A Pragmatist's Guide to Leveraged Finance (PDF)

A Pragmatist’s Guide to Leveraged Finance Credit Analysis for Bonds and Bank Debt Robert S. K richeff 2 Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Pamela Boland Operations Specialist: Jodi Kemper Senior Marketing Manager: Julie Phifer Assistant Marketing Manager: Megan Graue Cover Designer: Alan Clements Managing Editor: Kristy Hart Project Editor: Anne Goebel Copy Editor: Gayle Johnson Proofreader: Debbie Williams Senior Indexer: Cheryl Lenser Compositor: Nonie Ratcliff Manufacturing Buyer: Dan Uhrig © 2012 by Robert S. Kricheff Publishing as FT Press Upper Saddle River, New Jersey 07458 T his bo o k is so ld w ith the understanding that neither the autho r no r the publisher is engaged in rendering legal, acco unting, o r o ther pro fessio nal services o r advice by publishing this bo o k. E ach individual situatio n is unique. T hus, if legal o r financial advice o r o ther expert assistance is required in a specific situatio n, the services o f a co mpetent pro fessio nal sho uld be so ught to ensure that the situatio n has been evaluated carefully and appro priately. T he autho r and the publisher disclaim any liability, lo ss, o r risk resulting directly o r indirectly, fro m the use o r applicatio n o f any o f the co ntents o f this bo o k. FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales. For more information, please contact U.S. Corporate and Government Sales, 1-800-382-3419, [email protected]. For sales outside the U.S., please contact International Sales at [email protected]. Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners. All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher. Printed in the United States of America First Printing March 2012 ISBN-10: 0-13-285523-2 ISBN-13: 978-0-13-285523-5 Pearson Education LTD. Pearson Education Australia PTY, Limited Pearson Education Singapore, Pte. Ltd. 3 Pearson Education Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educatión de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Library of Congress Cataloging-in-Publication Data: Kricheff, Robert, 1963- A pragmatist’s guide to leveraged finance : credit analysis for bonds and bank debt / Robert Kricheff. -- 1st ed. p. cm. ISBN 978-0-13-285523-5 (hardcover : alk. paper) 1. Financial leverage. 2. Securities. I. Title. HG4521.K7375 2012 332.63’23--dc23 2011049988 4 I would like to dedicate this book, with love, to my wife and my parents, all of whom I am blessed to have. 5 Contents C hapter 1 Intro ductio n C hapter 2 C o mmo n Leveraged F inance T erms General Terms Yield and Spread Definitions Questions C hapter 3 D efining the M ark et and the R atings Agencies C hapter 4 T he Participants The Issuers The Sell Side The Buy Side Private Equity C hapter 5 W hy Is Leveraged F inance Analysis U nique? C hapter 6 T he M ajo r C o mpo nents o f Analysis The Components A Pragmatic Point on the Various Aspects of Analysis C hapter 7 So me F eatures o f B ank Lo ans Questions C hapter 8 A Primer o n Prices, Yields, and Spreads The Basics A Few Points on Yields A Few Points on Spreads Bank Loan Coupons Duration Total Returns Deferred Payment Bonds: Prices and Yields A Pragmatic Point on Terminology Questions C hapter 9 A Primer o n Key Po ints o f F inancial Statement Analysis EBITDA Capital Expenditures Interest Expenses 6 Taxes Changes in Working Capital Free Cash Flow The Balance Sheet A Pragmatic Point on Financial Statements Questions C hapter 10 C redit R atio s EBITDA/Interest Ratio Debt/EBITDA A Pragmatic Point on the Leverage Ratio A Pragmatic Point on Valuations Free Cash Flow Ratios Changes in Working Capital Dividends Acquisitions One-Time Charges The FCF/Debt Ratio A Pragmatic Point on Free Cash Flow Questions C hapter 11 B usiness T rend Analysis and O peratio nal R atio s Business Trends Margins and Expenses Capital Expenditures Questions C hapter 12 E xpectatio ns, M o deling, and Scenario s Sales and Revenue A Full Model Scenarios A Pragmatic Point on Bank Maintenance Covenants and Expectations Questions C hapter 13 Structural Issues: C o upo ns Loan Coupons Bond Coupons Zero and Zero-Step Coupons How the Coupon Is Determined 7 Modeling Changes in Coupons Questions C hapter 14 Structural Issues: M aturities, C alls, and Puts Maturities Calls Clawback 10% Call Cash Flow Sweeps AHYDO Other Bank Prepayments Open-Market Repurchases A Pragmatic Point on Early Refinancing of Debt Questions C hapter 15 Structural Issues: R ank ing o f D ebt Ranking Structural Subordination Subsidiary Guarantees Questions C hapter 16 Key Leveraged F inance C o venants Debt Incurrence Defined Terms and Carve-outs Defined Term Examples Carve-outs Restricted Payments Change of Control Asset Sale Reporting Requirements Other Covenants Affirmative/Maintenance Covenants Restricted and Unrestricted Groups Questions C hapter 17 Amendments, W aivers, and C o nsents Questions C hapter 18 M ak ing M o ney o r Lo sing It O ff o f New s E vents 8 Scenario: An Issuer Makes an Acquisition FastFoodCo (FFC) Facts GoodFoodCo (GFC) Facts Deal Facts Scenario: The Issuer Gets Bought Scenario: An Issuer Announces an IPO Scenario: An Issuer Is Facing a Maturity A Pragmatic Point on the Blended Price to Retire Debt Questions C hapter 19 M anagement and O w nership C hapter 20 I’m Lo o k ing at D ebt, So W hy D o es E quity M atter? Valuation Monitoring Equities Questions C hapter 21 Value, R elative Value, and C o mparable Analysis Questions C hapter 22 New Issuance C hapter 23 D istressed C redits, B ank ruptcy, and D istressed E xchanges Claims Classes of Claims Subordination Claims Arising from Bankruptcy Valuing the Enterprise Sale or Restructuring Restructuring Without Bankruptcy A Few Pragmatic Points on Bankruptcy Reorganizations Questions C hapter 24 Preparing a C redit Snapsho t C hapter 25 T he Investment D ecisio n Pro cess A Sample Investment Process Big-Picture Items The Company Credit Fundamentals Event Analysis 9 Security Analysis Relative Value and Return The Decision Some Investment Traps C hapter 26 C lo sing C o mments Answ ers Index 10 Acknowledgments For their help and advice in preparing this project, I would like to thank John Lutz of McDermott Will & Emery LLP and Andrew N. Rosenberg of Paul, Weiss, Rifkind, Wharton & Garrison LLP. Both are great attorneys and entertaining, to say the least. And thanks to John Kolmer, a great person and boss, whom I still tell stories about. 11 About the Author R o bert S. Kricheff is a Managing Director and Head of the Americas High Yield Sector Strategy for Credit Suisse. He has more than 20 years of experience doing credit analysis. In his career he has followed numerous industries, including media, cable, satellite, telecom, gaming, entertainment, healthcare, and energy. He has worked with emerging-market corporate debt as well as strategy and portfolio analysis. His work has covered investment vehicles including bonds, converts, loans, preferred stocks, and credit default swaps. He has a BA from New York University in economics and an MSc from the University of London SOAS in financial economics. 