Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: daixieit

BFC3341 tutorial questions/solutions and readings

Chapter six, Part 2, BFC3341

DISCLAIMER

The following materials have been prepared by Dr Andrew Sanford for the convenience of BFC3341 students. The suggested solutions are summarized from the BFC3341 textbook and do not represent any original work by the preparer. Students can find all the suggested solutions in their textbook (Petitt 4th Edition).

Reference:

Petitt, Barbara S. Fixed Income Analysis,  4th Edition. John Wiley & Sons P&T, 20191017. VitalBook file.

PART 2

Please note: In addition to the prescribed questions and tasks assigned for Chapter 6 (Part 2), I have included several other ‘motivating’ questions (PreQ), to focus the suggested responses. - Dr Andrew Sanford.

Exercise 4: Section five is dedicated to industry practice on credit risk analysis.

PreQ: What is the role of credit analysis, and what is its main focus?

● The goal of credit analysis is to assess an issuer’s ability to satisfy its debt obligations, including bonds and other indebtedness, such as bank loans.

● The main focus in credit analysis is to understand a company’s ability to generate cash flow over the term of its debt obligations.

(Petitt, 20191017, p. 279) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: How does credit analysis differ from equity analysis?

● There are motivational differences, however, between equity and fixed-income investors that are an important aspect of credit analysis.

● Management works for the shareholders of a company.

● Its primary objective is to maximize the value of the company for its owners.

● In contrast, management’s legal duty to its creditors—including bondholders—is to meet the terms of the governing contracts.

(Petitt, 20191017, p. 280) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

(a) What is 4C analysis?

● Framework traditionally used for evaluating credit risk

● Comprises four dimensions

○ Capacity refers to the ability of the borrower to make its debt payments on time.

○ Collateral refers to the quality and value of the assets supporting the issuer’s indebtedness.

○ Covenants are the terms and conditions of lending agreements that the issuer must comply with.

○ Character refers to the quality of management. Each of these will now be covered in greater detail.

(Petitt, 20191017, p. 281) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

Task: In the first C, Capacity, understand industry structure, industry fundamental, company fundamentals and ratios and ratio analysis.

PreQ : What do we mean by industry structure?

● Framework for analysis of industry forces affecting the firm.

○ Threat of entry

○ Power of suppliers

○ Power of buyers/customers

○ Threat of substitutes

○ Rivalry amongst existing competition

PreQ: What do we mean by industry fundamentals?

● Firm’s sensitivity to macroeconomic factors

● Firm’s growth prospects,

● Firm’s profitability

● Firm’s need to maintain high credit quality.

PreQ: What do we mean by company fundamentals?

● Following analysis of an industry’s structure and fundamentals, the next step is to assess the fundamentals of the company: the corporate borrower. Analysts should examine the following:

○ Competitive position

○ Track record/operating history

○ Management’s strategy and execution

○ Ratios and ratio analysis

(Petitt, 20191017, pp. 282-283) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: What are the ratios and ratio analysis?

● A number of financial measures derived from the company’s principal financial statements are examined.

● Credit analysts calculate a number of ratios to assess the financial health of a company, identify trends over time, and compare companies across an industry to get a sense of relative creditworthiness.

● Typical values of these ratios vary widely from one industry to another because of different industry characteristics previously identified: competitive structure, economic cyclicality, regulation, and so on.

PreQ: What three categories can we divide these ratios into?

● Key credit analysis measures can be divided into three different groups:

● Profitability and cash flow

● Leverage

● Coverage

(Petitt, 20191017, p. 284) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

(b) Exercise literature reading the subsection on Ratios and ratio analysis from textbook page 284-295.

PreQ: What are the profitability ratios

Profitability

● Profitability and cash flow generation is what companies use to service their debt.

● Credit analysts look at operating profit margins and operating income to get a sense of a company’s underlying profitability and see how it varies over time.

● EBIT: Operating income = operating revenues - operating expenses and is commonly referred to as “earnings before interest and taxes” (EBIT).

● Focusing on EBIT is useful to determine a company’s performance prior to costs arising from its capital structure (i.e., how much debt it carries versus equity).

● And “before taxes” is used because interest expense is paid before income taxes are calculated.

● There are several measures of cash flow used in credit analysis; some are more conservative than others because they make certain adjustments for cash that gets used in managing and maintaining the business or in making payments to shareholders.

● The cash flow measures and leverage and coverage ratios discussed below are non-IFRS in the sense that they do not have official IFRS definitions; the concepts, names, and definitions given should be viewed as one usage among several possible, in most cases.

