2013 CFA Level 1 - Book 5

StudySession 16

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

LOS 59.i

Analysts can use duration and convexity to estimate the impact on return (the percentage change in bond price) of a change in credit spread.

For small spread changes:

return impact :=:;j -duration x spread

For larger spread changes:

return impact :=:;j -duration x spread + 22_convexity x ( spread)2

LOS 59.j

High yield bonds are more likely to default than investment grade bonds, which increases the importance of estimating loss severity. Analysis of high yield debt should focus on liquidity, projected financial performance, the issuer's corporate and debt structures, and debt covenants.

Credit risk of sovereign debt includes the issuing country's ability and willingness to pay. Ability to pay is greater for debt issued in the country's own currency than for debt issued in a foreign currency. Willingness refers to the possibility that a country refuses to repay its debts.

Analysis of general obligation municipal debt is similar to analysis of sovereign debt, focusing on the strength of the local economy and its effect on tax revenues. Analysis of municipal revenue bonds is similar to analysis ofcorporate debt, focusing on the ability of a project to generate sufficient revenue to service the bonds.

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Study Session 16

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

CONCEPT CHECKERS

1 .

2.

3 .

4.

5 .

6.

7.

8 .

9.

Expected loss can decrease with an increase in a bond's:

A. default risk.

B. loss severity.

C. recovery rate.

Absolute priority of claims in a bankruptcy might be violated because: A. of the paripassu principle.

B. creditors negotiate a different outcome.

C. available funds must be distributed equally among creditors.

"Notching" is best described as a difference between a(n): A. issuer credit rating and an issue credit rating.

B. company credit rating and an industry average credit rating.

C. investment grade credit rating and a non-investment grade credit rating.

Which of the following statements is least likely a limitation of relying on ratings from credit rating agencies?

A. Credit ratings are dynamic.

B. Firm-specific risks are difficult to rate.

C. Credit ratings adjust quickly to changes in bond prices.

Ratio analysis is most likely used to assess a borrower's:

A. capacity.

B. character.

C. collateral.

Higher credit risk is indicated by a higher:

A. FFO/debt ratio.

B. debt/EBITDA ratio.

C. EBITDNinterest expense ratio.

Compared to other firms in the same industry, an issuer with a credit rating of AAA should have a lower:

A. FFO/debt ratio. B. operating margin. C. debt/capital ratio.

Credit spreads tend to widen as:

A. the credit cycle improves.

B. economic conditions worsen.

C. broker-dealers become more willing to provide capital.

Compared to shorter duration bonds, longer duration bonds: A. have smaller bid-ask spreads.

B. are less sensitive to credit spreads.

C. have less certainty regarding future creditworthiness.

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StudySession 16

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

10. One key difference between sovereign bonds and municipal bonds is that sovereign Issuers:

A. can print money.

B. have governmental taxing power.

C. are affected by economic conditions.

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Study Session 16

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

CHALLENGE PROBLEM

Woden, Inc., is a high yield bond issuer with a credit rating ofBa2/BB. Woden presents the following balance sheet for the most recent year (in millions of dollars):

Cash	10
Accounts receivable	15
Inventories	...5.2
Current assetS	80
Land	10
Property, plant, and equipment, net	85
Goodwill	..22
Non-current assets	120
Total assetS	200

Accounts payable	10
Short-term debt	5
Current portion oflong-term debt	_.2
Current liabilities	18
Long-term bank loans	30
Secured bonds	10
Unsecured bonds	_.1.Q
Total long-term debt	60
Net pension liability	_n
Total liabilities	100
Paid-in capital	10
Retained earnings	_..2.Q
Total shareholders' equity	100
Total liabilities and equity	200

For the year, Woden's earnings before interest, taxes, depreciation, and amortization (EBITDA) were $45 million.