12 1. Introduction What’s in this chapter: What the market is How companies become part of the leveraged finance market Unique aspects of leveraged finance credit analysis The two starting points of credit analysis The high-yield leveraged bond and loan market is over $2.3 trillion in North America, about € 650 billion in Europe, and $600 billion in emerging markets—and it’s still growing. Perhaps you want to manage money in this sector, sell, trade, work as a banker, be a credit analyst, work in capital markets or credit default swaps, or work as an advisor. Or maybe you work in the finance department of a company that issues this debt. Whatever the case, the basic skills of credit analysis are key to being able to operate effectively. This skill set is also exceptionally valuable for those operating in the equity markets, especially if you ever have to focus on distressed or leveraged equities. The market is unique. It has certain features of traditional investment-grade fixed income, but it also has the event-driven volatility typically associated with equities. Furthermore, it has structural features within the securities and among the participants that are unique to the leveraged market. For these reasons, the analysis involved in evaluating these investments is unique. This book covers the major practical aspects of doing that analysis. It does not delve into theory. Instead, it focuses on how people in these markets work as they prepare and utilize leveraged finance credit analysis, using explanatory examples. Although leveraged loans and bonds have been issued in several currencies, including U.S. dollars, Canadian dollars, British sterling, and euros, the issuers are still predominantly based in the U.S. But the Eurozone and emerging markets are growing quickly. This book primarily uses examples from the U.S. dollar markets. The core of the market are bonds and loans issued by corporations that generally are rated below investment grade by the major rating agencies or sometimes are never rated at all. The market encompasses a wide spectrum of credit risk, from fairly stable BB-rated securities that are close to investment grade all the way down to those in bankruptcy. The companies that make up this market join the market in a few ways. Some are known as “fallen angels.” These companies were investment-grade debt issuers, but as operations weakened or some specific event occurred, they were downgraded and became part of the leveraged market. This happened to General Motors for a period of time. The existence of the leveraged finance market allows these fallen angels to still have access to public and private financing and gives first-time issuers the flexibility to finance growth projects. Other companies issued debt that was initially rated below investment grade by the major agencies. Typically the funding was raised for expansion or acquisition that added leverage. Leveraged buyouts are another common way in which an issuer comes to the leveraged debt market. Usually this is where private equity firms or individual investors add debt to buy out a company. Sometimes developmental companies issue in the debt markets. These are fairly early-stage companies. This type of funding was key for the development of the cable and satellite television industries and the mobile telephone industry. Many of these companies got most of their early funding through the leveraged finance markets and probably would not have developed as quickly without financial innovations in this market. New casinos and oil refineries have also come to this market to be financed as start-ups. For many years, some of the stalwarts of the investment-grade market were part of the 13 below-investment-grade market. These include issuers such as Comcast and Viacom. A company’s ability to access funding in the leveraged finance markets can be a key to survival and can lead to great growth and job creation. Many companies that have grown dramatically were greatly helped in this process by access to this source of debt financing: One company had $24 million in revenue and 225 employees when it first accessed the leveraged finance debt market to fund expansion. By the end of 2010 it had over $300 million in revenue and more than 800 full-time employees. Another company grew from about $100 million in revenue and 975 employees to $1.9 billion in revenue and 1,700 employees. Yet another company first accessed the high-yield market as a leveraged buyout with $1.2 billion in revenue. It grew 20% over 5 years and added about 900 employees. All these companies accessed the leveraged debt markets multiple times as they grew their businesses. Ever since Michael Milken and his team at Drexel Burnham Lambert helped the modern high-yield market evolve, it has been a place driven by innovation and events. Few companies in the high-yield market are stagnant or stable. Some produce steady improvements as they evolve toward investment grade, and others go through transitions, evolving through new ventures or acquisitions. Still others may be for sale or are looking to refinance to return capital to shareholders. Finally, some companies are struggling and may be slipping toward default and bankruptcy. It is unlikely that any below-investment-grade companies are in a state of equilibrium. It is often said that for your analysis to be proven right when you buy a bond, you just need to wait to maturity, but for your analysis to be proven right when you buy a stock, you must convince others that you are right. This is true. Correct credit analysis in buying a bond will eventually reap the yield at which the bonds were bought, or sometimes greater if an early takeout occurs. When you buy a stock, the only way the price goes up is when more people become convinced that they should pay more for it than you just did. In leveraged finance, if you buy a bond or loan and it goes along just fine and pays off at maturity, the return usually outperforms many other assets because of the high coupon. Because of this investment’s ability to outperform just by fulfilling its obligations, a credit analyst in this market always looks to protect his downside in an investment and considers how things could go wrong. Therefore, when analyzing scenarios for a credit, a good analyst must take a cynical approach and constantly ask himself how he could get hurt. Additionally, in the interim between buying a bond/loan and its being retired, the prices can move about fairly wildly. So an analyst must keep in mind the investment time frame within which he is working. When doing credit analysis, you must remember that the work that is being done is heading toward a conclusion. Your approach may vary depending on whether your goal is to decide to buy, sell, or hold a security or to underwrite a new financing. Analyzing these companies and their credit quality is a dynamic process. The tools described in this book are just that—tools. No quantitative model can give a complete answer of whether a debt security for a company will default, or whether one loan will outperform another. The tools covered in this book are used every day and are valuable in determining a security’s value. However, making a decision about a credit involves numerous subjective aspects. That’s what makes it much more of an art than a science. Leveraged finance credit analysis borrows tools that are typically associated with many other fields. Some of these tools come from traditional fixed income markets, as well as equity markets and probability and game theory. It is often said that the leveraged finance market has characteristics of both fixed income and equity. This fact is evident in the tools used to analyze credits in this market. 