CHAPTER
FORTY-THREE
CREDIT ANALYSIS FOR CORPORATE BONDS

MARTIN FRIDSON, CFA

Global Credit Strategist
BNP Paribas Asset Management

FRANK J. FABOZZI, PH.D., CFA, CPA

Professor of Finance
EDHEC Business School

ADAM B. COHEN, J.D.

Founder
Covenant Review

The purpose of this chapter is to provide a framework for the credit analysis of corporate bonds. Although there are numerous types of corporate bonds outstanding, three major issuing segments can be differentiated: industrials, utilities, and finance companies. This chapter will deal primarily with industrials in its general description of bond analysis and then discuss utility and finance issues. Special factors that must be considered in the credit analysis of high-yield corporate issues are addressed. At the end of this chapter, credit scoring models for identifying potential issuers that may default are described.

APPROACHES TO CREDIT ANALYSIS

Traditionally, credit analysis for corporate bonds has focused almost exclusively on the default risk of the bond—the chance that the bondholder will not receive the scheduled interest payments or principal at maturity. This one-dimensional analysis concerned itself primarily with the calculation of a series of ratios historically associated with fixed income investment. These ratios typically would include fixed charge coverage, leverage, and funds flow/total debt. Such an approach was deemed appropriate when interest rates were stable and investors purchased bonds with the purpose of holding them to maturity. Under those conditions, fluctuations in the market value of the bonds owing to interest-rate changes were minimal, and fluctuations owing to credit changes of the bond issuer were mitigated by the fact that the investor had no intention of selling the bond before maturity. During the past four decades, however, the purpose of buying bonds has changed dramatically. Investors still purchase bonds for security and thereby forgo the higher expected return of other assets such as common stock. Increasingly, however, investors buy bonds to trade them actively with the purpose of making a profit on changes in interest rates or in absolute or relative credit quality. The second dimension of corporate bond credit analysis addresses the latter purpose of buying a bond. What is the likelihood of a change in credit quality that will affect the price of the bond? This second dimension deals primarily with ratios and profitability trends, such as return on equity, operating margins, and asset turnover, generally associated with common stock analysis. Both dimensions should be applied in corporate bond analysis because they address the same issue—default or credit risk–from complementary perspectives. Only by using both dimensions of credit analysis will the analyst address the dual purpose of bondholding: security of interest and principal payments and stability or reduction in credit risk during the life of the bond.

Parts of this chapter are based on the chapter by Jane Tripp Howe that appeared in previous editions of this handbook.

Another outgrowth of the shift from buy-and-hold strategies to active bond management is a premium on prompt responses to news that affects a company’s ability to generate cash flow to cover its interest charges. A sudden leap or plunge in stock price may reflect significant new information about a company’s future profitability that the bond market does not yet reflect. By taking a clue from the equity market, an astute investor may get a jump on competitors in catching an upswing or avoiding a downswing in the issuer’s bonds.

Beyond this sort of reactive approach, bond investors can use equity-based information to conduct systematic and potentially profitable analysis. The idea that stock analysis and bond analysis are intertwined has been advanced by the development of options analysis.1 Underlying this line of reasoning is the basic insight that all of a company’s liabilities derive their value from the same set of cash flows. This suggests that the intrinsic value of the equity must be consistent with the intrinsic value of the debt. (Note that the equity value referred to here is economic value, rather than the accounting value represented on the balance sheet by shareholders’ equity.)

The ability to derive analytical benefits from these insights springs from the expectation that the company’s owners will cease paying interest, that is, default on their debt, if the value of their equity drops to zero. This rational response is analogous to homeowners whose mortgages exceed the value of their houses “mailing the keys to the bank” instead of continuing to make interest payments. It follows that the bigger the equity cushion beneath bondholders, the more remote is the probability of default.

Exhibit 43–1 supports the argument that a large equity cushion, as measured by the company’s valuation in the stock market, implies a small likelihood of default. The table ranks 22 U.S. investment-grade chemical companies by the ratio of market value of equity to total liabilities (MV/TL). A relationship between the equity valuations and the corresponding bond ratings is apparent. The top half of the rankings includes six of the seven companies (86%) rated within the single-A category. The bottom half includes 10 of the 14 companies (71%) that are rated within the triple-B category.

EXHIBIT 43–1
Stock-Based Credit Comparison of Investment-Grade Chemical Companies

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The alignment is by no means perfect, however. Most strikingly, Mosaic has the highest MV/TL ratio in the group (8.54×) and the lowest rating (BBB–), whereas DuPont ranks 19th in MV/TL, yet has the second highest rating (A). Anomalies of this sort may help to identify a bond that is misrated, perhaps because the rating agencies have not yet fully responded to changes that the equity market has incorporated into the company’s share price. Indeed, Mosaic rose from BB to BBB–at Standard & Poor’s between October 2004 and June 2008. That left the rating one step lower than Moody’s equivalent Baa2, which Mosaic reached in August 2009 following a long climb from B1 in November 2006. Perhaps the rating agencies were being more deliberate than the equity market in recognizing a genuine reduction in default risk at the company.

Drawing a definitive conclusion, however, requires more than a simple comparison of a company’s credit rating and stock valuation. Other factors could explain the ratings disparity between Mosaic and DuPont. For one thing, potash and phosphate producer Mosaic has a much less diversified product line than DuPont, and its earnings are highly sensitive to volatile commodity prices. In addition, Mosaic’s stock price shot up dramatically in 2010 after an attempted takeover of Potash Corp. by BHP Billiton focused investors’ attention on the value of potash reserves. This effect could have proved temporary. A long-run view of default risk might favor DuPont, despite the near-term restraint on its earnings imposed by a slow economic recovery in 2010.

More generally, the probability of default is a function not only of the equity cushion’s size, but also its volatility. A company with a comparatively small equity cushion may receive a fairly high rating if its stock price is exceptionally stable. An extremely steady share price makes the company’s equity value very unlikely to fall to zero and trigger a default.

A final caveat on the interpretation of equity valuations in the context of credit analysis is that under certain circumstances an increase in the equity cushion can indicate increased risk of default. The ultimate effect of a leveraged buyout (LBO) is that a substantial portion of the equity in the company’s capital structure is replaced by debt, resulting in substantially heightened credit risk. For example, SunGard Data Systems fell from BBB+ to B+ at Standard & Poor’s in connection with its 2005 LBO. To effect the transaction, however, the LBO sponsor must pay a premium to prevailing market value to acquire the stock from the existing shareholders. Sometimes, word of the pending LBO leaks into the market before the deal is announced, pushing the share price higher. That results in a short-run increase in the equity cushion, but analysts who leap to the conclusion that credit risk is declining will receive a rude surprise when the true cause of the price appreciation comes to light.

INDUSTRY CONSIDERATIONS

The first step in analyzing a bond is to gain some familiarity with the industry. Only within the context of an industry is a company analysis valid. For example, a company growing at 15% annually may appear attractive. However, if the industry is growing at 50% annually, the company is competitively weak. Industry considerations can be numerous. An understanding of the nine variables discussed in this section, however, should give the general fixed income analyst a sufficient framework for properly interpreting a company’s prospects:

• Economic cyclicality

• Growth prospects

• Research and development expenses

• Competition

• Sources of supply

• Degree of regulation

• Labor

• Accounting

• Event risk

In some industries, for instance, an analysis of labor costs must consider technological advances that have made it feasible to outsource certain functions to lower-wage countries. Examples include handling of customer inquiries, analysis of diagnostic results, and financial statement analysis. Also, cross-border differences in accounting standards complicate credit quality comparisons of industry peers domiciled in different countries.

Economic Cyclicality

The economic cyclicality of an industry is the first variable an analyst should consider in reviewing an industry. Does the industry closely follow gross domestic product (GDP) growth, as does the retailing industry, or is it recession-resistant but slow-growing, like the regulated electric utility industry? The growth in earnings per share (EPS) of a company should be measured against the growth trend of its industry. Major deviations from the industry trend should be the focus of further analysis. Some industries may be somewhat dependent on general economic growth but be more sensitive to demographic changes. For example, the aging of the U.S. population should cause demand for health care to grow faster than the economy as a whole. Analysts must bear in mind, however, that efforts by government and employers to control health care costs may limit revenue growth. Other industries, such as banking, are sensitive to interest rates. When interest rates are rising, the earnings of banks with a high federal funds exposure underperform the market because their loan rates lag behind increases in the cost of money. Conversely, as interest rates fall, banking earnings outperform the market because the lag in interest change works in the banks’ favor.

In general, however, the earnings of few industries correlate perfectly with one economic statistic. Not only are industries sensitive to many economic variables, but often various segments within a company or an industry move countercyclically or at least with different lags in relation to the general economy. For example, the housing industry can be divided between new construction and remodeling and repair. New construction historically has led GDP growth, but repair and remodeling have exhibited less sensitivity to general trends. Therefore, in analyzing a company in the construction industry, the performance of each of its segments must be compared with the performance of the subindustry.

Growth Prospects

A second industry variable related to economic cyclicality is the growth prospects for an industry. Is the growth of the industry projected to increase and be maintained at a high level, such as in the nursing home industry, or is growth expected to decline, as in the defense industry? Each growth scenario has implications for a company. In the case of a fast-growth industry, how much capacity is needed to meet demand, and how will this capacity be financed? In the case of slow-growth industries, is there a movement toward diversification or a consolidation within the industry, such as in the railroad industry? A company operating within a fast-growing industry often has a better potential for credit improvement than does a company whose industry’s growth prospects are below average. However, barriers to entry and the sustainability of growth must be considered along with growth prospects for an industry. If an industry is growing rapidly, many new participants may enter the business, causing oversupply of product, declining margins, and possible bankruptcies.

The growth prospects of an industry also should be considered in a global context, particularly if a company has international exposure. Frequently, the growth prospects of an industry vary by country. For example, the soft drinks industry is declining in the United States but continues to achieve high growth in many emerging market countries.

Research and Development Expenses

The broad assessment of growth prospects is tempered by the third variable—the research and development (R&D) expenditures required to maintain or expand market position. Products with high-tech components can become dated and obsolete quickly. Therefore, although a company may be well situated in an industry, if it does not have the financial resources to maintain a technological lead or at least expend a sufficient amount of money to keep technologically current, its position is likely to deteriorate in the long run. In the short run, however, a company with R&D expenditures consistently below industry averages may produce above-average results because of expanded margins.

Evaluation of research and development is further complicated by the direction of technology. Successful companies not only must spend an adequate amount of resources on development, but they also must be correct in their assessment of the direction of the industry. Deployment of significant amounts of capital may not prevent a decline in credit quality if the capital is misdirected. For example, computer companies that persisted in devoting a high percentage of their capital expenditures to the mainframe component of their business suffered declines in credit quality as the mainframe business declined. In industries such as software and telecommunications, new technologies emerge frequently, and not all achieve market viability. A company that ties its product plans to the wrong technology loses competitive ground in addition to being unable to recover a substantial investment in R&D.

Competition

Competition is based on a variety of factors, with their relative importance varying by industry. Price is almost always a major competitive consideration, but product quality also affects the customers’ decisions. For many consumer products it is difficult to measure product quality by objective standards. Brand name recognition and celebrity endorsements consequently shape perceptions of product quality. Companies also compete by striving to achieve advantages in distribution and by cultivating long-term relationships with customers.