○ Earnings before interest, taxes, depreciation, and amortization (EBITDA)

○ Funds from operations (FFO)

○ Free cash flow before dividends (FCF before dividends)

○ Free cash flow after dividends (FCF after dividends)

(Petitt, 20191017, pp. 284-285) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: What are the leverage ratios?

Leverage ratios.

● The most common leverage ratios are the debt/capital, debt/EBITDA, and measures of funds or cash flows/debt ratios.

● Many analysts adjust a company’s reported debt levels for debt-like liabilities, such as underfunded pensions and other retiree benefits, as well as operating leases. When adjusting for leases, analysts will typically add back the imputed interest or rent expense to various cash flow measures.

○ Debt/capital.

○ Debt/EBITDA.

○ FFO/debt.

○ FCF after dividends/debt.

(Petitt, 20191017, p. 286) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: What are the coverage ratios?

Coverage ratios measure an issuer’s ability to meet—to “cover”—its interest payments. The two most common are the EBITDA/interest expense and EBIT/interest expense ratios.

● EBITDA/interest expense.

● EBIT/interest expense.

(c) Exercise literature reading on collateral, covenants, and character from textbook page 296-298.

PreQ: What is the purpose of collateral analysis?

● Low Credit Quality Companies: Collateral, or asset value, analysis is typically emphasized more with lower credit quality companies.

● Value and quality of assets are difficult to observe directly.

PreQ: What factors should a credit analysis consider?

● Factors to consider:

○ Nature and amount of intangible assets on the balance sheet. (i.e. Intellectual property, goodwill)

○ Amount of depreciation an issuer takes relative to its capital expenditures.

○ Equity market capitalization.

○ Reliance on human and intellectual capital rather than physical assets.

● Key point of collateral analysis is to assess the value of the assets relative to the issuer’s level—and seniority ranking—of debt.

(Petitt, 20191017, p. 295) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: What issues are there to covenants analysis?

● Covenants are an important but underappreciated part of credit analysis.

● Strong covenants protect bond investors from the possibility of management taking actions that would hurt an issuer’s creditworthiness.

● Bondholders are generally not able to negotiate strong covenants on most new bond issues.

● Covenants on new bond issues tend to be stronger during weak economic or market conditions because investors seek more protection during such times. There are a few organized institutional investor groups focused on strengthening covenants: the Credit Roundtable in the United States and the European Model Covenant Initiative in the United Kingdom.

● Covenant language is often very technical and written in “legalese,” so it can be helpful to have an in-house person with a legal background review and interpret the specific covenant terms and wording.

● One might also use a third-party service specializing in covenant analysis, such as Covenant Review.

PreQ: What issues should be considered in character analysis?

● Character of a corporate borrower can be difficult to observe. The analysis of character as a factor in credit analysis dates to when loans were made to companies owned by individuals.

● An assessment of the soundness of management’s strategy.

● Management’s track record in executing past strategies

● Use of aggressive accounting policies and/or tax strategies.

● These are potential warning flags to other behaviors or actions that may adversely impact an issuer’s creditworthiness.

● Any history of fraud or malfeasance—a major warning flag to credit analysts.

● Previous poor treatment of bondholders

(Petitt, 20191017, pp. 296-297) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

Exercise/Question 5: Section six is on credit risk vs. return.

Task: Read the whole section with special attention to page 300-307.

PreQ: What are the five components of corporate yields?

● Yield on corporate bond = Real risk-free interest rate

+ Expected inflation rate

+ Maturity premium

+ Liquidity premium

+ Credit spread

● Non-default bonds = Real risk-free interest rate + Expected inflation rate + Maturity premium

● Corporate bonds  = non-default bonds + Liquidity premium + Credit spread

(Petitt, 20191017, p. 300)  Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: What is considered the yield spread?

● Yield Spread = Liquidity premium + Credit spread

PreQ: What factors can affect the yield spread?

● Spreads on all corporate bonds can be affected by a number of factors, with lower-quality issuers typically experiencing greater spread volatility. These factors, which are frequently linked, include the following:

1. Credit cycle. As the credit cycle improves, credit spreads will narrow.

2. Broader economic conditions. Not surprisingly, weakening economic conditions will push investors to desire a greater risk premium and drive overall credit spreads wider.

3. Financial market performance overall, including equities. In weak financial markets, credit spreads will widen

4. Broker-dealers’ willingness to provide sufficient capital for market making. Bonds trade primarily over the counter, so investors need broker-dealers to commit capital for market-making purposes.