14 Credit analysis starts from two basic items: The first is financial liquidity. You want to analyze whether the company that is being looked at has liquidity from cash generated by operations or elsewhere, to pay the investors interest and principal over the life of the loan. The second item is asset protection. The asset value is key. If the liquidity is not there to repay the investor in the debt, the holder of the loan or bond must look to the value of the underlying asset from which it can be repaid. Almost all the other aspects of the credit analysis derive from these two fairly basic ideas. This book spends a good amount of space on a few topics. Two chapters are on financial ratios and metrics, because these are often key determinants of credit quality and are strong tools to use when comparing the relative value of various investment options. A significant amount of space is also devoted to structural issues and the basics of bankruptcy analysis. Understanding these factors can be key in protecting your downside. Understanding these issues also is critical in explaining how various investments in the same capital structure should be valued relative to each other. One chapter gives examples of how you can use these tools to react to breaking news events, as analysts must do every day. Some concepts, such as spreads, floating-rate notes, and deferred pay coupons, are repeated in a few places in different ways, because new market participants often ask about them. When you get to the chapters on ratio analysis, modeling, and structural issues, go online and find financial results for several companies. Read through them and try the analysis as shown in the examples in this book. Keep in mind that nothing is a constant in the analysis of leveraged finance securities. Many examples in this book might seem to be followed by a contradiction. It is important for you to always be aware of exceptions to the norm. When doing credit analysis, remember that nothing is always true, and nothing is ever certain. The volatility caused by companies in transition and the unique nature of almost every security in the market make leveraged finance credit analysis frustrating but also challenging and fun. But you cannot become complacent in this market. With that point in mind, I end this chapter with a great Oscar Wilde quote that is a good creed for anyone who wants to do leveraged finance credit analysis: To believe is very dull. To doubt is intensely engrossing. To be on the alert is to live; to be lulled into security is to die. 15 2. Common Leveraged Finance Terms What’s in this chapter: Definitions of some key terms, including common synonyms Terms used to describe prices and returns on debt instruments Key points relating to how bonds and loans trade Like most specialties, from firefighting to neurosurgery, the leveraged finance market has its own lingo. This chapter outlines some key terms commonly used in the market and throughout this book. Some definitions are fairly generic to the securities business, and others are specific to or more widely used in only the leveraged finance market. This industry often has several synonyms for the same word. Even the market itself goes by several names: leveraged finance, high yield, junk market. All these terms refer to the market for debt instruments that are rated below investment grade. This chapter and book list common synonyms to make you familiar with the various interchangeable terms that market participants often use. General Terms amo rtizatio n Usually refers to the required paydown of a debt instrument. On company financial statements this refers to the depletion of intangible assets on the balance sheet, just as depreciation refers to the same for tangible assets. call The right to purchase a bond or loan at a set price for a set period of time. co rpo rate bank lo an A loan to a company. Legally, it is not a security, but a financing. It usually takes the form of a term loan (typically not reborrowable) or a revolver (that can be repaid and reborrowed). Other terms often used include loan, bank debt, and syndicated loan. co rpo rate bo nd A loan to a company in the form of a security. Bonds are also called debentures or notes. co venant A rule laid out in the indentures and loan documents by which the company agrees to operate as part of the terms of the loan or the bond. Affirmative covenants are something the company must do. This can include items such as a requirement to report financials or a minimum cash flow. Financial covenants or maintenance convenants are typical in bank debt and include financial tests Negative covenants typically prevent or restrict what a company can do. They may include requirements that must be met before a dividend is paid or more money is borrowed. credit Refers to the issuer of the bond or loan. default 16 When the company that issues a bond or loan fails to make a required payment on time. A technical default occurs when a maintenance/affirmative covenant is violated. equity What is left of value in a company after the debt and other obligations are subtracted from the total value. This can also refer to a company’s common stock. grace perio d Most loan agreements and bond indentures have a set period of time in which they are allowed to cure a nonprincipal default before the borrowers can accelerate and force a bankruptcy. This grace period typically is 30 days. indenture The legal document containing all the terms that the issuer of a bond agrees to. interest rate The interest that is required to be paid on the loan. This is sometimes called a coupon. issuer The company that issues the loan or bond. leverage A company’s level of debt. LIB O R London Interbank Offering Rate. An interest rate that is often used as the base rate for floating-rate notes. Similar to the U.S. prime rate. lo an bo o k /bank bo o k Usually a summary of a new loan offering. Sometimes it is private. Generally it is a bank loan version of the bond prospectus. maturity The date on which the bond or loan must