2013 CFA Level 1 - Book 5

Study Session 16

Cross-Reference to CFA Institute Assigned Reading #59 - Fundamentals ofCredit Analysis

Example: Impact on return

An 8-year semiannual-pay corporate bond with a 5.75% coupon is priced at $ 1 08.32. This bond's duration and reported convexity are 6.4 and 0.5. The bond's credit spread narrows by 75 basis points due to a credit rating upgrade. Estimate the return impact with and without the convexity adjustment.

Answer:

return impact (without convexity adjustment) - modified duration x D.spread- 6.4 X -0.0075

0.0480

0.048 or 4.80%

return impact with convexity adjustment

- modified duration X D.spread + _2!_convexity X (D.spread)2

-6.4 X -0.0075 + _2!_(50.0) X (-0.0075)2

0.0480 + 0.0014

0.0494 or 4.94%

Notice that convexity needed to be corrected to match the scale of duration.

We can calculate the actual change in the bond's price from the information given to illustrate the need for the convexity adjustment.

Beginning yield to maturity:

N = 16; PMT = 5.75 I 2 = 2.875; FV = 1 00; PV = -108.32; CPT --t 1/Y = 2.25 X 2 = 4.50

Yield to maturity after upgrade: 4.50 - 0.75 = 3.75% Price after upgrade:

1/Y = 3.75 I 2 = 1 .875; CPT --t PV = -1 13 .71

The calculated bond price of $ 1 1 3.71 is an increase of (1 13 .71 I 108.32) - 1 = 4.98%. The approximation is closer with the convexity adjustment.

©20 12 Kaplan, Inc.

Page 171

StudySession 16

Cross-Reference to CFA Institute Assigned Reading #59 - Fundamentals ofCredit Analysis

LOS 59.j: Explain special considerations when evaluating the credit of high yield, sovereign, and municipal debt issuers and issues.

CFA® Program Curriculum, Volume 5, page 650

High Yield Debt

High yield or non-investmentgrade corporate bonds are rated below Baa3/BBB by credit rating agencies. These bonds are also calledjunk bonds because of their higher perceived credit risk.

Reasons for non-investment grade ratings may include:

•High leverage.

•Unproven operating history.

•Low or negative free cash flow.

•High sensitivity to business cycles.

•Low confidence in management.

•Unclear competitive advantages.

•Large off-balance-sheet liabilities.

•Industry in decline.

Because high yield bonds have higher default risk than investment grade bonds, credit analysts must pay more attention to loss severity. Special considerations for high yield bonds include their liquidity, financial projections, debt structure, corporate structure, and covenants.

Liquidity. Liquidity or availability of cash is critical for high yield issuers. High yield issuers have limited access to additional borrowings, and available funds tend to be more expensive for high yield issuers. Bad company-specific news and difficult financial market conditions can quickly dry up the liquidity of debt markets. Many high yield issuers are privately owned and cannot access public equity markets for needed funds.

Analysts focus on six sources of liquidity (in order of reliability): 1 . Balance sheet cash.

2.

Working capital.

3.Operating cash flow (CFO).

4.Bank credit.

5.	Equity issued.
6.	Sales of assets.

For a high yield issuer with few or unreliable sources of liquidity, significant amounts of debt coming due within a short time frame may indicate potential default. Running out of cash with no access to external financing to refinance or service existing debt is the primary reason why high yield issuers default. For high yield financial firms that

Page 172

©2012 Kaplan, Inc.

Study Session 16

Cross-Reference to CFA Institute Assigned Reading #59 - Fundamentals ofCredit Analysis

•Restricted payments. The covenant protects lenders by limiting the amount of cash that may be paid to equity holders.

•Limitations on liens. The covenant limits the amount of secured debt that a borrower can carry. Unsecured debt holders prefer the issuer to have less secured debt, which increases the recovery amount available to them in the event of default. Restricted versus unrestricted subsidiaries. Issuers can classifY subsidiaries as restricted or unrestricted. Restricted subsidiaries' cash flows and assets can be used to service the debt of the parent holding company. This benefits creditors of holding companies because their debt is pari passu with the debt of restricted subsidiaries, rather than structurally subordinated. Restricted subsidiaries are typically the holding company's larger subsidiaries that have significant assets. Tax and regulatory issues can factor into the classification of subsidiary's restriction status. A subsidiary's restriction status is found in the bond indenture.

Bank covenants are often more restrictive than bond covenants, and when covenants are violated, banks can block additional loans until the violation is corrected. If a violation is not remedied, banks can trigger a default by accelerating the full repayment of a loan.

In terms of the factors that affect their return, high yield bonds may be viewed as a hybrid of investment grade bonds and equity. Compared to investment grade bonds, high yield bonds show greater price and spread volatility and are more highly correlated with the equity market.

High yield analysis can include some of the same techniques as equity market analysis, such as enterprise value. Enterprise value (EV) is equity market capitalization plus total debt minus excess cash. For high yield companies that are not publicly traded, comparable public company equity data can be used to estimate EV. Enterprise value analysis can indicate a firm's potential for additional leverage, or the potential credit damage that might result from a leveraged buyout. An analyst can compare firms based on the differences between their EV/EBITDA and debt/EBITDA ratios. Firms with

a wider difference between these ratios have greater equity relative to their debt and therefore have less credit risk.

Sovereign Debt

Sovereign debt is issued by national governments. Sovereign credit analysis must assess both the government's ability to service debt and its willingness to do so. The assessment of willingness is important because bondholders usually have no legal recourse if a national government refuses to pay its debts.

A basic framework for evaluating and assigning a credit rating to sovereign debt includes five key areas:

1 .	Institutional effectiveness includes successful policymaking, absence of corruption,
2.	and commitment to honor debts.
	Economic prospects include growth trends, demographics, income per capita, and
	size of government relative to the private economy.