Some companies are able to maintain strong competitive positions over extended periods through patents and trademarks. The flip side is that the expiration of a patent can lead to a major revenue loss. This is particularly pertinent for a pharmaceutical maker that will have to begin competing with generic drug producers once patent protection expires on a highly successful product. Another danger signal is heavy concentration of revenues at a small number of customers. In such a situation, a decision by a major customer to switch to another provider could deal a severe blow.

Increasingly, all forms of competition are waged on an international basis and are affected by fluctuations in relative currency values. Companies that fare well are those that compete successfully on a global basis and concentrate on the regions with the highest potential for growth. Consumers are largely indifferent to the country of origin of a product as long as the product is of high quality and reasonably priced. This fact is exemplified by the significant increase in the manufacture of automobiles and automobile parts in Mexico that are shipped to the United States.

Competition within an industry relates directly to the market structure of an industry and has implications for pricing flexibility. An unregulated monopoly is in an enviable position in that it can price its goods at a level that will maximize profits. Most industries encounter some free-market forces and must price their goods in relation to supply and demand, as well as the price charged for similar goods. In an oligopoly, a pricing leader is not uncommon. A concern arises when a small company is in an industry that is moving toward oligopoly. In this environment, the small company’s costs of production may be higher than those of the industry leaders, and yet it may have to conform to the pricing of the industry leaders. In the extreme, a price war could force the smaller companies out of business. This situation has occurred in the automobile industry over many decades, first on a national and later on a global basis. Many U.S. producers either failed or merged with larger competitors as the field narrowed to the Big Three—General Motors, Ford Motor Company, and Chrysler. In addition to getting squeezed on costs and pricing, smaller automakers faced a disadvantage in producing fewer models, making them more sensitive to changes in consumer tastes than the industry leaders. Similarly, concentration in one region of the world became a handicap as the industry globalized. Recessions usually vary in severity from country to country, so global producers could reduce their vulnerability to economic downturns by spreading their sales across continents.

A concern also arises when there is overcapacity in the industry. Often overcapacity is accompanied by price wars. Generally, price wars result in an industry-wide financial deterioration as battles for market share are accompanied by declining profits or losses.

Sources of Supply

The market structure of an industry and its competitive forces have a direct impact on the fifth industry variable—sources of supply of major production components. A company that is not self-sufficient in its factors of production but is sufficiently powerful in its industry to pass along increased costs is in an enviable position.

Degree of Regulation

In a regulated monopoly such as electric power generation, pricing is determined by a government body. The intention is to prevent companies from extracting excess profits, yet to provide a fair rate of return on capital. That policy tends to promote stable earnings regardless of economic conditions. State regulatory commissions vary, however, in their responsiveness to requests for rate relief to offset increased costs.

Non-monopoly industries face regulation in such areas as labor practices, financial reporting, product safety, and environmental impact. The costs of complying with these regulations are often substantial and the ability to pass the costs on to customers varies by industry. Compliance with regulations that are stricter than in other countries may disadvantage companies relative to foreign-based competitors. Violating regulations can result in costly fines as well as reputational damage that may result in lost business.

Labor

The seventh industry factor requiring analysis is the labor situation. Is the industry heavily unionized? If so, what has been the historical incidence of strikes? What level of flexibility does management have to reduce the labor force? When do the current contracts expire, and what is the likelihood of timely settlements? The labor situation is also important in nonunionized companies, particularly those whose labor situation is tight. What has been the turnover of professionals and management in the firm? What is the probability of a firm’s employees, such as highly skilled engineers, being hired by competing firms? What is the likelihood of union activity in nonunionized companies? Are the states in which unionization is a possibility right-to-work states and therefore more difficult to unionize? How much of a cost advantage do the nonunionized companies have over the unionized companies?

The more labor-intensive an industry, the more significance the labor situation assumes. This fact is evidenced by the domestic automobile industry, in which overcapacity and high unionization have contributed to high fixed costs and cyclic record operating losses.

Occasionally, analysts concentrate on the per-hour wages of the labor force. Such an emphasis is misleading. An evaluation of the labor force should concentrate on work rules because work rules are more important in the overall efficiency of an organization than the wage rates. This is an important factor in the profitability of some automobile supply companies.

Accounting

One more industry factor to be considered is accounting. Does the industry have special accounting practices, such as those in the insurance industry or the electric utility industry? If so, an analyst should become familiar with industry practices before proceeding with a company analysis. Also important is whether a company is liberal or conservative in applying accounting rules. The norm of an industry should be ascertained and the analyst should analyze comparable figures.

Particular attention should be paid to companies that use an accounting system other than U.S. generally accepted accounting principles (GAAP). Reported results should be reconciled with those which would have been reported under U.S. GAAP. In addition, changes in GAAP should be scrutinized.

Care also should be taken when dealing with historical data. Frequently, companies adjust prior years’ results to accommodate discontinued operations and changes in accounting. These adjustments can mask unfavorable trends. For example, companies that regularly dispose of underperforming segments and then highlight the more profitable continuing operations may be trying to hide poor management. To appreciate all trends fully, both the unadjusted and the adjusted results should be analyzed.

Accounting practices also demand attention when mergers and acquisitions occur. How much of pro-forma synergies are attributable to savings that are not yet realized but are allowed in pro-forma results? How much goodwill is generated by the combination? Are any contracts written up because the acquiring company believes that it can improve the historical performance of the company it acquired? A conscientious analyst will be aware of these accounting entries and determine whether they reflect a pro forma reality or, a too-optimistic assessment of future performance.

Event Risk

The final industry factor to consider is event risk. This term refers to a major discontinuity in a company’s financial performance. It includes transactions that radically alter a company’s capital structure, such as leveraged buyouts and takeovers that are heavily financed with debt. Event risk also comprises shocks such as natural disasters, environmental catastrophes, nationalizations, terrorist attacks, and revelations of accounting fraud.

Shocks can have severe credit impact, up to and including bankruptcy. As an example, during the course of June 2010 Moody’s Investors Service lowered BP’s credit rating all the way from Aa1 to A2. The two-stage downgrade reflected potential costs of containment, cleanup, litigation, and fines arising from the company’s massive oil spill in the Gulf of Mexico. Shocks are unforeseeable by their nature, but to some extent it is possible to assess a company’s probability of experiencing a shock.

FINANCIAL ANALYSIS

Having achieved an understanding of an industry, the analyst is ready to proceed with a financial analysis. The financial analysis should be conducted in three phases. The first phase consists of traditional ratio analysis for bonds. The second phase, generally associated with common stock research, consists of analyzing the components of a company’s return on equity. The final phase considers such nonfinancial factors as management and foreign exposure and includes an analysis of the indenture.

Traditional Ratio Analysis

There are numerous ratios that can be calculated in applying traditional ratio analysis to bonds. Of these, the following eight will be discussed in this section:

• Pretax interest coverage

• Leverage

• Cash flow

• Net assets

• Intangibles

• Unfunded pension liabilities

• Age and condition of plant

• Working capital

These selected ratios are the ones with the widest degree of applicability. In analyzing a particular industry, however, other ratios assume significance and should be considered.

Pretax Interest Coverage

Generally, the first ratio calculated in credit analysis is pretax interest coverage. This ratio measures the number of times interest charges are covered on a pretax basis. Pretax interest coverage is calculated by dividing pretax income plus interest charges by total interest charges. The higher the coverage figure, the safer is the credit. If interest coverage is less than 1×, the company must borrow or use cash flow or proceeds from the sale of assets to meet its interest payments.

Generally, published coverage figures are pretax as opposed to after-tax because interest payments are a pretax expense. Although the pretax interest coverage ratio is useful, its utility is a function of the company’s other fixed obligations. For example, if a company has other significant fixed obligations, such as rents or leases, a more appropriate coverage figure would include these other fixed obligations. An example of this is the retail industry, in which companies typically have significant lease obligations. A calculation of simple pretax interest coverage would be misleading in this case because fixed obligations other than interest are significant.

The analyst also should be aware of any contingent liabilities such as a company’s guaranteeing another company’s debt. Although the company being analyzed may never have to pay interest or principal on the guaranteed debt, the existence of the guarantee diminishes the quality of the pretax coverage. In addition, the quality of the guaranteed debt must be considered.

Once pretax interest coverage and fixed-charge coverage are calculated, it is necessary to analyze the ratios’ absolute levels and the numbers relative to those of the industry. For example, pretax interest coverage for an electric utility of 3.0× is consistent with an A rating, whereas the same coverage for a drug company would indicate a lower rating.

Exhibit 43–2 shows the various key pretax interest coverage ratios reported by Standard & Poor’s and how they are computed by that rating agency. The exhibit defines each measure used in a ratio and the formula.

EXHIBIT 43–2
S&P Glossary of Terms and Formula for Key Ratios

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Leverage

A second important ratio is leverage, which can be defined in several ways. The most common definition of leverage is long-term debt as a percent of total capitalization. The higher the level of debt, the higher is the percentage of operating income that must be used to meet fixed obligations. If a company is highly leveraged, the analyst also should look at its margin of safety. 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.

The traditional method of calculating leverage uses the company’s capital structure as stated in the most recent balance sheet. A helpful supplement to the traditional ratio is the market-adjusted debt ratio. It uses debt as reported, but substitutes for stated shareholders’ equity the market value of all outstanding shares.

One drawback to the traditional, book-value-based leverage ratio is that the accounting rules generally require physical assets to be recorded at historical cost. They may be written down to reflect impairment, but not written up to reflect increases in their economic value, unless they become involved in an acquisition. Furthermore, the accounting rules require immediate expensing, rather than capitalizing, of many outlays that create substantial long-run value. Examples include research and development, the creation of brand names, and the buildup of an effective sales organization. Consequently, the traditional ratio may overstate leverage by understating the economic value of the company’s equity.

The market-adjusted version is a useful corrective, because under normal conditions, the stock market will reflect a disparity—whether positive or negative—between the book value and economic value of a company’s assets. Analysts should bear in mind, however, that share prices can be highly volatile. As gauged by the company’s stock market value, leverage may look considerably higher a month from now than today, with the change mainly reflecting a general drop in share prices rather than a fundamental decline in the company’s earnings prospects.

Finance companies traditionally have been among the most highly leveraged companies. Debt-to-equity ratios of 10:1 are not unusual for captive finance companies that finance the sales of, and have debt guarantees from, parent companies engaged in manufacturing or retailing. For noncaptive companies, ratios of 5:1 to 7:1 are typical nowadays. Investors tolerate finance companies’ high leverage because of the generally liquid nature of their assets. Loans, receivables, and other financial instruments ordinarily can be sold without substantial loss of face value if necessary to repay maturing debt. In contrast, industrial companies typically include large amounts of plant and equipment that cannot be disposed of so quickly. Therefore, book-value-based leverage of 5:1 or more would cause an industrial company to be viewed as highly speculative.

In addition to considering the absolute and relative levels of leverage of a company, the analyst should evaluate the debt itself. How much of the debt has a fixed-rate, and how much has a floating rate? A company with a high component of debt tied to the prime rate may find its margins being squeezed as interest rates rise if there is no compensating increase in the price of the firm’s goods. Such a debt structure may be beneficial during certain phases of the interest-rate cycle, but it precludes a precise estimate of what interest charges for the year will be. In general, a company with a small percentage of floating-rate debt is preferable to a similarly leveraged company with a high percentage of floating-rate debt.