be repaid. Another term for this is due date. mo ney terms Refers to the principal due, maturity, and interest rate. These terms typically cannot be changed during the life of the loan or bond without agreement from all the borrowers. par Face value, or 100% of the principal of a note or loan. pari passu A Latin term meaning “without partiality.” Generally refers to two debt instruments being ranked equally. principal The amount owed on a loan or bond at maturity. Other terms that are often used include face value and par 17 value. pro fo rma A Latin term meaning “as a matter of form.” Refers to financial statements that have been adjusted for certain assumptions such as a merger or new debt offering. pro rata A Latin term meaning “according to the rate.” Refers to a method of allocating something equally and proportionally. pro spectus When a new bond is being issued, this is a summary document of the company’s business, recent results, and indenture. This is one of the best documents for you to quickly get familiar with a company. put The right to sell a bond or loan at a set price for a set period of time. technical default When the company that issues a bond or loan fails to follow one of the rules under its covenants; this usually involves the violation of an affirmative covenant in the bank loans, not a payment. tranche From the French for “cut” or “slice.” Refers to a portion of an investment issue. Typically used to reference the different tiers of debt in a capital structure. For example, within one company’s capitalization, a bank loan and a senior subordinated bond would each be referred to as a separate tranche. Yield and Spread Definitions spread A commonly used measure of value. It uses the yield-to-maturity (YTM) minus some interest rate benchmark. In the U.S. market it is usually used against a treasury bond with an equivalent maturity of the bond. In the European market it is typically measured off a sterling, bund, or European government note. Bank loans are typically spread off of LIBOR. This gives an idea of a bond/loan’s yield relative to other interest rate instruments of different maturities. spread-to -w o rst (ST W ) The same as a spread, but using the yield-to-worst (YTW). STW is usually the best tool to compare the relative value of different bonds/loans with varying maturities. yield-to -call (YT C ) The yield assuming that the bonds are taken out at the next call date. yield-to -maturity (YT M ) A calculation that takes into consideration the price that is paid for the bond/loan, as well as the interest payments and principal payments expected to be made over the life of the bond and the amount of time to maturity. It calculates an annualized return on the investment. It assumes that cash payments are reinvested at the same rate that the bond/loan is paying. 18 yield-to -w o rst (YT W ) A more commonly used variation of YTM. Assumes the retirement based on the call schedule with the worst return. It really applies only when a bond/loan is being bought at a premium (a price above par) and calculates which would be the lowest return to any possible call date. Here are some simple and logical things to remember about bond prices and yields: Bonds trading below par are referred to as trading at a discount. Bonds trading above par are referred to as trading at a premium. When bonds are at par, the yield is equal to the coupon. When bonds are at par or at a discount, the YTW and YTM are the same. When they are at a premium, the two can differ. T rading Parlance When a trader gives a market, it usually is given with a bid and an ask. (This is common for most security and loan markets.) The bid is where the trader is willing to buy, and the ask is where the trader is willing to sell. If the market bid is 98 and the market offer is 99, it might be written like this: 98=99. If the trader is willing to only bid on the bonds, it might be written like this: 98=. If someone accepts the bid price and sells the bonds to the trader, the trader may say he has been hit. If someone buys the bonds from the trader, the trader may say he has been lifted. Let’s finish this chapter with some quick comments on trading bonds and loans. Typically the minimum size at which a corporate bond can be traded is $1,000. However, in practice, the minimum “round lot” trade is $1,000,000. The same is true for loans. (This is one reason why it tends to be an institutional investor market and not an individual investor market.) When prices are given for bonds and loans, they are typically given as a percentage of face value. For example, if a bond is trading at 100% of face value, you would quote the price as par, or 100. If it was trading at a discount to face value—for example, at 98 or 99—this would mean for a round lot the buyer would pay $980,000 or $990,000. Although a percentage sign actually should be placed after these prices, in practice this is rarely done. More commonly people mistakenly use a dollar sign. Sometimes a price is given in yield instead. Yields are usually given as a percentage, so a 10% bond at par may be referred to as trading at par, or at 100, or at a yield of 10%. Unless otherwise stated, this usually refers to the yield-to-worst. Bank loans and bonds trading at very low spreads (said to be trading tight) are frequently quoted by their spread-to-worst rather than a percentage of par or a yield. When spreads are used, they are typically quoted in basis points (bp). There are 100bp in 1%. So if a US$ bond is trading at 10% and the equivalent maturity treasury is trading at 6%, the spread between the two would be 4 percentage points. But this would typically be quoted in basis points as a “spread of 400 bp.” Interest payments are made on specific dates, typically monthly on bank loans and semiannually on bonds. But the bonds continue to accrue interest between the payment dates. In a typical transaction, when you buy a bond, you pay the seller the price plus accrued interest. For example, if a bond has a 10% coupon and pays semiannually, it pays 5% on each interest payment date. If someone bought the bond halfway between the interest payment dates (90 days after the last coupon payment), he or she would pay the price set for the bond plus 2.5% of accrued interest. If a bond is trading without accrued interest because it is in default, it is said to 19 be trading flat. Questions 1. Which of the following terms does not refer to a bond? A. Debenture B. Note C. Preferred D. Subordinated note 2. A maintenance covenant is also typically known as what? A. A negative covenant B. A blocking covenant C. A ratio test D. An affirmative covenant 3. When a seven-year bond is trading at a yield-to-worst of 9%, and a seven-year treasury bond is trading at a yield of 3%, what is the bond’s spread? A. 13% or 1,300 bp B. 7% or 700 bp C. 6% or 600 bp D. 9% or 900 bp 4. If a buyer is paying 98 for $2,000,000 par amount of bonds (with no accrued interest), how much will