Corporate Debt Instruments and Credit Analysis Chapter 20 All Pages

Corporate Debt Instruments Corporate Debt Securities Corporate Bonds Secured Bonds Mortgage Debt secured by real property or personal property Collateral Trust Bonds secured by financial assets Unsecured Bonds (Debenture Bonds) Credit-Enhanced Bond guaranteed by a Third Party guaranteed by a Bank Letter of Credit Medium-Term Notes (MTNs) Commercial Paper Directly-PlacedDealer Placed

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

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

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

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

Part III - Assessing issuers ability to pay pg Business risk Governance risk Financial risk

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

Governance risk Pg Ownership structure  Managers and shareholders aligned Board strength  Independent boards (bigger is better)  Audit committee strength Financial disclosure policies  Aggressive versus conservative accounting policies Shareholders rights

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

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