The maturity structure of the debt also should be evaluated. What is the percentage of debt that is coming due within the next five years? As this debt is refinanced, how will the company’s embedded cost of debt be changed?

The existence of material operating leases can understate the leverage of a firm. Operating leases should be capitalized to give a true measure of leverage.

A company’s bank lines often constitute a significant portion of its total debt. These lines should be analyzed closely in order to determine the flexibility afforded to the company. The lines should be evaluated in terms of undrawn capacity as well as security interests granted. In addition, the analyst should determine whether the line contains a “material adverse change” (MAC) clause under which the line could be withdrawn. For example, a company that has drawn down its bank lines completely and is in jeopardy of activating its MAC clause may have trouble refinancing any debt. In a similar manner, undrawn lines should be evaluated in terms of their capacity to replace commercial paper, if needed. In the event that a company’s commercial paper rating is downgraded, the company’s access to the commercial paper market may evaporate quickly. In this scenario, the company may be forced to draw on its bank lines to replace its maturing commercial paper. A company whose commercial paper is fully backed by bank lines is in a stronger position than one whose bank lines do not cover its outstanding commercial paper.

Exhibit 43–2 shows the key leverage ratios used by Standard & Poor’s and the formula for calculating each ratio.

Cash Flow

A third important ratio is cash flow as a percent of total debt. Cash flow is often defined as net income from continuing operations plus depreciation, depletion, amortization, and deferred taxes. In calculating cash flow for credit analysis, the analyst also should subtract noncash contributions from subsidiaries. In essence, the analyst should be concerned with cash from operations. Any extraordinary sources or uses of funds should be excluded when determining the overall trend of cash-flow coverage. Cash dividends from subsidiaries also should be questioned in terms of their appropriateness (too high or too low relative to the subsidiary’s earnings) and also in terms of the parent’s control over the upstreaming of dividends. Is there a legal limit to the upstreamed dividends? If so, how close is the current level of dividends to the limit?

Net Assets

A fourth significant ratio is net assets to total debt, which gauges a company’s ability to repay debt by liquidating assets to generate cash. This is not something companies do under normal circumstances; their ordinary practice is to refinance debt as it comes due or repay it from operating cash flow. Asset liquidation for debt repayment is most apt to occur when a company is under financial strain, when asset values are likely to be depressed. Therefore, analysts must be mindful that at the point at which liquidation value becomes relevant, it may differ significantly from the value currently reflected on the balance sheet and also from the present market value.

Discrepancies between book value and liquidation value arise from the inherently illiquid nature of many fixed assets. Consider a specialized piece of heavy equipment in a mine in a remote area. The balance sheet value associated with this asset is its purchase price less depreciation charges recorded since the equipment was acquired. Not reflected in that valuation are the costs of transporting the equipment to a buyer. Moreover, the depreciation charges, which were set at the time of the machinery’s purchase, may not take into account the possibility of subsequent introduction of a competing, more cost-effective model, which would reduce the value of earlier-generation equipment.

To identify gaps between book value and liquidation value, analysts can obtain information on sales of comparable assets. In the energy sector, for example, widely reported sales of oil reserves provide dollars-per-barrel benchmarks. Acquisitions of retailing chains and restaurants similarly furnish useful estimates of current market value of comparable properties.

Even when such market-based data can be found, however, debt holders must be cautious about concluding that their principal will be fully covered in liquidation. For example, suppose that during a period of airline industry prosperity an airline sells bonds collateralized by planes. The prices then being paid for used aircraft may imply that the collateral’s asset value comfortably exceeds the face amount of the bonds. The bonds may come due, however, when the notoriously cyclical airline business is in a downturn, making it difficult for the borrower to refinance the debt. Demand for used aircraft is likely to be minimal at that point, reducing the liquidation value of the collateral to much less than the bonds’ face amount.

Takeovers, recapitalizations, and other restructurings increase the importance of asset coverage protection. Unfortunately for some bondholders, mergers or takeovers may decimate their asset coverage by adding layers of debt to the corporate structure that is senior to their holdings. While the analyst may find it difficult to predict takeovers, it is crucial to evaluate the degree of protection from takeovers and other restructurings that the bond indenture offers.

In extreme cases, the analyst must consider asset coverage in the case of bankruptcy. This is particularly important in the case of lease obligations because the debtor has the ability to reject leases in bankruptcy. In the case of lease rejections, the resulting asset protection may depend on a legal determination of whether the underlying lease is a true lease or a financing arrangement. Even if the lease if determined to be a true lease, the determination of asset protection is further complicated by a determination of whether the lease relates to nonresidential real property or to personal property. The difference in security (i.e., recovery in a bankruptcy) is significant. Damages under a lease of nonresidential real property are limited to three years of lease payments. Damages under a lease of personal property are typically based on all amounts still due under the lease.

In addition to the major variables just discussed, the analyst also should consider several other financial variables, including intangibles, unfunded pension liabilities, the age and condition of the plant, and working capital adequacy.

Intangibles

Intangibles often represent a small portion of the asset side of a balance sheet. Occasionally, particularly with companies that have or have had an active acquisition program, intangibles can represent a significant portion of assets. In this case, the analyst should estimate the actual value of the intangibles and determine whether this value is in concert with a market valuation. A carrying value significantly higher than market value indicates a potential for a writedown of assets. The actual write-down may not occur until the company actually sells a subsidiary with which the intangibles are identified. However, the analyst should recognize the potential and adjust capitalization ratios accordingly.

Unfunded Pension Liabilities

Unfunded pension liabilities also can affect a credit decision. Although a fully funded pension is not necessary for a high credit assessment, a large unfunded pension liability that is 10% or more of net worth can be a negative. Of concern is the company with unfunded pension liabilities high enough to interfere with corporate planning.2 For example, in the late 1980s, a steel company with high unfunded pension liabilities might have delayed or decided against closing an unprofitable plant because of the pension costs involved. The analyst also should be aware of a company’s assumed rate of return on its pension funds and salary-increase assumptions. The higher the assumed rate of return, the lower the contribution a company must make to its pension fund, given a set of actuarial assumptions. Occasionally, a company having difficulty with its earnings will raise its actuarial assumption and thereby lower its pension contribution and increase earnings. The impact on earnings can be dramatic. In other cases, companies have attempted to “raid” the excess funds in an overfunded retirement plan to enhance earnings.

In periods of declining interest rates, the analyst also must consider the discount rate companies use to discount their future obligations. Companies generally use the yield of AA corporate bonds as a discount factor, a benchmark that has been criticized by market analysts.

Age and Condition of Plant

The age of a company’s plant also should be estimated, if only to the extent that it differs dramatically from industry standards. A heavy industrial company with an average plant age well above that of its competitors is probably already paying for its aged plant through operating inefficiencies. In the longer term, however, the age of the plant is an indication of future capital expenditures for a more modern plant. In addition, underdepreciation of the plant significantly increases reported earnings.

The availability of information regarding the average age and condition of plants varies among companies. On the one hand, airline carriers readily provide the average age of their fleet and the money they will save as they replace older aircraft with more fuel-efficient aircraft that require fewer people in the cockpit. On the other hand, the average age of a plant compared with the industry average is not always available for some companies such as paper producers. Furthermore, companies with older plants generally emphasize the capital improvements that have been made to them over the years, which distort direct comparisons. In this case, it is helpful to read closely several years of management’s explanation of operating results in the annual reports. Often this section will include mentions of above-average maintenance expense and machines that were out of service for a period of time for maintenance. Such comments indicate that the plants and machines may not be as efficient as portrayed initially.

Working Capital

A final variable in assessing a company’s financial strength concerns the strength and liquidity of its working capital. Working capital is defined as current assets less current liabilities. Working capital is considered a primary measure of a company’s 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 company’s liquidity measures, the better it can weather a downturn in business and cash flow.

In assessing this variable, the analyst should consider the normal working capital requirements of a company and industry. The components of working capital also should be analyzed. Although accounts receivable are considered to be liquid, an increase in the average days a receivable is outstanding may be an indication that a higher level of working capital is needed for the efficient running of the operation. Furthermore, companies frequently have account receivable financing, some with recourse provisions. In this scenario, comparisons among companies in the same industry may be distorted.

The state of contraction or expansion also should be considered in evaluating working capital needs. Automobile manufacturers typically need increased working capital in years when automobile sales increase.

Analysis of the Components of Return on Equity

Once the preceding financial analysis is complete, the bond analyst traditionally examines the earnings progression of the company and its historical return on equity (ROE). This section of analysis often receives less emphasis than the traditional ratio analysis. It is equally important, however, and demands equivalent emphasis. An analysis of earnings growth and ROE is vital in determining credit quality because it gives the analyst necessary insights into the components of ROE and indications of the sources of future growth. Equity analysts devote a major portion of their time to examining the components of ROE, and their work should be recognized as valuable resource material.

A basic approach to examining the components of ROE breaks down return on equity into four principal components: pretax margins, asset turnover, leverage, and one minus the tax rate.3 These four variables multiplied together equal net income/stockholders’ equity, or return on equity, as shown below:

Net income/equity = (net pretax income/sales + operating pretax income/sales) × (sales/assets) × (assets/equity) × (1 – tax rate)

The analyst should examine the progression of these four components of ROE for a minimum of five years and through at least one business cycle. The progression of each variable should be compared with the progression of the same variables for the industry, and deviations from industry standards should be further analyzed. For example, perhaps two companies have similar ROEs, but one company is employing a higher level of leverage to achieve its results, whereas the other company has a higher asset-turnover rate. Since the degree of leverage is largely a management decision, the analyst should focus on asset turnover. Why have sales for the former company turned down? Is this downturn a result of a general slowdown in the industry, or is it that assets have been expanded rapidly, and the company is in the process of absorbing these new assets? Conversely, a relatively high rise in asset-turnover rate may indicate a need for more capital. If this is the case, how will the company finance this growth, and what effect will the financing have on the firm’s embedded cost of capital?

The analyst should not expect similar components of ROE for all companies in a particular industry. Deviations from industry norms are often indications of management philosophy. For example, one company may emphasize asset turnover, and another company in the same industry may emphasize profit margin. As in any financial analysis, the trend of the components is as important as the absolute levels.

Nonfinancial Factors

After the traditional bond analysis is completed, the analyst should consider some nonfinancial factors that might modify the evaluation of the company. Among these factors are the degree of foreign exposure, the quality of management, and ownership. The amount of foreign exposure should be ascertainable from the annual report. Sometimes, however, specific country exposure is less clear because the annual report often lists foreign exposure by broad geographic divisions. If there is concern that a major portion of revenue and income is derived from potentially unstable areas, the analyst should carefully consider the total revenue and income derived from the area and the assets committed. Further consideration should be given to available corporate alternatives should nationalization of assets occur. Additionally, the degree of currency exposure should be determined. If currency fluctuations are significant, has management hedged its exposure?