she actually pay the seller? A. $980,000 B. $1,960,000 C. $2,000,000 D. $2,980,000 5. If a bond has a 10% coupon and pays on a 360-day calendar and is selling at par (100), how much do you pay for $1,000,000 face amount of bonds if it is 90 days since the last interest payment? A. $1,250,000 B. $1,500,000 C. $1,025,000 D. $1,000,000 20 3. Defining the Market and the Ratings Agencies What’s in this chapter: How the market is defined by the ratings agencies Agency ratings and price impact Ways to use the ratings agencies The leveraged finance market is also called the high yield market and the junk bond market. The leveraged finance market is generally defined to include bonds and loans issued by corporations that the major credit rating agencies (Moody’s, Standard & Poor’s [S&P], and sometimes Fitch) have assigned ratings they believe are below investment grade. Many pools of investment money have strict limits on investing in bonds/loans rated below investment grade. Although it never caught on, I always liked the idea of referring to the market as the BIG debt market—as in Below Investment Grade. Table 3-1 lists the categories for Moody’s and S&P. T able 3-1. R atings C atego ries o f the M ajo r Agencies Bonds that are rated BBB-/Baa and above are considered investment grade or nonspeculative. In the ratings descriptions for Moody’s, the Ba-rated category is the first one said to “...have speculative elements and are subject to substantial credit risk.”1 Standard & Poor’s includes a paragraph describing all the bonds rated BB and below and says that they “...are regarded as having significant speculative characteristics.”2 1 “About Moody’s Ratings: Ratings Policy & Approach.” Moody’s Investors Service Inc., 2011. 2 “General Critera: Understanding Standard & Poor’s Rating Definitions.” Sta0ndard & Poor’s Financial Services LLC, 2011. 21 Although some criticisms about the ratings agencies have been laid out in great detail during the mortgage crisis, they do add value and play an important role in the market. These agencies are typically shown projections from the companies. You can glean some insights from agency write-ups, particularly on new issues. They also highlight short-term and long-term concerns. However, their value to an analyst or investor in trying to determine trading value is very limited. The agencies are typically backward-looking in their analysis. More importantly, in a market such as the leveraged finance market, which is heavily event-driven, the agencies respond slowly to new credit events. They also give little to no insight into how the debt will trade and what prices represent value. For market participants, how the bonds and loans trade is one of the most important factors, and generally the ratings do not help too much. At any given time you can typically find two identically rated single B issues trading at yields that are 1,000 basis points (bp) apart or more, a significant variance. The variance within the CCC-rated category can be even greater. This shows how little the markets sometimes value the agencies’ ratings when trying to determine trading levels on below-investment-grade debt. There are some trigger points in ratings that can have an impact on trading levels, but it often takes some time after the facts are in place for the agencies to react. For example, many bond buyers are limited in or restricted from buying CCC+ and below rated bonds. Similarly, many funds have limits on buying issues rated less than investment grade, so an upgrade to BBB can add to the universe of potential buyers and cause prices to rally. These crossover points can influence trading levels, although much of the price movement often occurs well before the ratings agencies get around to actually upgrading or downgrading the debt. So when reading agency write-ups, look for some of these fact patterns that the ratings agencies would want to see to lead to key rating changes. A useful item in most credit agency write-ups is that they specify what the company would have to do to get upgraded or downgraded. This is particularly helpful when a credit is on the verge of going to investment grade. You should also monitor credits that are just barely clinging to an investment-grade rating and may be on the watch for a downgrade. These credits may be the next opportunities in high yield. Many nonrated loans and bonds are also considered part of the leveraged finance market. Note that convertible bonds are typically not included. But sometimes when they trade at such low levels, or the stock price has moved so much that they are a “busted” convert, meaning that the feature to convert to equity is perceived to have no value, they attract high-yield investors. Many bonds and loans in the below-investment-grade market are nonrated. The ratings agencies charge to rate a company, and some choose not to pay the agencies, even if it may cost them in the pricing of the coupon on their financing. Other companies that sometimes expect a CCC rating or lower decide that the agency rating won’t help them and choose not to hire the agency. The agencies may choose to rate a company even if they are not hired to do so. 22 4. The Participants What’s in this chapter: What types of companies and organizations are the major players in the market Participants are broken into the issuers, the sell side, the buy side, and private equity How each one operates in the market and its traditional roles Broadly speaking, the marketplace has three major groups of participants, which are fairly typical in most securities markets. The first category is the issuers, which in this case are corporations. The second is the sell side—the arrangers of the financings. They provide liquidity in the secondary markets and, to a certain extent, are investors as well. Third is the buy side—a diverse group of potential investors in these financial instruments. For the leveraged finance market we will add private-equity firms as a significant participant as well. We will omit numerous other subsets of market participants, such as lawyers and street brokers, who also play important roles in the marketplace. The Issuers In the leveraged finance market for bank loans and bonds, the issuers of these debt instruments are all corporations or corporate-like entities. They can choose to issue the debt for diverse reasons. Issuers may simply be looking for more capital to expand, to take on a new project, or to build a new facility. The issuer may be a growing company that utilized various forms of less permanent capital to grow and is looking to put in place a more permanent debt structure. The issuer may be looking to fund an acquisition. Or it may be facing an unusual obligation, such as a lawsuit or tax settlement. Alternatively, the company may be issuing debt for purely financial reasons. It might want to replace older maturing debt or return some capital to shareholders. Or perhaps the company is going private, and