson Education

Financial Risk (continued)

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 companys operating leases.

2013 Pearson Education

Financial Risk (continued)

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 companys 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
companys activities.

2013 Pearson Education

Financial Risk (continued)

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.

2013 Pearson Education

Financial Risk (continued)

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.

2013 Pearson Education

Financial Risk (continued)

Working Capital
Working capital is defined as current assets less
current liabilities.
Working capital is considered a primary measure of
a companys 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 companys liquidity measures, the
better it can weather a downturn in business and
reduction in cash flow.
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 analysts perspective.

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
companys 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 companys debt. All else being equal, the bonds
then become better credits and should go up in value
relative to competing bond investments.
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 issuers business risk and corporate government risk.

2013 Pearson Education

Key Points (continued)

In assessing the ability of an issuer to service its debt, analysts assess

the issuers 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 companys 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 firms 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 analysts perspective.
This is particularly the case in analyzing high-yield bonds.

2013 Pearson Education