5. General market supply and demand. In periods of heavy new issue supply, credit spreads will widen if there is insufficient demand. In periods of high demand for bonds, spreads will move tighter.

(Petitt, 20191017, p. 300) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

Task: Understand the calculation.

PreQ: When spread changes occur, how can we determine the price impact?

● The simplest example is that of a small, instantaneous change in the yield spread. In this case, the price impact, i.e., the percentage change in price (including accrued interest), can be approximated by

○ Price impact ≈ – MDur × ∆Spread

● Where MDur is the modified duration.

● For larger spread changes (and thus larger yield changes), the impact of convexity needs to be incorporated into the approximation:

○ Price impact ≈ –(MDur × ∆Spread) + ½Cvx × (∆Spread)²

● In this case, one must be careful to ensure that convexity (denoted by Cvx) is appropriately scaled to be consistent with the way the spread change is expressed.

● In general, for bonds without embedded options, one can scale convexity so that it has the same order of magnitude as the duration squared and then express the spread change as a decimal.

● For example, for a bond with duration of 5.0 and reported convexity of 0.235, one would re-scale convexity to 23.5 before applying the formula. For a 1 percent (i.e., 100 bps) increase in spread, the result would be

○ Price impact = (–5.0 × 0.01) + ½ × 23.5 × (0.01)² = –0.048825 or –4.8825 percent

(Petitt, 20191017, pp. 302-303) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

Exercise/Question 6: Section seven is about high-yield, sovereign, non-sovereign credit analysis.

Task: Exercise literature reading textbook 307-311.

This section focuses on special considerations in evaluating the credit of debt issuers from the following three market segments: high-yield corporate bonds.

PreQ: What grade is considered to be ‘high yield’?

● Those rated below Baa3/BBB– by the major rating agencies.

PreQ: For what reasons might a bond be rated as ‘high yield’?

● There are many reasons companies are rated below investment grade, including

○ Highly leveraged capital structure

○ Weak or limited operating history

○ Limited or negative free cash flow

○ Highly cyclical business

○ Poor management

○ Risky financial policies

○ Lack of scale and/or competitive advantages

○ Large off-balance-sheet liabilities

○ Declining industry (e.g., newspaper publishing)

● Companies with weak balance sheets and/or business profiles have lower margin for error and greater risk of default relative to higher-quality investment-grade names.

● And the higher risk of default means more attention must be paid to recovery analysis (or loss severity, in the event of default).

● Consequently, high-yield analysis typically is more in-depth than investment-grade analysis and thus has special considerations

PreQ: What special considerations must be taken when doing high-yield credit analysis?

● Greater focus on issuer liquidity and cash flow

● Detailed financial projections

● Detailed understanding and analysis of the debt structure

● Understanding of an issuer’s corporate structure

● Covenants

● Equity-like approach to high yield analysis

PreQ: Why is liquidity important?

● Liquidity—that is, having cash and/or the ability to generate or raise cash—is important to all issuers.

● It is absolutely critical for high-yield companies.

● Investment grade firms can more easily rollover existing debt.

● High yield firms may have no access to some debt market funding, commercial paper, bank credit facilities

● High yield firms may be privately held with less access to equity markets.

PreQ: What are the sources of liquidity available to a firm?

● Thus, issuer liquidity is a key focus in high-yield analysis. Sources of liquidity, from strongest to weakest, are the following:

○ Cash on the balance sheet:Cash on the balance sheet is easy to see and self-evident as a source for repaying debt.

○ Working capital:working capital can be a large source or use of liquidity, depending on its amount, its use in a company’s cash-conversion cycle, and its role in a company’s operations.

○ Operating cash flow: Operating cash flow is a ready source of liquidity as sales turn to receivables, which turn to cash over a fairly short time period.

○ Bank credit facilities: Bank lines, or credit facilities, can be an important source of liquidity, though there may be some covenants relating to the use of the bank lines that are crucial to know

○ Equity issuance: Equity issuance may not be a reliable source of liquidity because an issuer is private or because of poor market conditions if a company does have publicly traded equity.

○ Asset sales: Asset sales are the least reliable source of liquidity because both the potential value and the actual time of closing can be highly uncertain.

PreQ: How might an analyst use their knowledge of liquidity sources and a company’s debt?

● The amount of these liquidity sources should be compared with the amount and timing of upcoming debt maturities.