the debt will finance this transaction (effectively another way of returning capital to shareholders). These are some, but not all, of the reasons a company might access the markets. Some companies are quite comfortable staying rated below investment grade for their lifetime. Many management teams in certain industries believe that their company has optimal leverage that keeps it rated high yield based on its growth characteristics, its tax structure, and the best way for it to maximize long-term returns for its owners. Other entities believe that the lower leverage and lower cost of capital that an investment-grade rating brings are the best route to take for a company’s capital structure. So some companies are striving to get upgraded and leave the market, and others are more comfortable with more leverage. The Sell Side The sell side is primarily made up of investment banks and commercial banks. Many commercial banks also have investment banking operations, so the two are not mutually exclusive. Investment banks fulfill many roles for their corporate clients as well as their investment clients. On the corporate side, investment banks advise companies on funding their financial needs, develop strategies for expanding, divestitures of assets and acquisitions, and generally help them with liability management. Investment banks also help companies raise funding. In the leveraged market this comes in the form of debt and usually entails bank lending and bond issuance. 23 On the bank loan side, investment banks and/or commercial banks advise the company on the structure, size, and covenants of the borrowing. Then they undertake due diligence about the company and help educate potential investors about the loans and help place the loan, utilizing investor feedback where needed. The process is similar when bond issuance is involved. However, when the funding is in the form of a loan, the bank loan arranger (or agent bank) typically holds, or retains, a reasonable amount of the loan on its books. Also, if there is a revolving facility, the banks usually hold this as well. On the bond side, the investment bank is required to fully distribute the issue before it can start market making in the bonds. This is an interesting juxtaposition between the two markets. An important role of the investment bank or commercial bank is that it uses its balance sheet to provide liquidity to the investors who bought the initial debt. The initial investors may want to buy more or sell some, or all, of the position they own over time. The bank also looks to keep investment professionals abreast of developments at the corporation that issued the debt. It should be noted that the sell side also includes bankers, salesmen, traders, analysts, and capital markets personnel. The Buy Side The buy side encompasses a broad range of buyers and investors of leveraged finance instruments. Ultimately these asset managers get the funds they invest from individuals, pension and other retirement funds, insurance accounts, endowments, and similar sources. Individual investors rarely invest directly in high-yield corporate debt. Individual investors may put money into mutual funds that are dedicated to the leveraged debt markets. Or there may be funds that invest part of their pool of assets into leveraged loans and bonds. These funds could be diversified fixed-income funds or even equity funds. A number of other types of funds may select part of their investments to be in the high-yield markets. Mutual funds typically are long only, meaning that they do not short investment instruments. A significant number of assets that are managed by money managers and others are not in mutual funds. These may be pools of money from pension funds, endowments, or wealthy individuals. Individuals may also have life insurance policies. Part of the large pool of investments that insurance companies invest in can encompass high-yield loans and bonds. Like retirement money and mutual fund money, it can be managed in-house or by third parties. Institutional managers as well as wealthy individuals and others can choose to invest in alternative investment vehicles, such as hedge funds or distressed investment funds. Hedge funds and most distressed investment funds can short securities as well as be long them. Additionally, hedge funds tend to be more flexible about investing in bonds or bank debt. Many of the other types of asset managers tend to be more limited in either one or the other. Many hedge funds are not dedicated to investing in the leveraged debt markets and may opportunistically increase or decrease their overall exposure to the asset class. Hedge funds tend to have a different payout schedule than the other asset managers discussed here. Hedge funds often have a bar for a fairly high return that must be achieved to enhance the management’s payout. Therefore, they tend to invest in higher-yielding and/or distressed investments that have greater risk but usually potential for greater return. Also, a number of funds focus on distressed and bankrupt situations as well. These may not be limited to investing in loans and bonds; they may be involved in other asset classes such as equities or trade claims. Another buy-side participant is the structured products manager. These managers are typically running money in structures such as collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs). These 24 products buy debt to fit a structured format that meets certain diversity, coupon, and maturity profiles and usually has a limited life. These vehicles often are more biased toward buy-and-hold-type strategies. These structured products have been a much larger factor in the loan market than the bond market. Private Equity Private-equity (PE) firms are an important participant in the market. Although they usually fall into the “issuer” category, they are a special type of issuer. PE firms generally raise funds that are designed to buy companies, increase the value of the enterprises they buy, and then over time monetize these gains. They typically do this by selling the company, bringing the company public, paying themselves dividends, or using some other means to return value to themselves and their investors. PE firms often use leverage in their acquisitions to enhance their returns. Financings to fund PE transactions make up a large part of the leveraged finance market. By their nature these companies that are owned by PE firms tend to be somewhat event-driven as the sponsors (another term for PE buyers) look to enhance value and eventually monetize their investment. Some PE firms may also appear in the public markets to buy back the debt securities of the companies they own if they have gotten cheap. Because many of the new debt issues that come to market are not publicly registered and issued under securities rule 144a, almost all the participants outlined here are qualified institutional buyers (QIBs). Under U.S. securities