©20 12 Kaplan, Inc.

Page 175

StudySession 16

Cross-Reference to CFA Institute Assigned Reading #59 - Fundamentals ofCredit Analysis

3.	International investment position includes the country's foreign reserves, its
	external debt, and the status of its currency in international markets.
4.	Fiscal flexibility includes the government's willingness and ability to increase
	revenue or cut expenditures to ensure debt service, as well as trends in debt as a
	percentage of GDP.
5 .	Monetary flexibility includes the ability to use monetary policy for domestic
	economic objectives (this might be lacking with exchange rate targeting or

membership in a monetary union) and the credibility and effectiveness of monetary policy.

Credit rating agencies assign each national government two ratings: (1) a local currency debt rating and (2) a foreign currency debt rating. The ratings are assigned separately because defaults on foreign currency denominated debt have historically exceeded those on local currency debt. Foreign currency debt typically has a higher default rate and

a lower credit rating because the government must purchase foreign currency in the open market to make interest and principal payments, which exposes it to the risk of significant local currency depreciation. In contrast, local currency debt can be repaid by raising taxes, controlling domestic spending, or simply printing more money. Ratings can differ as much as two notches for local and foreign currency bonds.

Sovereign defaults can be caused by events such as war, political instability, severe devaluation of the currency, or large declines in the prices of the country's export commodities. Access to debt markets can be difficult for sovereigns in bad economic times.

Municipal Debt

Municipal bonds are issued by state and local governments or their agencies. Municipal bonds usually have lower default rates than corporate bonds with same credit ratings.

Most municipal bonds can be classified as general obligation bonds or revenue bonds. General obligation (GO) bonds are unsecured bonds backed by the full faith credit of the issuing governmental entity, which is to say they are supported by its taxing power.

Unlike sovereigns, municipalities cannot use monetary policy to service their debt and usually must balance their operating budgets. Municipal governments' ability to service their general obligation debt depends ultimately on the local economy (i.e., the tax base). Economic factors to assess include employment, trends in per capita income and per capita debt, tax base dimensions (depth, breadth and stability), demographics, and ability to attract new jobs (location, infrastructure). Credit analysts must also observe revenue variability through economic cycles. Relying on highly variable taxes that are subject to economic cycles, such as capital gains and sales taxes, can signal higher credit risk. Municipalities may have long-term obligations such as underfunded pensions and post-retirement benefits. Inconsistent reporting requirements for municipalities are also an ISSUe.

Revenue bonds finance specific projects. Revenue bonds often have higher credit risk than GO bonds because the project is the sole source of funds to service the debt.

Page 176

©2012 Kaplan, Inc.

Study Session 16

Cross-Reference to CFA Institute Assigned Reading #59 - Fundamentals ofCredit Analysis

Analysis of revenue bonds combines analysis of the project, using techniques similar to those for analyzing corporate bonds, with analysis of the financing of the project.

A key metric for revenue bonds is the debt service coverage ratio (DSCR), which is the ratio of the project's net revenue to the required interest and principal payments on the bonds. Many revenue bonds include a covenant requiring a minimum debt

service coverage ratio to protect the lenders' interests. Lenders prefer higher debt service coverage ratios, as this represents lower default risk (better creditworthiness).

©2012 Kaplan, Inc.

Page 177

Study Session 16

Cross-Reference to CFA Institute Assigned Reading #59 - Fundamentals ofCredit Analysis

LOS 59.e
Components of traditional credit analysis are known as the four Cs:
•	Capacity: The borrower's ability to make timely payments on its debt.
•	Collateral: The value of assets pledged against a debt issue or available to creditors if
	the issuer defaults.
•	Covenants: Provisions of a bond issue that protect creditors by requiring or
	prohibiting actions by an issuer's management.
•	Character: Assessment of an issuer's management, strategy, quality of earnings, and
	past treatment of bondholders.

LOS 59.f
Credit analysts use profitability, cash flow, and leverage and coverage ratios to assess debt
issuers' capacity.
•	Profitability refers to operating income and operating profit margin, with operating
	income typically defined as earnings before interest and taxes (EBIT).
•	Cash flow may be measured as earnings before interest, taxes, depreciation, and
	amortization (EBITDA); funds from operations (FFO); free cash flow before
	dividends; or free cash flow after dividends.

•	Leverage ratios include debt-to-capital, debt-to-EBITDA, and FFO-to-debt.
•	Coverage ratios include EBIT-to-interest expense and EBITDA-to-interest expense.

LOS 59.g

Lower leverage, higher interest coverage, and greater free cash flow imply lower credit risk and a higher credit rating for a firm. When calculating leverage ratios, analysts should include in a firm's total debt its obligations such as underfunded pensions and off-balance-sheet financing.

For a specific debt issue, secured collateral implies lower credit risk compared to unsecured debt, and higher seniority implies lower credit risk compared to lower seniority.

LOS 59.h

Corporate bond yields comprise the real risk-free rate, expected inflation rate, credit spread, maturity premium, and liquidity premium. An issue's yield spread to its benchmark includes its credit spread and liquidity premium.

The level and volatility of yield spreads are affected by the credit and business cycles, the performance of financial markets as a whole, availability of capital from broker­ dealers, and supply and demand for debt issues. Yield spreads tend to narrow when the credit cycle is improving, the economy is expanding, and financial markets and investor demand for new debt issues are strong. Yield spreads tend to widen when the credit cycle, the economy, and financial markets are weakening, and in periods when the supply of new debt issues is heavy or broker-dealer capital is insufficient for market making.

©20 12 Kaplan, Inc.

Page 179