For firms in Woden's industry, credit rating standards for an investment grade (Baa3/ BBB-) credit rating include a debt-to-EBITDA ratio less than 1.8x and a debt-to-capital ratio (based on all sources offinancing) less than 40%. On a conference call with analysts, Woden's management states that they believe Woden should be upgraded to investment grade, based on its debt-to-EBITDA ratio of l .Sx and its debt-to-capital ratio of 34%.

Why might a credit analyst disagree with management's assessment?

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Study Session 16

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

ANSWERS - CONCEPT CHECKERS

1 . C An increase in the recovery rate means that the loss severity has decreased, which decreases expected loss.

2. B A negotiated bankruptcy settlement does not always follow the absolute priority of claims.

3.A Notching refers to the credit rating agency practice ofdistinguishing between the credit rating of an issuer (generally for its senior unsecured debt) and the credit rating of particular debt issues from that issuer, which may differ from the issuer rating because of provisions such as seniority.

4.c Bond prices and credit spreads change much faster than credit ratings.

5.A Ratio analysis is used to assess a corporate borrower's capacity to repay its debt obligations on time.

6.

BA higher debt/EBITDA ratio is sign ofhigher leverage and higher credit risk. Higher FFO/debt and EBITDA/interest expense ratios indicate lower credit risk.

7.c A low debt/capital ratio is an indicator of low leverage. An issuer rated AAA is likely to have a high operating margin and a high FFO/debt ratio compared to its industry group.

8.

BCredit spreads widen as economic conditions worsen. Spreads narrow as the credit cycle improves and as broker-dealers provide more capital to bond markets.

9.c Longer duration bonds usually have longer maturities and carry more uncertainty of future creditworthiness.

10.A Sovereign entities can print money to repay debt, while municipal borrowers cannot. Both sovereign and municipal entities have taxing powers, and both are affected by economic conditions.

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Study Session 16

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

ANSWERS - CHALLENGE PROBLEM

The debt ratios calculated by management are based on the firm's short-term and long-term debt:

Total debt = 5 + 3 + 30 + 10 + 20 = 68

Debt/EBITDA = 68 I 45 = 1.5x

Debt/capital = 68 I 200 = 34o/o

A credit analyst, however, should add Woden's net pension liability to its total debt:

Debt + net pension liability = 68 + 22 = 90

Adjusted debt/EBITDA = 90 I 45 = 2.0x

Adjusted debt/capital = 90 I 200 = 45o/o

Additionally, a credit analyst may calculate what the debt-to-capital ratio would be ifWoden wrote down the value ofits balance sheet goodwill and reduced retained earnings by the same amount:

Adjusted capital = 200 - 25 = 175

Adjusted debt I adjusted capital = 90 I 175 = 51o/o

These adjustments suggest Woden does not meet the requirements for an investment grade credit rating.

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SELF-TEST: FIXED INCOME INVESTMENTS

14 questions, 21 minutes

1 .

2.

3.

4.

5.

An estimate of the price change for an option-free bond caused by a 1 % decline
in its yield to maturity based only on its modified duration will result in an
answer that:
A.	is too small.
B.	is too large.
C. may be too small or too large.
Three companies in the same industry have exhibited the following average
ratios over a 5-year period:
	5-Year Averages	Alden	Barrow	Collison
Operating margin		13.3%	15.0%	20.7%
Debt!EBITDA		4.6x	0.9x	2.8x
EBIT/Interest		3.6x	8.9x	5.7x
FFO/Debt		12.5%	14.6%	11 .5%
Debt/Capital		60.8%	23.6%	29.6%

Based only on the information given, the company that is expected to have the highest credit rating is:

A. Alden.

B. Barrow.

C. Collison.

Which statement about the theories of the term structure of interest rates is most

accurate?

A. Under the liquidity preference theory, the yield curve will be positively sloped.

B. A yield curve that slopes up and then down (humped) is consistent with the market segmentation theory but not with the pure expectations theory.

C. Evidence that life insurance companies have a strong preference for 30-year bonds supports the market segmentation theory.

Which of the following is least likely a common form of external credit enhancement?