law, you must be a QIB to be able to buy and trade 144a securities. The $1 million-plus size of a typical trade, the number of rule 144a bonds, the private nature of the bank loans, the relative illiquidity, and the expense to diversify a portfolio tend to keep individuals from investing in the high-yield market directly. But they can do so through many of the vehicles described here. Depending on what type of firm you work at, you might be asked to do very different things with your credit work. Although the priorities of what to focus on may vary, the basics of the work will still be the same. 25 5. Why Is Leveraged Finance Analysis Unique? What’s in this chapter: Why volatility exists in the leveraged finance market How and why the analysis for this market uses components of fixed income, equity, and investment banking, among others Why leveraged finance credit analysis is different from investment grade and equities Leveraged finance analysis encompasses key components from other types of securities analysis. It also emphasizes and incorporates features unique to its market. This combination of tools commonly used in equity, debt, and corporate finance makes the analytical work done in this market unique. Companies with more debt leverage (or gearing in the UK) have less margin for error. Therefore, the security prices of these companies react more dramatically to relatively smaller changes in operating results or news headlines than prices of companies with less leverage (such as investment-grade companies). This more volatile reaction in price is more similar to stocks than to traditional investment-grade corporate or government-issued bonds. Investors in investment-grade bonds fully expect to get their principal and interest serviced from cash flows or other liquidity sources. The speculative nature and higher debt levels in the high-yield market make it more important to have a sense of the company’s underlying asset value. This is in case cash flows cannot service the debt. Investors look to the asset value as a way to restructure and service the debt or recapture value in a bankruptcy. This heavy focus on the underlying asset value is more akin to your analyzing the fundamental value in an equity than typical bond analysis. We would also argue that mergers, acquisitions, and asset sales are significantly more common on a relative basis in the leveraged finance markets than in the investment-grade market, which also aligns much of the analysis more to equity-like analysis than to traditional debt analysis. Meanwhile, leveraged finance bonds and loans are still debt instruments. Key ratios that are used to analyze these debt instruments are also used in investment-grade corporate analysis. Additionally, interest rate movements and access to borrowing markets are clearly more of a focus in debt markets than in equity markets and are important in the analysis explored in this book. Many measures of value used in leveraged finance, such as yield and spread, are used throughout the debt markets. But when situations get distressed, you often switch to a total return basis. Then prices and measures of value are more akin to what is seen in equity markets. Because of the typical amount of debt on the companies in this market, management teams and investment bankers are likely to spend much more time on the capital structure of these companies than a typical investment grade debt issuer. Management and their advisors regularly look at ways to improve their cost of borrowing and increase liquidity. Undertaking major financings is a regular event for many of these companies. Therefore, when you analyze these companies’ bonds and loans as an investor, you must also use the type of analysis that is used in corporate finance concerning funding choices, liquidity, and access to capital markets. As shown later, you must also analyze how the position of an existing debt instrument can get hurt or be improved by undertaking a new financing or transaction. Corporate structural issues can occasionally become a factor in equity and investment-grade analysis. But it is a way of life to focus on these topics when doing leveraged finance analysis. Covenant analysis, structural 26 rankings, and such are an everyday part of the job in leveraged finance analysis. These topics come up much less frequently in investment-grade work and even more rarely in equity analysis. Leveraged finance analysts spend much more time on these structural and covenant issues than investment- grade and equity analysts do. However, understanding these aspects can greatly enhance the work of investment-grade and equity analysts. Finally, although you usually hope that default can be avoided, you must always keep an eye toward bankruptcy analysis. This involves analyzing asset values, liquidity, ranking of securities, and legal issues. How securities would ultimately get treated in a bankruptcy is critical in understanding how different issues within the same capital structure should trade relative to each other, even if the company is far from worrying about bankruptcy. The combination of skills used in leveraged finance credit analysis is increasingly being used to look at securities and investments outside the debt world. Private-equity investors for a long time have made sure to understand the nuances of analyzing and pricing leveraged debt in a transaction. This skill set also has increasingly been used to analyze and invest in the underlying equities of these high-yield credits. Some equity investment funds are actually dedicated to leveraged equities. It is worth noting that numerous studies and regularly published data show that the leveraged finance market is more highly correlated to equities (especially mid-cap and small-cap equities) than to fixed-income markets. This data goes all the way back to the days when Michael Milken at Drexel Burnham was developing the modern market, up to more recent studies by the likes of Credit Suisse. The factors outlined here are why the market is often viewed as a hybrid and why the analytical tools used are a combination of numerous tools from various other areas that create a unique skill set. Incorporating all these factors and deciding which analytical tools and factors take priority in different situations is an art that you develop through practice and exposure to different situations. This book tries to give you a sample. 