● A large amount of debt coming due in the next 6–12 months alongside low sources of liquidity will be a warning flag for bond investors and could push an issuer into default because investors may choose not to buy new bonds intended to pay off the existing debt.

PreQ: What is the principal reason issuers default?

● Insufficient liquidity—that is, running out of cash or no longer having access to external financing to refinance or pay off existing debt—is the principal reason issuers default.

● Although liquidity is important for industrial companies, it is an absolute necessity for financial firms, as seen in the case of Lehman Brothers and other troubled firms during the financial crisis of 2008.

● Financial institutions are highly levered and often highly dependent on funding longer-term assets with short-term liabilities.

PreQ: Why are financial projections so important for high yield credit analysis?

● Because high-yield companies have less room for error, it’s important to forecast, or project, future earnings and cash flow out several years, perhaps including several scenarios, to assess whether the issuer’s credit profile is stable, improving, or declining and thus whether it needs other sources of liquidity or is at risk of default.

● Ongoing capital expenditures and working capital changes should be incorporated as well.

● Special emphasis should be given to realistic “stress” scenarios that could expose a borrower’s vulnerabilities.

PreQ: Why is debt structure important for high yield credit analysis?

● High-yield companies tend to have many layers of debt in their capital structures, with varying levels of seniority and, therefore, different potential recovery rates in the event of default.

● (Recall the historical table of default recovery rates based on seniority in Exhibit 2.)

● A high-yield issuer will often have at least some of the following types of obligations in its debt structure:

○ (Secured) Bank debt

○ Second lien debt

○ Senior unsecured debt

○ Subordinated debt, which may include convertible bonds

○ Preferred stock

● The lower the ranking in the debt structure, the lower the credit rating and the lower the expected recovery in the event of default. In exchange for these associated higher risks, investors will normally demand higher yields.

(Petitt, 20191017, pp. 307-309) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: Why is the corporate structure important to high yield credit analysis?

● Many debt-issuing corporations, including high-yield companies, utilize a holding company structure with a parent and several operating subsidiaries.

● Knowing where an issuer’s debt resides (parent versus subsidiaries) and how cash can move from subsidiary to parent (“upstream”) and vice versa (“downstream”) are critical to the analysis of high-yield issuers.

(Petitt, 20191017, pp. 311-312) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: Why is Covenant Analysis important for high yield credit analysis?.

● As discussed earlier, analysis of covenants is very important for all bonds. It is especially important for high-yield credits because of their reduced margin of safety. Key covenants for high-yield issuers may include the following:

○ Change of control put: Under the change of control put, in the event of an acquisition (a “change of control”), bondholders have the right to require the issuer to buy back their debt (a “put option”), often at par or at some small premium to par value.

○ Restricted payments: The restricted payments covenant is meant to protect creditors by limiting how much cash can be paid out to shareholders over time.

○ Limitations on liens and additional indebtedness: The limitations on liens covenant is meant to put limits on how much secured debt an issuer can have.

○ Restricted versus unrestricted subsidiaries: issuers may classify certain of their subsidiaries as restricted and others as unrestricted as it pertains to offering guarantees for their holding company debt.

(Petitt, 20191017, pp. 313-314) Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

PreQ: Why can an Equity-like approach to high-yield analysis be useful?

● High-yield bonds are sometimes thought of as a “hybrid” between higher-quality bonds, such as investment-grade corporate debt, and equity securities. Their more volatile price and spread movements are less influenced by interest rate changes than are higher-quality bonds, and they show greater correlation with movements in equity markets.

● Consequently, an equity market–like approach to analyzing a high-yield issuer can be useful.

● One approach is to calculate an issuer’s enterprise value. Enterprise value (EV) is usually calculated by adding equity market capitalization and total debt and then subtracting excess cash.

● Enterprise value is a measure of what a business is worth (before any takeover premium) because an acquirer of the company would have to either pay off or assume the debt and it would receive the acquired company’s cash.

● Bond investors like using EV because it shows the amount of equity “cushion” beneath the debt. It can also give a sense of

○ (1) how much more leverage management might attempt to put on a company in an effort to increase equity returns or

○ (2) how likely—and how expensive—a credit-damaging leveraged buyout might be.

Petitt, B. S.  (20191017). Fixed Income Analysis,  4th Edition [VitalSource Bookshelf version].  Retrieved from vbk://9781119628132

Task: Work out the calculation in Example 10 page 310.

Refer to Excel Spreadsheet. Chapter_6_Part_2_Example10.xlsx