The internationalization of the bond markets and the ability of countries to issue debt in other countries highlight the importance of understanding the effect of currency risks. For example, many Mexican companies issued U.S. dollar–denominated debt in the early 1990s. This issuance had a positive impact on the financials of these Mexican companies because of the generally lower interest rates available in the United States relative to Mexico. However, when the peso was devalued significantly in December 1994, the ability of some of these companies to meet their U.S. dollar–denominated obligations was questioned. Of particular concern were the companies whose revenues were largely denominated in pesos but whose interest expense was denominated in U.S. dollars.

The quality and depth of management are more difficult to evaluate. The best way to evaluate management is to spend time with management, if possible. Earnings progress at the firm is a good indication of the quality of management. Negative aspects would include a firm founded and headed by one person who is approaching retirement and has made no plan for succession. Equally negative is the firm that has had numerous changes of management and philosophy. On the other hand, excessive stability is not always desirable. In discussing the factors it considers in assigning a credit rating, Moody’s Investors Service notes the following regarding the quality of management:

Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is a management’s ability to react appropriately that will sustain the company’s performance.4

In assessing management quality, the analysts at Moody’s, for example, try to understand the business strategies and policies formulated by management. Following are factors that are considered: (1) strategic direction, (2) financial philosophy, (3) conservatism, (4) track record, (5) succession planning, and (6) control systems.

In recent years, focus has been on the corporate governance of the firm and the role of the board of directors. The bylaws are the rules of governance for the corporation. The bylaws define the rights and obligations of officers, members of the board of directors, and shareholders. Several firms have developed services that assess corporate governance. One type of service provides confidential assessment of the relative strength of a firm’s corporate governance practices. The customer for this service is a corporation seeking external evaluations of its current practice. The second is a service that rates (or scores) the corporate governance mechanisms of companies. Generally, these ratings are made public at the option of the company requesting an evaluation.

Analysts should also consider the ownership of a company. If a single family or small group of investors holds a controlling interest, the company may tend to be overly conservative in its response to changes in its markets. Owners also should be judged in terms of whether they are strategic or financial. Often financial buyers invest for the short to intermediate term, hoping to sell their positions (or the entire company) at a profit. If such a sale involves a leveraged buyout, the credit quality of the bonds is lowered, sometimes dramatically.

COMBINING FINANCIAL AND NONFINANCIAL ANALYSIS

The ultimate credit judgment on a company must consider both its financial risk profile and its business risk profile. Strength in one aspect of credit quality may be offset by weakness in the other. Exhibit 43–3 illustrates one approach to integrating the two modes of analysis.

EXHIBIT 43–3
Business and Financial Risk Profile Matrix

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Standard & Poor’s employs a matrix of six levels of business risk, from “excellent” to “vulnerable,” and six levels of financial risk, from “minimal” to “highly leveraged.” The table shows the midpoint of the range of ratings that may be assigned to a company within a given cell. The actual rating ordinarily will be within one notch of that rating. For example, in most cases a company with a “satisfactory” business risk profile and an “intermediate” financial risk profile will be rated in the range of BBB + to BBB–.

Certain cells, such as “excellent” business risk profile/“highly leveraged” financial risk profile, are blank. This is because such combinations are extremely improbable. For some companies, overarching risks such as major litigation and balance-sheet-straining acquisitions fall outside the matrix. Finally, the matrix excludes ratings lower than CCC+ because by definition, companies in those categories reflect an acute vulnerability or impending crisis.

Specific obligations may be rated higher than the company rating, based on security, or lower than the company rating, based on subordination within the capital structure. Subordination includes structural subordination, whereby servicing of a holding company’s debt depends on receiving dividends from subsidiaries. By law, dividends can be paid only after the subsidiaries’ own debt has been serviced.

Exhibit 43–4 provides a key to the classifications of companies within the six financial risk profile categories. For example, a company with funds flow from operations to debt of 45% to 60%, debt/earnings before interest, taxes, depreciation, and amortization (EBITDA) of 1.5 to 2×, and debt/capital of 25% to 35% is deemed to have “modest” financial risk. S&P characterizes these benchmark ratios as guidelines rather than absolute rules. For instance, a company with very stable financial ratios may qualify for a particular financial risk category despite a somewhat lower FFO/debt percentage or a higher debt/capital percentage than shown in the exhibit. Electric utilities benefit from this leeway because of their demonstrated superiority in access to capital, their liquidity, and their effective management of capital programs and maturity schedules.

EXHIBIT 43–4
Financial Risk Indicative Ratios (Corporate)

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INDENTURE PROVISIONS

An indenture is a contract that defines the legal rights and obligations of the issuer and the bondholders, represented through the trustee, with respect to a bond issue. The indenture establishes fundamental rules for three primary investor concerns: (1) payments by the issuer to bondholders; (2) limits on the kinds of issuer behavior that may harm bondholders’ prospects for repayment; and (3) the enforcement mechanisms available to bondholders if issuers do not fulfill their obligations.

First, the indenture and the related note that represents the debt enshrine a bondholder’s individual right to the timely payment of principal and interest. The bond may also be subject to special pricing and redemption provisions, such as a ratings-based coupon step-up, a call schedule, a make-whole redemption, a sinking fund, or a maintenance and replacement fund. These payment provisions are discussed in Chapter 12.

Second, the indenture will contain provisions called covenants that attempt to limit some issuer behavior that could increase credit risk. For example, if an issuer doubles its amount of outstanding debt in order to pay dividends to shareholders while neglecting reinvestment in its business, then bondholders will face a greater risk of a payment default on their bonds. A strong Debt covenant or Restricted Payments covenant could limit this kind of recapitalization event. Indenture analysis is principally focused on restrictive covenants not only to help evaluate contractual protections against risky behavior by issuers, but also to consider the upside possibility of a consent solicitation or a premium tender for their bonds if the issuer wants to take actions that otherwise would be restricted by the bond covenants. Covenant protections can have important market pricing implications, especially in the leveraged-buyout (LBO) context. When the Texas power company TXU Corp. was acquired in 2007, it had significant bonds outstanding at three different legal entities. The TXU holding company bonds had very weak covenant protections and remained outstanding and traded well below par for years after the LBO, while the TXU Energy subsidiary bonds had stronger covenant protections that would have impeded the optimal LBO financing, and so they were redeemed at a premium. The value of a third set of bonds was relatively protected because they had been issued by a different, state-regulated subsidiary with limits on its ability to borrow.

Covenant protections can vary enormously even among bonds of the same issuer, but they can generally be described as being investment-grade or high-yield type covenants. Some industry groups such as real estate investment trusts (REITs) and finance companies have special covenant features, as explained below. Bear in mind that covenants vary over time as investors become more or less sensitive to event risk and the view of what is “market” practice changes. For example, Change of Control puts and secured debt restrictions became very important for investment-grade bond investors following the 1988 LBO of RJR Nabisco, but then generally waned over the next two decades, until the buyout boom of the mid-2000s and resulting bondholder losses resurrected these kinds of protections.

Enforcement is the third primary concern. If there is a default under the indenture, then the enforcement of bondholder rights is handled according to detailed rules that are generally similar among all corporate indentures. Generally, if there is payment default because a principal or interest payment is not made on time, then the trustee may act on its own to sue for payment, although an individual bondholder can also sue for payment. If there is a covenant default, such as selling an asset in violation of an Asset Sales covenant, then enforcement could occur in several ways. The issuer might realize its mistake and attempt to cure, or remedy, the breach if possible. The issuer might ask bondholders for permission in a consent solicitation for a waiver from having to comply with the indenture provision or for an amendment to the indenture so that the covenant is changed. Bondholders or the trustee might become aware of a default and formally give notice of a default to try to accelerate the bonds for early payment. Sometimes, the issuer, trustee, and bondholders might disagree about the meaning of an indenture covenant and litigate the matter. For example, when Tyco International split its businesses into three separate, publicly traded companies, bondholders sued to stop the transaction based on a violation of the Mergers covenant, and Tyco paid to settle the litigation. Typically, either the trustee or 25% of bondholders must act in order to declare a default and attempt to accelerate the bonds.

Bond indentures should be considered in light of the covenants in bank credit agreements. Frequently, loan covenants can be more restrictive than bond covenants. In particular, credit agreements often contain maintenance covenants that require the borrower to maintain a certain level of consolidated net worth, a ratio of total debt to cash flow, or some other financial metrics that serve as a proxy for the creditworthiness of the borrower. If a maintenance covenant is breached, then the lenders can seek to accelerate. Bondholders sometimes hope that the more restrictive bank credit agreements will provide some aura of protection to bondholders, but investors should be cautious about this idea. Borrowers often ask lenders for waivers and amendments, and in recent years there are numerous examples in which some market participants took credit views based on expected covenant breaches that turned out to be incorrect, such as when MGM Mirage (Resorts) obtained a series of amendments from its lenders in 2009 that involved pledging additional collateral. Similarly, some analysts expected Clear Channel to face insolvency based on noncompliance with its leveraged-based maintenance covenant in 2009, but this view was based on a misunderstanding of the credit agreement definitions.

Note that the prospectus or offering memorandum for a bond will contain a description of the covenants, but it is the indenture that controls as the legally binding contract, and so the indenture should be used for covenant analysis. The indenture of a U.S. issuer usually can be obtained from the SEC’s EDGAR website if the issuer is a public company or otherwise files with the SEC. Alternately, the indenture may be obtained from the trustee who is listed in the prospectus or sometimes directly from the issuer.

Outlined below are the most common indenture covenants, and how they vary for investment-grade versus high-yield bonds. Following that is an explanation of some special industry and bond types. Bear in mind that covenants work together as a kind of “system” where one corporate action can implicate multiple indenture provisions.

Typical Bond Covenants
Guarantees/Future Guarantors Covenant

A bond is primarily the obligation of the issuer. Often the issuer is a holding company that relies on its own subsidiaries to upstream cash for the issuer to make payments to bondholders. If the issuer fails to make a payment, then bondholders may want to make a claim for payment against the subsidiaries that hold the operating assets. This is possible if there are subsidiary guarantees by which the issuer’s subsidiaries promise to pay interest and principal if the issuer does not. A bond may have subsidiary guarantees when it is issued, or a Future Guarantors covenant may require subsidiaries to provide guarantees in the future. Guarantees are an important determinant of recoveries in bankruptcy, especially when there may be significant debt, trade claims, or other liabilities against subsidiaries. A guarantee can put the bondholders’ claims on an equal footing with other claims against subsidiaries.

Investment-grade bonds usually do not have subsidiary guarantees, while high-yield bonds typically are offered with these guarantees.

Debt Covenant

The Debt covenant limits the amount of additional borrowings by the issuer. A Debt covenant has become rare among investment-grade bonds, but is customary for high-yield issues. The typical version says that the issuer and its subsidiaries generally cannot incur debt unless a Ratio test is met, which typically requires meeting a pro forma 2× EBIDTA: interest expense coverage ratio or a maximum debt: EBITDA leverage ratio. However, even when the Ratio test cannot be met, certain types of Permitted Debt are allowed. Permitted Debt includes specific carveouts such as for a set amount of credit facilities, project and acquisition financing, and a general purpose debt basket. Generally, a Debt covenant is designed to allow an issuer to borrow more money when its EBITDA and total asset base are increasing. The risk to bondholders is that the new debt remains even if financial results decline, because the Debt covenant is not a maintenance covenant.

Importantly, for the Debt covenant and other restrictive covenants, investors must confirm which entities in the capital structure must obey the covenants. Ideally, the issuer and all its subsidiaries would be subject to the covenants, but many indentures exempt so-called unrestricted subsidiaries.