A. Portfolio insurance.

B. A corporate guarantee.

C. A letter of credit from a bank.

A bond with an embedded put option has a modified duration of 7, an effective duration of 6 and a convexity of 62.5. If interest rates rise 25 basis points, the bond's price will change by approximately:

A. 1 .46%.

B. 1 .50%. c. 1.54%.

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Self-Test: Fixed Income Investments

1 1 .

12.

13.

14.

A bank loan department is trying to determine the correct rate for a 2-year loan to be made two years from now. Ifcurrent implied Treasury effective annual spot rates are: 1 -year = 2%, 2-year = 3%, 3-year = 3.5%, 4-year = 4.5%, the base (risk-free) forward rate for the loan before adding a risk premium is closest to:

A. 4.5%.

B. 6.0%. c. 9.0%.

Compared to mortgage passthrough securities, CMOs created from them most
likely have:
A.	less prepayment risk.
B.	greater average yields.
C. a different claim to the mortgage cash flows.
The arbitrage-free approach to bond valuation most likely:
A.	can only be applied to Treasury securities.
B.	requires each cash flow to be discounted at a rate specific to its time period.
C. shows that discounting each cash flow at the yield to maturity must result in
	the correct value for a bond.

Which of the following statements least accurately describes a form of risk
associated with investing in fixed income securities?
A.	Credit risk has only two components, default risk and downgrade risk.
B.	Other things equal, a bond is more valuable to an investor when it has less

liquidity risk.

C. Bonds that are callable, prepayable, or amortizing have more reinvestment risk than otherwise equivalent bonds without these features.

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Self-Test: Fixed Income Investments

SELF-TEST ANSWERS: FIXED INCOME INVESTMENTS

1. A Duration is a linear measure, but the relationship between bond price and yield for an option-free bond is convex. For a given decrease in yield, the estimated price increase using duration alone will be smaller than the actual price increase.

2.B Four ofthe five credit metrics given indicate that Barrow should have the highest credit rating ofthese three companies. Barrow has higher interest coverage and lower leverage than Alden or Collison.

3.C The market segmentation theory is based on the idea that different market participants (both borrowers and lenders) have strong preferences for different segments of the yield curve. Ifexpectations are that future short-term interest rates will be falling enough, then the yield curve could be downward sloping even given rhar there is an increasing premium for lack ofliquidity at longer maturities. A humped yield curve is consistent with expectations that short-term rates will rise over the near term and then decline.

4.A External credit enhancements are financial guarantees from third parties that generally support the performance of the bond. Portfolio insurance is not a third party guarantee.

5. A Effective duration must be used with bonds that have embedded options.

p = (-)(ED)( y) + (C)( y)2

.6.P = (-)(6)(0.0025) + (62.5)(0.0025)2 = -0.015 + 0.00039 = -0.014610% or

-1.461%

6.B The bond with the highest duration will benefit the most from a decrease in rates. The lower the coupon, lower the yield to maturity, and longer the time to maturity, the higher will be the duration.

7.B A conversion provision is an embedded option that favors the buyer, not the issuer, so buyers will accept a lower YTM with a conversion option. Call options and caps favor the issuer and increase the YTM that buyers will require.

8. C Spread volatility is typically greatest for lower quality and longer maturities. The BBB rated 15-year corporate bond has the lowest credit quality and longest maturity of the three choices.

9.B Adecrease in yield volatility will decrease the values of embedded options. The security holder is short the prepayment option. The decrease in the value ofthe prepayment option increases the value ofthe security, and the required yield will decrease. The security holder is long the pur option so the value ofa putable bond will decrease with a decrease in yield volatility and the required yield will increase.

10.C Since the OAS is less than the Z-spread for Bond A, the effect of the embedded option is to increase the required yield, so it must be a call option and not a put option. The OAS is the spread after taking out the effect of the embedded option. Since the OAS is higher for Bond B, it represents the better value after adjusting for the value ofthe call in Bond A.

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