64 Credit Analysis for Corporate Issuers

Jequa's Funds From Operations (FFO)

• Jequa, a Japanese company, has a FFO closest to ¥759 billion
• FFO equals net income from continuing operations plus depreciation, amortization, deferred taxes, and other noncash items
• The FFO calculation is ¥503 (net income) + ¥256 (depreciation & amortization) = ¥759 billion

Covenants for Investment-Grade Bonds

• Issuers of unsecured, investment-grade bonds are most likely to have covenants necessitating tax payments in full and on time
• Debt covenants of unsecured investment-grade issuers include affirmative (positive) covenants
• Affirmative covenants specify actions required of the issuer, such as paying taxes or adhering to accounting principles
• Covenants of secured high-yield bonds define what the issuer cannot do, like issuing new debt or paying dividends

Becque Ltd.'s Debt-to-EBITDA Ratio

• Becque Ltd., a European Union company, has a three-year average debt-to-EBITDA ratio closest to 4.6x
• EBITDA equals operating income plus depreciation and amortization
• Year 1 EBITDA: €262 + €201 = €463 billion
• Year 2 EBITDA: €361 + €212 = €573 billion
• Year 3 EBITDA: €503 + €256 = €759 billion
• Debt/EBITDA ratio for Year 1: 2,590 / 463 = 5.6x
• Debt/EBITDA ratio for Year 2: 2,717 / 573 = 4.7x
• Debt/EBITDA ratio for Year 3: 2,650 / 759 = 3.5x
• Three-year average: 4.6x

Corporate Family Ratings

• For BBD Enterprises, whose senior secured bonds are rated A+, the corporate family rating would most likely be lower than A+
• Credit ratings are assigned to both an issuer's corporate family and specific bond issues
• Corporate family rating relies on the issuer's senior unsecured bonds
• Senior secured bonds have a higher claim priority meaning the corporate credit rating is most likely below the senior secured bonds

Recovery Rates and Bankruptcy Proceedings

• Recovery rates are highest for debt with the highest priority of claims
• Lower seniority ranking leads to lower recovery rates and increased credit risk
• Courts often deviate from the priority of claims during bankruptcy to expedite the process

Corporate Bonds and Yield

• Senior subordinated bonds offer the highest yield
• Bonds ranked by seniority offer differing yields depending on their class
• Junior secured bonds rank most senior
• Senior unsecured bonds rank second in seniority
• Senior subordinated bonds rank least senior

Issuer Credit Rating vs. Issue Credit Rating

• One difference between an issuer credit rating and an issue credit rating is that an issuer credit rating reflects the borrower's overall creditworthiness
• Senior unsecured debt usually establishes an issuer credit rating with issue ratings possibly being notched up or down

Structural Subordination

• Structural subordination means that a parent company's debt has a lower priority of claims than a subsidiary’s debt
• Subsidiary cash flows are used to pay its debts before the parent company can service its debt

Debt Priority

• Subordinated debt has a lower priority of claims than unsecured debt
• Second lien is a form of secured debt with a higher claim priority than unsecured debt
• Pari passu refers to equal claim priority for different debt issues in the same category

Miko Corp. and BluTech Inc. Bonds

• Miko's bonds are structurally subordinated to BluTech's bonds
• BluTech's bondholders have priority of claims to its cash flows
• Miko's bonds are effectively structurally subordinated to BluTech's bonds with respect to BluTech's cash flows

Covenants for Secured High-Yield Bonds

• A bond agreement between a lender and the issuer of secured high-yield bonds would most likely include covenants where the issuer must not enter into transactions with certain affiliates
• Covenants of secured high-yield bonds define what the issuer cannot do: issue new debt, pay dividends to shareholders, or enter into certain business agreements
• Affirmative covenants are found in agreements between lenders and unsecured investment-grade issuers

Credit Rating and Secured Bonds

• A firm with a corporate family rating (CFR) of A3/A- that issues secured bonds with a limitation on liens and a change of control put, the credit rating agencies notch this issue at A2/A
• Issue credit rating may be notched upward because both the priority of claims and the covenants suggest the issue has less credit risk than the issuer
• Issue is a secured bond, and therefore has a higher seniority ranking
• A change of control put protects lenders by requiring the borrower to buy back its debt in the event of an acquisition
• A limitation on liens limits the amount of secured debt that a borrower can carry
• Both covenants act to reduce the credit risk of the issue

High-Yield Bonds

• High-yield bondholders are concerned with increases in both Probability of Default (POD) and Loss Given Default (LGD)

Stock Buyback Programs

• Issuing $200 million to finance a stock buyback program can lead to a credit downgrade because it evidences preferential treatment of equity investors over debt investors
• Issuing new bonds to reduce shares outstanding and reduce economic dilution reduces risk to shareholders, leading to a ratings downgrade

Priority of Debt Repayment

• Senior unsecured debt has the lowest priority of debt repayment
• All unsecured debt ranks in lower priority to any secured debt (including first lien, second lien, and junior secured debt)

Borrowers and Net Income

• An increase in net income is most likely to decrease a borrower's debt-to-EBITDA ratio
• An increase in net income is likely a result from increases in earnings before interest, taxes, depreciation and amortization (EBITDA) and operating income
• The only ratio listed that has earnings or operating cash flow in the denominator is the debt-to-EBITDA ratio
• The ratio will decrease as the denominator increases

Hybrid Approach

• A fixed income analyst assessing assets, liabilities, future cash flows, market share, and event risk, uses a hybrid approach
• The hybrid approach combines bottom-up (idiosyncratic factors relating to the issuer) and top-down approaches (factors relating to the market)