Subsidiary Debt Covenant

Investment-grade bonds occasionally have a Subsidiary Debt covenant that is intended to limit the amount of money that can be borrowed by subsidiaries, and therefore reduce the risk of structural subordination.

Negative Pledge/Liens Covenant

Bondholders generally do not want other debt to be secured ahead of or alongside their bonds, because secured debt will recover ahead of unsecured debt in bankruptcy. This concern is addressed by one of two similar provisions that have an important substantive difference. A Negative Pledge covenant is used for almost all unsecured bonds and generally requires that if some other debt becomes secured, then the bonds must be equally and ratably secured. The Negative Pledge for an investment-grade bond will typically only restrict pledging some subset of the issuer’s total assets (for example, manufacturing plants), allow exceptions to finance capital expenditures and asset acquisitions, and have a general secured debt carveout equal to 10% to 15% of a balance sheet metric such as consolidated net tangible assets or stockholders’ equity. For a high-yield bond, the covenant will typically apply to all of the issuer’s assets, but a lengthy list of Permitted Liens will have carveouts matched to particular items of Permitted Debt and other exceptions.

In comparison, a secured bond should have a true Liens covenant, which restricts securing other debt and does not give the issuer the option to secure new debt by ratably securing the existing bonds, but would still allow some Permitted Liens.

Sale/Leaseback Covenant

A Sale/Leaseback covenant is standard for investment-grade bonds and is especially important when there is significant credit support from owned manufacturing facilities or high value real estate, such as department stores with owned locations. If a company sells real estate and then takes back a lease on that property, the bondholder is harmed twice: first, as there would be fewer assets to recover against in bankruptcy, and second, as the issuer will have committed itself to future lease payments. Therefore, the covenant usually blocks a sale/leaseback transaction unless it is used to finance a new location, or the proceeds of the sale are used to repay long-term debt or acquire new assets. This covenant has been fading from usage in high-yield bonds, in part because the sale would be addressed by the Asset Sales covenant of a high-yield bond, while aspects of the lease would be addressed by the Debt and Liens covenant.

Restricted Payments Covenant

A Restricted Payments covenant primarily limits the amount of dividends that can be paid to stockholders. While these dividend restrictions might occasionally appear in investment-grade bond issues, they are now generally restricted to high-yield bonds. Typically, 50% of the issuer’s net income can be paid to stockholders, on the theory that the other half of profits should be reinvested in the business or used to pay down debt. Paying dividends based on net income is also usually conditioned upon meeting the pro forma Ratio test of the Debt covenant. This same Restricted Payments covenant will also generally limit stock purchases, repaying subordinated debt before its maturity, and making so-called restricted investments in entities such as joint ventures that might not be obligated to obey the indenture covenants.

Asset Sales Covenant

The Asset Sales covenant is rare for investment-grade bonds but standard for high-yield bonds. The covenant does not prevent asset sales, but generally requires that the proceeds of a sale be used to acquire new assets or repay debt that is secured or otherwise effectively senior to the bonds. If that is not done, then the issuer usually must offer to buy back the bonds at par within a year.

Mergers Covenant

The Mergers covenant, also known as the successor obligor provision, is designed to ensure a degree of continuity between the bond debt and the issuer’s assets that support the debt. If the issuer merges with another company or transfers “substantially all” of its assets to another company, then the bond obligation must remain with the merged company or bulk of the assets. Otherwise, investment-grade bondholders could be left holding bonds of a mere shell company that has sold off its assets, because an investment-grade bond usually does not have an Asset Sales covenant.

High-yield bonds have a similar Mergers covenant, but their version would generally require meeting the Debt covenant’s Ratio test as a condition to the merger or asset transfer.

Change of Control Covenant

The Change of Control covenant is nearly universal for high-yield bonds and allows bondholders to put bonds back to the issuer at 101% upon a defined Change of Control. This covenant is currently common for nonfinancial investment-grade bonds, but with the additional requirement that the bonds become rated below investment-grade. The Change of Control definition may include one or more triggers such as: (1) a sale of substantially all assets; (2) the acquisition of more than half of the issuer’s voting stock by a third party; (3) a merger with another company; (4) a liquidation of the company; and (5) a hostile change in the board of directors. The Change of Control put can be blunt protection against the risk of credit-damaging leverage in an LBO, a chance to assess the new ownership of the issuer, or a simple 101% put opportunity for a bond trading below par.

Special Covenants and Situations

Some industries and special situations have bond covenants that vary from the common pattern and we outline these below.

Real Estate Investment Trusts

REITs are almost always investment-grade issuers, and their covenants have a great degree of similarity to each other. The REIT indenture usually has one or more maintenance covenants based on levels of secured debt, unsecured debt, and interest coverage.

Utilities

Utilities tend to be investment-grade issuers yet have traditionally issued secured debt, often under the title of First Mortgage Bonds with indentures that have been used for decades, and sometimes feature maintenance and replacement funds and sinking funds. These secured bonds may limit the amount of additional debt that may be issued under the mortgage to a certain percentage of net property. Today, many utilities issue bonds with limited covenants that look like those of other investment-grade issuers, with only a standard make-whole redemption option. However, investors have some comfort that state utility regulations may effectively limit the leverage of these companies.

Finance Companies

Finance companies are usually investment-grade issuers and have less complex covenants than in the past. A negative pledge type Liens covenant is common, and if the issuer is a finance subsidiary of an operating company, such as GE Capital is a business of General Electric, then the parent may have a support guarantee in which the parent promises to invest in the finance subsidiary for it to maintain a certain net worth or other credit metric.

Banks and Insurance Companies

The holding companies for banks and insurance companies are typically rated investment-grade and their bonds will have a limited Liens covenant that restricts pledging shares of major subsidiaries and perhaps a limited kind of Asset Sales covenant that restricts selling significant minority stakes in major subsidiaries. The regulated subsidiaries may issue their own, higher-rated debt, in which the covenants are often less important because state and federal laws practically limit borrowing by regulated subsidiaries.

Split-Rated Issuers

Bonds issued with one investment-grade rating and one high-yield rating often have investment-grade covenants, but perhaps with the addition of a strong Future Guarantors covenant or a limited Restricted Payments covenant that controls dividend payments.

Secured High-Yield Bonds

Traditionally, bank loans were secured and bonds were not. This began to change significantly in the 2000s as bank lenders became comfortable with the idea of allowing bonds to be sold with second liens that would recover behind the bank loans. In 2010 over one-fourth of U.S. high-yield bonds were sold with some collateral protection, and both first and second liens are now common. These bonds are often subject to an intercreditor agreement that affirms the primacy of the lenders’ liens and limits somewhat the arguments that bondholders can make in bankruptcy.

Private Bonds

So-called private bonds are usually small offerings that are sold to just a handful of institutions, tend not to trade frequently, and are generally not covered by research or media outlets. These bonds can often be more heavily negotiated and include loan-like maintenance covenants.

UTILITIES

Historically, utilities have been regulated monopolies. These companies generally operate with a high degree of financial leverage and low fixed-charge coverage (relative to industrial companies). These financial parameters have been accepted historically by investors owing to the regulation of the industry and the belief that there is minimal, if any, bankruptcy risk in those securities because of the essential services they provide.

The changing structure of the electric utility industry brought about by significant investment in nuclear generating units and their inherent risk, as well as the transition to deregulation, has changed this belief. Initially, the faltering financial position of General Public Utilities precipitated by the Three Mile Island nuclear accident and the regulatory delays in making a decision regarding the units highlighted the default risk that exists in the industry. Subsequently, the defaults of several Washington Public Power Supply System issues, the restructuring of Tucson Electric Company, and the bankruptcies of Public Service Company of New Hampshire and El Paso Electric Company and the transition to deregulation reemphasized the default risk. In addition, the industry is faced with the acid rain issue and increased uncertainty in construction costs and growth rates.

Segments within the Utility Industry

There are three major segments within the utility industry: electric companies, gas companies, and telephone companies. This chapter will deal primarily with electric utilities. Many companies are involved in both electric and gas service, so analysis requires a working knowledge of both businesses. A working knowledge of the different facets of the electric utility industry is also required as traditional electric utilities diverge in their strategies, with some companies emphasizing transmission and distribution exclusively while other companies emphasize generation.

Nonfinancial Factors

Although financial factors are important in analyzing any company, nonfinancial factors are particularly important in the electric utility industry and may alter a credit assessment. The following nonfinancial factors are of particular importance to the utility industry: (1) regulation, (2) source of the company’s energy, (3) growth and stability of the company’s territory, (4) capital structure, (5) degree of activity in international and nonutility investments, and (6) competitive position.

To reflect the importance of nonfinancial factors, S&P utilizes a 10-point business risk assessment. In June 2004 S&P assigned new business profile scores to refine its assessment of relative risk among the utility and power companies. At that point the rating agency also divided the group into subsectors to allow more in-depth statistical analysis of the distribution of its ratings and its rating changes. The subsectors are Transmission and Distribution—Water, Gas, and Electric; Transmission Only—Electric, Gas, and Other; Integrated Electric, Gas, and Combination Utilities; Diversified Energy and Diversified Non-Energy; and Energy Merchant/Developers/Trading and Marketing.

Regulation

The utility industry includes both regulated and unregulated entities. In some cases, the two types coexist as subsidiaries within a single corporate structure. Power generation has been deregulated in some states, with merchant power companies selling electricity at competitive rates, but remains regulated in others. The transmission segment remains highly regulated. Retail distribution is deregulated, with consumers free to choose their providers based on such factor as price and quality of service.

For regulated entities, regulation is perhaps the most important credit analysis variable. Regulators, operating mainly at the state level, largely determine how much profit these businesses earn and retain. If a company has regulated operations in more than one state, the analyst should weight the evaluation of the regulatory environment by the revenues generated in each state. Evaluating regulatory commissions is a dynamic process.

The evaluation of regulatory commissions is a dynamic process. The composition of commissions changes because of retirements, appointments, and elections. The implications of personnel changes are not clear until decisions are made. For example, it is not always the case that elected commissioners are pro-consumer and appointments by a conservative governor are pro-business. Several brokerage firms can assist in evaluations of commissions.

In addition, the Federal Energy Regulatory Commission (FERC) regulates interstate operations and the sale of wholesale power. Currently, FERC regulation is considered to be somewhat more favorable than that of the average state regulatory commission.

Utilities that are constructing or operating nuclear reactors are also subject to the regulation of the Nuclear Regulatory Commission (NRC). The NRC has broad regulatory and supervisory jurisdiction over the construction and operation of nuclear reactors. Importantly, the NRC approves licensing of nuclear reactors, as well as the transfer of licenses.

Regulation is best quantified by recent rate decisions and the trend of these decisions. Although a company being analyzed may not have had a recent rate case, the commission’s decisions for other companies operating within the state may be used as a proxy. Regulatory commissions are either appointed or elected. In either case, the political atmosphere can have a dramatic effect on the trend of decisions.

