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Corporate Debt Instruments and Credit Analysis

Corporate Debt Instruments and Credit Analysis. Chapter 20 All Pages. Corporate Debt Instruments. Credit analysis for corporate bonds Trading Strategy. Strategy – find bonds whose credit rating is too low (yield spread to Treasury is too high)

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Corporate Debt Instruments and Credit Analysis

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  1. Corporate DebtInstruments and Credit Analysis Chapter 20 All Pages

  2. Corporate Debt Instruments

  3. Credit analysis for corporate bondsTrading Strategy • Strategy – find bonds whose credit rating is too low (yield spread to Treasury is too high) • Buy Corp Bond with view that the market corrects to agree with your position • Make profits from the tightening credit spread • Can also play corporate bond spreads overall • Example: Buy IBM bonds & Sell Dell bonds • Spread trades involve going long the underpriced security and/or short the overpriced security • Shorting can be done through Credit Default Swaps (CDS)

  4. Areas analyzed by bond credit analystsPage 445 • I - Bond covenants • Protections to Bond Holders • II - Collateral analysis • What assets are available should issuer fail • III - Ability to make payments (financial situation) • Cash Flow generation

  5. Part I - Covenant analysis pg. 445-447 • Credit analysis involves close scrutiny of the indenture for each bond issue • Covenants can be strong or weak and involve loopholes • Meant to protect lenders (Bond Investors) • Two types • Affirmative (what they WILL do) • Negative (or Restrictive – what they CAN’T do) • Example – Limit ability to issue more debt

  6. Part II - Collateral analysis pg. 446 • Secured versus unsecured debt • Absolute priority rule puts secured first • Often unsecured creditors are made whole first in reorganization • Secured debtholders have stronger bargaining position in chapter 11 reorg • Sometimes Secured Debt holders end up holding debt in the newly re-emerging entity

  7. Part III - Assessing issuers ability to paypg. 446-456 • Business risk • Governance risk • Financial risk

  8. Business risk analysisPg. 447-450 • Risk associated with operating cash flows • Revenue (adjusted for accruals)-cash expenses-taxes • What could effect this? • Macro-economic risk • Overall economic slowdown • Industry risk – very important • Industry Growth Rates (relative to GDP) • Cyclical or not • Industry structure (different from most?) • Competitors/competitive position • R&D • Barriers to entry • Price takers or makers – ability to pass along costs?

  9. Governance riskPg. 450-453 • Ownership structure • Managers and shareholders aligned • Board strength • Independent boards (bigger is better) • Audit committee strength • Financial disclosure policies • Aggressive versus conservative accounting policies • Shareholders rights

  10. Financial riskPg. 453-456 • Look at ratios (versus industry) • Interest coverage ratio or pretax interest coverage • EBITDA/interest expense • High is good (indicates lower credit risk) • Leverage Ratio • LT Debt/ market capitalization • LT Debt/EBITDA (Text Example w/ Lear Corp) • Cash Flow • Very important for high risk borrowers (below invest. grade) • Operating cash, free cash*, discretionary cash * Most Commonly used

  11. Financial Risk ContinuedNet assets and working capital – pg. 455-456 • Ratio of Net Assets to Total Debt • Liquidation Value of assets should be considered • Liquidity of the assets is important (page 456 top) • Working Capital (Current Assets minus Current Liab) • Primary measure of company’s financial flexibility • Current ratio (current assets/current liabilities) • Acid test (takes out inventories from current assets) • Receivables quality is important • High liquidity is better than low

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