The regulators determine innumerable issues in a rate decision, although analysts often mistakenly focus only on the allowed rate of return on equity or the percentage of request granted. For example, a commission might rule that an electric utility must reduce rates by 10%. However, if the commission allows the utility to accelerate its depreciation, the negative effect on the cash flow of the company from the rate reduction may be largely offset, particularly if the company had been or was expected to exceed its allowed ROE. The commissions also determine how much of construction work in progress (CWIP) is allowed into the rate base. A company may appear to have a favorable allowed ROE but be hurt by the fact that only a small portion of the company’s capital is permitted to earn that return, and the CWIP earns nothing. Allowance of CWIP in the rate base was of critical importance during the 1980s because of the high construction budgets for nuclear generating plants and the length of time these plants were under construction. Some companies have had more than half their capital in CWIP that was not permitted to earn a return.

The importance of whether CWIP is allowed in the rate base is highlighted by the financial distress and January 1988 bankruptcy filing of Public Service Company of New Hampshire (PSNH). PSNH’s Seabrook Nuclear Unit I was virtually complete in 1986. However, licensing delays and New Hampshire’s statutory prohibition of CWIP in the rate base were major contributing factors in the bankruptcy filing.

In addition, regulators have a high degree of control over the cash flow of a company through the allowance or disallowance of accounting practices and the speed with which decisions are made on cases.

Source of the Company’s Energy

The source of the company’s energy is a second important variable, with the impact on fuel cost being especially important for merchant generators. Each fuel must be evaluated in the context of the overall cost of operating a plant. For many years, nuclear generation was out of favor because of extensive licensing requirements, high capital costs, and heavy decommissioning expenses. Companies with large dependence on nuclear power were viewed less favorably than those with natural gas or coal units. More recently, nuclear-based generation companies have gained popularity among investors as they have written down their capital costs, while coal has suffered from escalating pollution concerns and the cost of oil and natural gas has risen. Additionally, in the mid 2000s, a number of nuclear-powered utilities were successful in their requests for 20-year license renewals.

Growth and Stability of the Company’s Territory

The energy-source variable relates to a third variable—the growth and stability of the company’s territory. Although above-average growth is viewed positively in an industrial company, above-average growth gets mixed reviews with respect to an electric utility. An electric utility with above-average growth may face construction earlier than its competitors depending on the supply/demand balance and regulation in its service territory.

Slow growth is not necessarily positive if it places a utility in a position of excess capacity. The increase in cogeneration and the mergers executed in order to better match supply and demand can place a utility at risk. This can result if utility A is selling power to utility B. If the expiration of the contract coincides with utility B’s ability to purchase power for less and results in utility B’s nonrenewal of the contract, utility A may be negatively affected unless it can sell the power to a third utility. The issue of growth has been complicated by deregulation and the requirement in many states for disaggregation of generation from transmission and distribution, as well as the requirement that customers be allowed to choose their supplier. In this new era, utilities engaged in generation must be able to match supply and demand for power.

Corporate Structure

A fourth variable, whether or not a company is a subsidiary of a holding company, also should be considered. Holding-company status permits nonutility subsidiaries, but these subsidiaries (even if successful) will not necessarily improve the overall credit quality of the company. This depends on the regulatory atmosphere. Furthermore, when there are several electric utility subsidiaries, the parent is more likely to give relatively large equity infusions to the relatively weak subsidiaries. The stronger subsidiary may have to support the other subsidiaries. Finally, holding companies should be analyzed in terms of consolidated debt. Although a particular subsidiary may have relatively strong financial parameters, off-balance-sheet financing may lower the overall assessment.

Competitive Position

A final nonfinancial factor is the competitive position of a utility. An electric utility with a comparatively low rate structure is generally in a stronger position politically to request rate increases or to request a rate freeze than one with rates higher than national averages and particularly one with rates higher than regional averages.

The competitive position of an electric utility is increasingly important as customer choice increases. Companies with high overall rates, and particularly those with high commercial rates, may find themselves losing customers as access to transmission and distribution lines increases.

Financial Analysis

The changing competitive nature of the electric industry resulting from deregulation requires that the traditional evaluation of an electric utility be modified. Although historic ratio analysis still should be conducted, an electric company also should be evaluated in the context of its new competitive situation. Is new generation being constructed in its territory that produces energy at a lower cost than the established generation? How does the company plan to expend its excess cash flow? In an era of consolidation, will the company be acquired or be an acquirer? Will the company remain in generation or sell its generation and deal solely with transmission and distribution? Location is also important. Some merchant power plants have been constructed too far from the power grid to succeed.

The following major financial ratios should be considered in analyzing an electric utility: (1) leverage, (2) pretax interest coverage, (3) cash-flow/capital expenditures, and (4) cash flow/capital.

Leverage

In calculating the debt leverage of an electric utility, long-term debt/capitalization is standard. However, the amount of short-term debt also should be considered because this is generally variable-rate debt. A high proportion of short-term debt also may indicate the possibility of the near-term issuance of long-term bonds. In addition, several companies guarantee the debt of subsidiaries (regulated or nonregulated). The extent of these guarantees should be considered in calculating leverage.

Fixed-charge coverage for the electric utilities is low relative to coverage for industrial companies. This is accepted by investors because of the stability of the industry. However, emphasis should be placed not only on the exact coverage figures but also on the trend and quality of the coverage.

A third important ratio is net cash-flow/capital expendures. This ratio should be approximated for three years (the typical electric company’s construction forecast). The absolute level, as well as the trend of this ratio, gives important insights into the trend of other financial parameters. An improving trend indicates that construction spending probably is moderating, whereas a low net cash flow/spending ratio may indicate inadequate rates being approved by the commissions and a heavy construction budget. Estimates for construction spending are published in the company’s annual reports. Although these are subject to revision, the time involved in building generation makes these forecasts reasonably reliable. In calculating cash flow, the standard definition outlined earlier should be followed. However, allowance for funds used during construction (AFUDC) also should be subtracted.

FINANCE COMPANIES

Finance companies are essentially financial intermediaries. Their function is to purchase funds from public and private sources and to lend them to consumers and other borrowers of funds. Finance companies earn income by maintaining a positive spread between what the funds cost and the interest rate charged to customers. The finance industry is highly fragmented in terms of type of lending and type of ownership. This section will briefly outline the major sectors in the industry and then discuss the principal ratios and other key variables used in the analysis of finance companies.

Segments within the Finance Industry

The finance industry can be segmented by type of business and ownership. Finance companies lend in numerous ways in order to accommodate the diverse financial needs of the economy. Five of the major lending categories are (1) sales finance, (2) commercial lending, (3) wholesale or dealer finance, (4) consumer lending, and (5) leasing. Most often companies are engaged in several of these lines rather than one line exclusively. Sales finance is the purchase of third-party contracts that cover goods or services sold on a credit basis. In most cases, the sales finance company receives an interest in the goods or services sold. Commercial finance is also generally on a secured basis. However, in this type of financing, the security is most often the borrower’s accounts receivable. In factoring, another type of commercial lending, the finance company actually purchases the receivables of the company and assumes the credit risk of the receivables.

Dealer or wholesaler finance is the lending of funds to finance inventory. This type of financing is secured by the financed inventory and is short term in nature. Leasing, on the other hand, is intermediate- to long-term lending—the lessor owns the equipment, finances the lessee’s use of it, and generally retains the tax benefits related to the ownership.

Consumer lending historically has involved short-term, unsecured loans of relatively small amounts to individual borrowers. In part because of the more lenient bankruptcy rules and higher default rates on consumer loans, consumer finance companies have dramatically expanded the percentage of their loans for second mortgages. The lower rate charged to individuals for this type of loan is offset by the security and lower default risk of the loan.

There are numerous other types of lending in addition to those just described. Among these are real estate lending and export/import financing.

The ownership of a finance company can significantly affect evaluation of the company. In some instances, ownership is the most important variable in the analysis. There are three major types of ownership of finance companies: (1) captives, (2) wholly owned, and (3) independents.

Captive finance companies, such as Ford Motor Credit, are owned by the parent corporation and are engaged solely or primarily in the financing of the parent’s goods or services. Generally, maintenance agreements exist between the parent and the captive finance company under which the parent agrees to maintain one or more of the finance company’s financial parameters, such as fixed-charge coverage, at a minimum level. Because of the overriding relationship between a parent and a captive finance subsidiary, the financial strength of the parent is an important variable in the analysis of the finance company. However, captive finance companies can have ratings either above or below those of the parent.

A wholly owned finance company differs from a captive in two ways. First, it primarily finances the goods and services of companies other than the parent. Second, maintenance agreements between the parent and the subsidiary generally are not as formal. Frequently, there are indenture provisions that address the degree to which a parent can upstream dividends from a finance subsidiary. The purpose of these provisions is to prevent a relatively weak parent from draining a healthy finance subsidiary to the detriment of the subsidiary’s bondholders.

Independent finance companies are either publicly owned or closely held. Because these entities have no parent, the analysis of this finance sector is strictly a function of the strengths of the company.

Financial Analysis

In analyzing finance companies, several groups of ratios and other variables should be considered. There is more of an interrelationship between these ratios and variables than for any other type of company. For example, a finance company with a high degree of leverage and low liquidity may be considered to be of high investment quality if it has a strong parent and maintenance agreements. Variables should be viewed not in isolation but rather within the context of the whole finance company–parent company relationship.

Asset Quality

The most important variable in analyzing a finance company is asset quality. Unfortunately, there is no definitive way to measure asset quality. However, there are several variables that in the aggregate present a good indication of asset quality.

Diversification is one measure of portfolio quality. Is the portfolio diversified across different types of loans? If the company is concentrated in or deals exclusively in one lending type, is there geographic diversification? A company that deals exclusively in consumer loans in the economically sensitive Detroit area would not be viewed as favorably as a company with broad geographic diversification. Accounting quality is also an important factor in assessing portfolio quality. The security for the loans is also an important variable in portfolio quality. The stronger the underlying security, the higher is the loan quality. Analysts should be concerned primarily with the level of loans compared with levels of similar companies and the risk involved in the type of lending. For example, the expected loan loss from direct unsecured consumer loans is higher than for consumer loans secured by second mortgages. However, the higher fees charged for the former type of loan should compensate the company for the higher risk.

Numerous ratios of asset quality such as loss reserves/net charge-offs, net losses/average receivables, and nonperforming loans/average receivables give good indications of asset quality. However, finance companies have a high level of discretion in terms of what they consider and report to be nonperforming loans and what loans they charge off. Therefore, unadjusted ratios are not comparable among companies. In addition, companies periodically change their charge-off policies.

Despite the drawbacks of the asset-quality ratios, they are useful in indicating trends in quality and profitability. Of these ratios, loss reserves/net charge-offs is perhaps the most important ratio in that it indicates how much cushion a company has. A declining ratio indicates that the company may not be adding sufficient reserves to cover future charge-offs. Such a trend may lead to a future significant increase in the reserves and therefore a decrease in earnings as the increase is expensed. Net losses/average receivables and nonperforming loans/average receivables are other indicators of asset quality. An increasing ratio indicates a deterioration in quality. Declines may be exacerbated by an overall contraction or slow growth in the receivables. On the other hand, because of different accounting treatments, a stable net losses/average receivables ratio under deteriorating economic conditions may indicate a delay in loss recognition. Consideration also should be given to the age of receivables. In recent years, some finance companies have increased their lending dramatically over a short period of time and reported material improvement in their overall financial parameters. These results have been misleading in some cases where the dramatic improvement has been driven by inadequate reserves. Often the dramatic improvement has been followed by increased losses as the portfolio ages.

The long-term history of a company is also an indicator of credit quality. Does management have a history of managing risk conservatively? How long has management been in place? Is there pressure on management to accelerate growth? Has management responded to this type of pressure by expanding into more risky businesses either through acquisition or internal expansion?

Leverage

Leverage is a second important ratio used in finance company analysis. By the nature of the business, finance companies typically and acceptably are more highly leveraged than industrial companies. The leverage is necessary to earn a sufficient return on capital. However, the acceptable range of leverage depends on other factors, such as parental support, portfolio quality, and type of business. The principal ratio to determine leverage is total debt to equity, although such variations as total liabilities to equity also may be used. In a diversified company with high portfolio quality, a leverage ratio of 5 to 1 is acceptable. On the other hand, a ratio as high as 7 to 1 is acceptable for a captive with a strong parent and maintenance agreements. The analyst always should view the leverage of a finance company in comparison with similar companies.

Liquidity

The third important variable in finance company analysis is liquidity. Because of the capital structure of finance companies, the primary cause of bankruptcies in this industry is illiquidity. If for some reason a finance company is unable to raise funds in the public or private market, failure can follow quickly. This inability to raise funds could result from internal factors, such as a deterioration in earnings, or from external factors, such as a major disruption in the credit markets. Whatever the cause, a company should have some liquidity cushion. The ultimate fallback, a sale of assets, is only a last resort because the sales could have long-term detrimental effects on earnings. The traditional liquidity ratio is cash, cash equivalents, and receivables due within one year divided by short-term liabilities. The higher this ratio, the higher is the margin of safety. Also to be considered are the liquidity of the receivables themselves and the existence of bank lines of credit to provide a company with short-term liquidity during a financial crisis. Liquidity calculations also should consider contractual obligations to fund loans. In general, the smaller and weaker companies should have a higher liquidity cushion than companies with strong parental backing that can rely on interest-free loans from their parents in times of market stress. Finally, analysts should take into account a company’s ability to raise secured funding, either from banks or private investors or through asset-backed securities facilities.

Asset Coverage

A fourth important variable in the analysis of finance companies that is related to the three variables just discussed is the asset coverage afforded the bondholder. In assessing asset protection, the analyst should consider the liquidation value of the loan portfolio.

A definitive assessment of the value of assets is difficult because of the flexibility finance companies have in valuing assets. For example, a finance company that plans to liquidate its commercial real estate portfolio over 12 months in a depressed real estate environment will value its assets much lower than if it planned to sell the same assets systematically over a three- to five-year period. The value of interest-only securities (IOs) created from a finance company’s asset securitizations is also subjective and depends on future credit experience and prepayments. Is management conservative or aggressive in valuing these instruments? How has management valued the residuals of automobile leases? Are there periodic write-offs or gains on these loans?

Earnings Record

The fifth variable to be considered is the finance company’s earnings record. The industry is fairly mature and is somewhat cyclical. The higher the annual EPS growth, the better. However, some cyclicality should be expected. In addition, the analyst should be aware of management’s response to major changes in the business environment. The easing of personal bankruptcy rule over the years and the fact that personal bankruptcy is becoming more socially acceptable have produced significantly higher loan losses in direct, unsecured consumer loans. Many companies have responded to this change by contracting their unsecured personal loans and expanding their portfolios invested in personal loans secured by second mortgages.

Management

The sixth variable to be considered is the finance company’s management. This variable is difficult to assess. However, a company visit combined with an evaluation of business strategies and credit scoring methodologies (analysis used for assessing loan applicants) will provide some insight into this variable.

Size

A final factor related to the finance company or subsidiary is size. In general, larger companies are viewed more positively than smaller companies. Size has important implications for market recognition in terms of selling securities and of diversification. A larger company can more easily diversify the types and geographical location of its loans, thereby lessening the risk of its portfolio, than a smaller company can.

In addition to an analysis of the financial strength of the company according to the preceding variables, the analyst must incorporate the net effect of any affiliation the finance company has with a parent. If this affiliation is strong, it may be the primary variable in the credit assessment. The affiliation between a parent company and a finance subsidiary is straightforward; it is captive, wholly owned, or independent. However, the degree to which a parent will support a finance subsidiary is not as straightforward. Traditionally, the integral relationship between a parent and a captive finance subsidiary has indicated the highest level of potential support. However, it is becoming increasingly clear that a wholly owned finance subsidiary can have just as strong an affiliation. For example, General Electric Capital finances few or no products manufactured by its parent, General Electric Company (GE). GE, however, receives substantial tax benefits from its consolidation of its tax return with GE Capital. Additionally, GE has a sizable investment in the finance subsidiary. In this case, the parent also has a formal agreement with GE Capital by which it is committed to infuse capital if fixed charge coverage of 1.1 × is not maintained. Even aside from that mechanism, there is a strong presumption that GE would protect its investment in GE Capital if the finance subsidiary were to need assistance. In other cases, the benefit of a strong affiliation and maintenance agreement may be offset by weakness in the parent company’s financial position.

In addition to affiliation, affiliate profitability, and maintenance agreements, the analyst also should examine any miscellaneous factors that could affect the credit standing of the finance company. For example, new legislation could produce significant changes in the finance industry’s structure or profitability. Cases in point of recent years include the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

THE ANALYSIS OF HIGH-YIELD CORPORATE BONDS

High-yield bonds, sometimes disparagingly referred to as “junk bonds,” are corporate issues rated speculative grade (below Baa/BBB–). Like all corporate bonds, they combine interest rate risk with credit risk, but unlike investment-grade issues, credit risk dominates their price movements. The high-yield universe is split between fallen angels, which are bonds rated investment-grade at issuance and subsequently downgraded to speculative grade, and original issue high-yield bonds that were rated speculative grade at issuance. Fallen angels have the disadvantage of the looser covenants associated with their original ratings. In many cases, however, they are run by managers who are strongly motivated to recapture their investment-grade ratings through prudent financial policies that can lead to upgrading. Original issue high-yield bonds offer the advantage of stronger covenants and in some cases, the possibility that as comparatively new issuers that are not yet widely known, they are underrated by the rating agencies and undervalued by bond investors.

Many of the tools employed in evaluating investment-grade bonds can also be applied to high-yield issues, but the emphasis of the analysis is different. In contrast to the investment-grade universe, where it is extremely rare for a company to go directly to default, an average of more than 4% of speculative grade issuers default each year.5 As a consequence, high-yield analysts must focus intensely on the downside in a company’s operations, its sources of liquidity, and the salvage value of its assets in the event of default.

The price of a company’s high-yield bonds, like its stock price, can be highly sensitive to minor changes in the earnings outlook. High-yield analysts therefore operate much as equity analysts do in participating in companies’ earnings calls and tracking industry data that may shed light on future profits. They go beyond their equity counterparts in studying the details of the issuers’ funding capability and covenant provisions, which become highly pertinent under conditions of financial stress.

The following sections address aspects of credit analysis that require expanded attention in the analysis of high-yield corporate bonds.

Competition

In the popular mind, high-yield companies are small players in their markets, yet over the years there have been many exceptions to this stereotype. Examples include the three largest U.S. automakers (General Motors, Ford Motor Company, and Chrysler), the world’s largest operator of health care facilities (HCA), and the world’s largest casino operator (Caesars Entertainment). Size does not automatically confer a competitive advantage, nor do smaller companies invariably report inferior profit margins due to a lack of scale economies. Instead of participating in all market segments, including mature and highly competitive ones, some small companies manage to carve out highly profitable niches. They do not strive to minimize unit costs by maximizing volume, but instead obtain premium prices by offering superior selection or convenience.

By the same token, analysts should not accept at face value the glib assertions of high-yield market promoters that the rating agencies arbitrarily and mistakenly penalize companies for being small. The agencies do not rate companies speculative grade because they are small, but rather because of certain consequences of their smallness.

Some small companies lack geographical diversification and are therefore highly vulnerable to a regional economic downturn. Others have no credible succession plans in place because domination by strong-willed founders makes it difficult for them to attract and retain capable candidates at the next level of management. Neither should analysts assume, as private equity firms probably would like them to, that a high level of equity ownership by key employees is so powerful a motivator that corporate failure is inconceivable.

Cash Flow

One of the most important elements in analyzing a high-yield security is cash flow. In recent years, analysts have concentrated increasingly on free cash flow (FCF), defined as cash flow from operations minus capital expenditures. FCF can be calculated as follows:

EBIT × (1 – Tax Rate)

+ Depreciation and Amortization

– Changes in Working Capital

– Capital Expenditures

= Free Cash Flow

A company that generates free cash flow is not dependent on external financing and therefore should not be stymied by a temporary unavailability of credit. In addition, FCF generators are best positioned to refinance maturing debt during periods when capital markets are open, but only to the strongest high-yield borrowers. For a company in this select group, investors theoretically need concern themselves only with the risk that positive FCF generation will prove unsustainable.

The rise in popularity of free cash flow is partly a reaction to abuse of a popular cash-flow proxy of earlier decades, EBITDA. In the 1990s, competition for deals pushed the debt loads on leveraged buyouts (LBOs) to an extreme that made issuers look very weak by standard financial ratios such as EBITDA/Interest Expense. Underwriters responded by promoting “adjusted EBITDA.” The newfangled ratio conveniently eliminated the impact of operating losses that were deemed to reflect “restructurings,” which was too often a euphemism for failed investments. Even before this distortion of reality became common, EBITDA had serious shortcomings as a cash-flow measure by virtue of ignoring capital expenditures and working capital requirements. These are essential cash uses that a company may have difficulty funding in a period of tight credit.

For all its faults, EBITDA remains the high-yield market’s standard for calculating leverage. Analysts view a company’s total debt outstanding as some number of “turns” of EBITDA. Suppose, for instance, that a company’s debt is equivalent to four × its EBITDA at a time when corporate buyers and LBO sponsors are paying six × EBITDA to acquire comparable companies. Bondholders will feel comfortable that in the event of default they will fully recover their principal from the proceeds of a sale of the company in bankruptcy. As with free cash flow, the key assumption is that the level of cash generation will not fall. Proceeds equivalent to six × a greatly reduced EBITDA will not be as great as the company’s debt load.

Net Assets

In analyzing a bond, the analyst must ascertain or at least approximate the liquidation value of the assets. Are these assets valued properly on the balance sheet? Of particular interest may be real estate holdings. For example, in analyzing the gaming companies, a market assessment of land holdings should be included. On the other hand, one also should consider the likelihood of those assets being available for liquidation, if necessary. To whom do they belong? Are they mortgaged or being used as collateral? Assets are occasionally spun off to the equity owners of the company. In such a circumstance, the bondholders may experience a sudden and dramatic deterioration of credit quality. Other bondholders are secured by specific assets such as railroad cars or a nuclear power station. In these circumstances, the value and marketability of the collateral must be ascertained. Collateral, by definition, must be specific, and so must be the analysis. Ten railroad engines may appear to provide adequate collateral until it is discovered that the engines are not only obsolete but have not been maintained for a number of years. Five aircraft may appear to be adequate collateral until it is discovered that the engines were financed separately and do not constitute collateral.

Particular attention must be paid to the asset protection in a takeover situation. In this instance, assets that originally provided protection for an investor’s holdings could be used to secure new debt senior to the investor’s position.

The analyst also must focus on the location of the assets. If the assets are in a foreign country, the analyst should be familiar with that country’s laws regarding expatriation of funds. In the extreme case, the analyst should be familiar with that country’s laws regarding bankruptcy proceedings. Notwithstanding high-yield investors’ traditional claim that they focus on the verifiable values of hard assets, it is in fact common to attribute substantial value to certain items that do not even qualify as assets under generally accepted accounting principles. For example, media and telecommunications companies are often evaluated by attributing a dollar amount to each customer or potential customer. Current valuations may be justified by the prices being paid for comparable properties in mergers and acquisitions transactions. In the future, however, the value of these unofficial assets may evaporate as new technologies emerge to provide communications services more cheaply or more effectively. There is also a risk that if a company becomes financially distressed its existing customers (particularly business customers) may switch to other providers.

Management

Management is a critical element in the assessment of any company. Given enough time, poor management can bankrupt the most prosperous enterprise. Conversely, good management is essential to the long-run survival of all firms.

Many successful firms are launched by the top engineers or salespeople at industry-leading firms. They may bring strong talent and motivation, but analysts must evaluate the entire team to ensure that all key functions are in capable hands. Does the company have a strong financial manager? Are proper controls in place? Incentives can also play a significant role in determining a company’s long-run success. Ownership of a significant portion of the company by management is generally a positive, if not necessarily a panacea.

There are two principal ways to evaluate management. The first is to judge the team by its results. This is accomplished through financial analysis. The second way is to meet with senior managers to judge first-hand their vision for the firm as well as their understanding of the business. This is achieved by attending new-financing road shows, as well as arranging one-on-one meetings where possible, and participating in companies’ quarterly earnings calls.

An analyst must be well-prepared for meetings with management. Lack of preparation creates the risk of being swayed by a slick presentation that lacks true substance. In one presentation to potential bond investors, the senior management of a company that manufactured gas pump nozzles stated that European operations would generate major growth because of increased environmental requirements to reduce gasoline fumes at service stations. In an effort to estimate the potential for this new revenue opportunity, an analyst asked management to discuss the state of European environmental laws and how they differed from laws in the United States. Management was unable to answer the question. The company subsequently filed for bankruptcy.

Leverage

Companies that issue high-yield bonds generally are highly leveraged. Leverage per se is not harmful and in many circumstances is beneficial to growth. However, the degree of leverage should be evaluated in terms of its effect on the financial flexibility of the firm. As pointed out earlier, leverage should be calculated on absolute and market-adjusted bases. The most common approach to market adjustment is to calculate a market value for the equity of the firm. To the extent that the common stock is selling below book value, leverage will be understated by a traditional approach. Some firms also adjust the market value of debt in calculating leverage. This approach is interesting, but a consistent approach must be employed when convertibles are considered in the equity equation. The benefit of adjusting the equity side of the leverage equation is clear. As the market values a company’s equity upward, the market is indicating a willingness to support more leverage. A similar increase in the market adjustment of a firm’s debt may indicate an upward appraisal of creditworthiness or an overall lowering of interest rates. In either case, the company probably would have the opportunity to refinance at a lower cost and thereby increase profitability.

Care also should be taken to evaluate sources of leverage that are not stated clearly on the balance sheet. These sources arise from the use of complicated financings.6 For example, consider deferred-coupon bonds that are commonly used by high-yield issuers. Deferred-coupon bonds permit the issuer to postpone interest payment to some future year. As a result, the interest burden is placed on future cash flow to meet the interest obligations. Because of this burden, the presence of deferred-coupon bonds may impair the ability of the issuer to improve its credit quality in future periods. Moreover, if senior bonds have deferred-coupon payments, the subordinated bonds will be adversely affected as the amount of senior bonds increases over time relative to the amount of subordinated bonds. For example, one type of deferred-coupon bond that has been widely used in some years is the payment-in-kind (PIK) bond. With this bond structure, a high-yield issuer has the option either to pay interest in cash or pay the equivalent of interest with another bond with the same coupon rate. If the issuer does not have the ability to pay the interest in cash, payment with another bond will increase future interest expense and thereby adversely affect the issuer’s future cash flow. If the PIK bonds are senior bonds, subordinated bonds are adversely affected over time as more senior bonds are added to the capital structure and future interest expense is increased further.

Corporate Structure

High-yield issuers usually have a holding-company structure. The assets to pay creditors of the holding company will come from the operating subsidiaries. It is therefore, critical to analyze the corporate structure. Specifically, the analyst must understand how cash will be passed between subsidiaries and the parent company and among the subsidiaries. The corporate structure may be so complex that the payment structure becomes confusing.

For example, in the mid 2000s Charter Communications created a dizzyingly complex corporate structure. The cable television systems operator capitalized on its rapidly growing EBITDA to create and further leverage a succession of new intermediate holding companies. Eventually, the operating subsidiaries stood beneath a parent operating company and eight layers of holding companies with names such as Charter Communications Holding Company, LLC, Charter Communications Holdings, LLC, and CCH I Holdings, LLC.

Simply calculating financial ratios for the consolidated company did not produce an accurate picture of Charter’s debt-servicing capability. Each holding company’s ability to make interest payments depended on dividends from the companies positioned below it on the corporate totem pole. Those companies could not lawfully pay dividends before meeting their own debt service requirements and they were further constrained by restrictions, tied to leverage covenants, on upstreaming of dividends. This was an especially acute concern for holders of a convertible bond of the ultimate holding company, Charter Communications, Inc. (CCI).

Charter kept its highly leveraged web of companies solvent by frequently tapping the capital markets to retire maturing debt. Extensive intercompany loans further complicated the picture. The game ended when a financial crisis shut the markets down. Charter filed for bankruptcy in 2009 and the importance of mastering the intricacies of high-yield analysis once again became apparent. Senior secured lenders at the parent operating company and at the holding companies just above it, who were closest to the assets, recovered 100% of their principal. In contrast, note holders at some of the more remote holding companies recovered negligible amounts. Somewhat anomalously, convertible bond holders at CCI, who were furthest of all from the assets, enjoyed a higher percentage recovery than creditors of some intermediate holding companies. This was achieved partly with cash proceeds of the sale of the convertible issue, which had been retained at CCI to cover interest payments.

Covenants

While an analyst should consider covenants when evaluating any bond issue (investment-grade or high-yield), it is particularly important for the analysis of high-yield issuers. The importance of understanding covenants was summarized by one high-yield portfolio manager as follows:

Covenants provide insight into a company’s strategy. As part of the credit process, one must read covenants within the context of the corporate strategy. It is not sufficient to hire a lawyer to review the covenants because a lawyer might miss the critical factors necessary to make the appropriate decision. Also, loopholes in covenants often provide clues about the intentions of management teams.7

Note, however, that some specialized consulting firms offer assistance in interpreting covenants, combining financial sophistication with legal expertise.

Definitions

Great care must be paid to definitions. As discussed earlier with respect to cash flow, definitions can materially skew cash-flow projections. When asked to define certain terms, management often will state that its definitions are “standard.” There is no standard definition.

Definitions also should be evaluated in covenants. For example, a “change of control” typically triggers a 101% put option for the bondholder, but the term does not necessarily refer to all changes in controlling interest in the company. A change of control may be defined to include an acquisition of the company but not a merger (in which the company’s separate corporate structure disappears). In some cases, acquisition by a major existing shareholder is excluded from the definition.

CREDIT SCORING MODELS

To this point in the chapter, the focus has been on traditional ratios and other measures that credit analysts use in assessing default risk. Several researchers have used these measures as input to assess the default risk of issuers using the statistical technique of multiple discriminant analysis (MDA). This tool is primarily a classification technique that is helpful in distinguishing between or among groups of objects and in identifying the characteristics of objects responsible for their inclusion in one or another group. One of the chief advantages of MDA is that it permits a simultaneous consideration of a large number of characteristics and does not restrict the investigator to a sequential evaluation of each individual attribute. For example, MDA permits a credit analyst studying ratings of corporate bonds to examine, at one time, the total and joint impact on ratings of multiple financial ratios, financial measures, and qualitative factors. The analyst is thereby freed from the cumbersome and possibly misleading task of looking at each characteristic in isolation from the others. MDA seeks to form groups that are internally as similar as possible but that are as different from one another as possible.

From the preceding description of MDA it can be seen why it has been applied to problems of why bonds get the ratings they do and what variables seem best able to account for a bond’s rating. Moreover, MDA has been used as a predictor of bankruptcy. While the steps involved in MDA for predicting bond ratings and corporate bankruptcies are a specialist topic, the following discussion addresses the results of the work of Edward Altman, the primary innovator of MDA for predicting corporate bankruptcy.8 The models of Altman and others involved in this area are updated periodically. Here the purpose is only to provide an illustration of how MDA models work.

In one of Altman’s earlier models, referred to as the “Z-score model,” he found that the following MDA could be used to predict corporate bankruptcy.9

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

where

X1 = working capital/total assets (in decimal)

X2 = retained earnings/total assets (in decimal)

X3 = earnings before interest and taxes/total assets (in decimal)

X4 = market value of equity/total liabilities (in decimal)

X5 = sales/total assets (number of times)

Z = Z-score

Given the value of the five variables for a given firm, a Z-score is computed. The Z-score is used to classify firms with respect to whether or not there is potentially a serious credit problem that would lead to bankruptcy. Specifically, Altman found that Z-scores of less than 1.81 indicated a firm with serious credit problems, whereas a Z-score in excess of 3.0 indicated a healthy firm.

Subsequently, Altman and his colleagues revised the Z-score model based on more recent data. The resulting model, referred to as the “zeta model” found that the following seven variables were important in predicting corporate bankruptcies and were highly correlated with bond rating:10

• Earnings before interest and taxes (EBIT)/total assets

• Standard error of estimate of EBIT/total assets (normalized) for 10 years

• EBIT/interest charges

• Retained earnings/total assets

• Current assets/current liabilities

• Five-year average market value of equity/total capitalization

• Total tangible assets, normalized

While credit scoring models have been found to be helpful to analysts and bond portfolio managers, they do have limitations as a replacement for human judgment in credit analysis. Quantitative models are effective in identifying companies that share certain characteristics with defaulting companies, but many of the companies identified by the models do not default. One thing a statistical model cannot readily spot is the possibility of bringing in new management that will turn the company around and prevent a default. Therefore, an investor who is faced with a potentially large loss on a distressed company may benefit from assessing a company’s prospects for redirecting itself, rather than selling based solely on a quantitative score. In practice, professional high-yield bond and distressed-debt managers do not rely entirely on models such as the Z-score, but at most use them to supplement their own hands-on analysis.

KEY POINTS

• Credit analysis has evolved from exclusive focus on default risk in a buy-and-hold strategy to playing a role in active management of corporate bond portfolios.

• Equity-related information can help to create a systematic analysis, but it is important also to consider other determinants of credit risk.

• Key areas of a credit assessment include industry analysis, financial analysis, and indenture provisions.

• Analysis of high-yield, or speculative-grade, corporate bonds requires particular focus on the downside in a company’s operations, its cash flow, and the quality of its management.

• Quantitative credit scoring models cannot replace hands-on credit analysis, but can usefully supplement it.

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