27 6. The Major Components of Analysis What’s in this chapter: Why analysis starts with liquidity and asset value Why the issues of corporate and bond structure matter so much in analysis Why event analysis is used When relative value analysis is used Earlier, the two starting points of credit analysis were outlined: Is there enough liquidity to service the debt? In case there is not enough liquidity, is there enough asset value to get repaid through a sale of the company or restructuring? The next few chapters discuss credit analysis in detail. Before we move on, this chapter expands on these two basic points and shows you how understanding structure and ranking fits into understanding asset protection. You’ll also see how event analysis helps prepare you for sudden changes in trading levels. Liquidity and asset values may be the most basic foundation of leveraged credit analysis. However, the goal of the analysis is usually to reach a decision about a specific bond or loan. Without understanding structural issues and ranking, your ability to decide would be limited, and you would have a difficult time knowing how to react to any breaking news. You should look at each component of credit analysis from a historical perspective to get a sense of how the company has been progressing. However, it is critical that you also examine how each component might act in the future. Try to think through and analyze what can happen next and how the liquidity, asset values, and structural issues will be impacted. The Components As mentioned, the first component to focus on is financial liquidity. Does the company have enough cash- flow-generating capabilities to fund its operations? If not, what is the cash on hand? Does the company have other sources of liquidity to operate and pay the interest on the debt that is being analyzed? What are the options for paying back the principal? The second component is the asset value. If the company does not have the liquidity to pay off its obligations to the investors, what is the company’s underlying asset value? Is there enough asset value to repay the investment in the loan? This could be through the sale of the company or the sale of selected company assets. You must also factor in how long it might take to get the benefits of the asset value. Part of this analysis must take into account where the bond or loan that an investor is buying ranks in having a claim on the asset values. That brings us to the next component in the analysis of leveraged debt—a focus on structural issues. The corporate and debt structure can be a major factor in the value of a debt security. Items to examine here include the following: Which subsidiaries have which assets, and which entities issued the debt? What is the ranking of the notes? For example, are they secured or unsecured or subordinated? What are the key structural issues of the individual debt instrument? For example, is there an early call date at the company’s option? 28 What covenants in the security are being analyzed and what covenants are there in other debt instruments in the structure? For example, covenants may allow significantly more debt to be placed senior to the bond, thus weakening its position. What technical factors about the bond or loan are important? For example, what is the size of the issue, or the currency it is issued in? The next component is to analyze event scenarios. This involves laying out potential upcoming events, figuring out how likely they are to occur, and analyzing how each one may impact the securities you are examining. It is often useful in this analysis to create decision trees or timelines of possible events. Another major component is analyzing the investment’s relative value. This is a common theme throughout investing. In this part of analysis, you try to define the investment objective or goal. Does the debt instrument fulfill that objective at the current pricing better than other options? Part of the answer lies in the analysis of risk versus return on investment. You should examine how this risk versus return compares to other investment alternatives, whether it is other bonds, loans, equities, or commodities. Depending on what kind of organization you work for and the goals of your analysis, the answers can vary greatly. Some organizations are more focused on limiting risk, and others are more focused on total return opportunities. Additionally, some can evaluate options only among leveraged finance investments, whereas others can invest across the entire securities and commodity spectrum. Other typical constraints can include rules concerning diversification, currency, and geography. A Pragmatic Point on the Various Aspects of Analysis The basic building blocks of leveraged finance credit analysis are based on liquidity and asset value analysis. But you must remember that because credit analysts are always concerned about downside risk, even if a company appears to have excellent liquidity to meet its obligations, an analyst still wants to understand the underlying structural issues as they relate to asset protection as well. Therefore, for you to ultimately reach a decision—the goal of analysis—it is critical that you understand structural issues, event risk, and relative value. 29 7. Some Features of Bank Loans What’s in this chapter: Types of bank loans The role of the administrative agent Loan structure: coupons, amortization, calls Bank loans and amendments Leveraged bank loans have many features similar to the bonds in the market. But they also have many unique features, some of which are described in this chapter. Although these loans are typically called bank loans, syndicated loans, or just loans, in the leveraged finance market they are not always held by banks. However, they are usually initially arranged by banks. These loans end up being held and traded by a wide array of buy-side and sell-side participants. These loans are not securities, they are not traded on an exchange, and documentation for trades can vary greatly compared to bonds. In part, due to the lack of a central exchange for trade clearing, one of the features of this market is the inability to put on a traditional short. Bank loans generally can be divided into revolvers and term loans. Revolvers are loans that are typically for temporary funding of business. They can be borrowed and repaid and reborrowed over the life of the loan. Term loans usually are more permanent. Generally, if the principal is repaid, it cannot be reborrowed. The nature of a revolver is that the lender often has a large unfunded or undrawn commitment. The borrower usually pays a very low rate, maybe 0.25%, on the undrawn portion of the revolver but then pays a full interest rate on any drawn portion. The need to keep these undrawn funds available for the borrower means that revolvers tend to be held by commercial banks. Other investors, such as mutual funds or hedge funds, would need to hold money in reserve for the undrawn portion of the revolver. That would not be earning a full coupon, and this could damage its returns. Commercial and investment banks are more willing to supply funding for revolvers as this is part of their business of supplying liquidity. As with bonds, a lead bank underwrites the loans; it is the arranger and is usually also the administrative agent or agent bank. Agent banks have certain obligations regarding documentation, due diligence, and information flow. However, an important difference is that in the sale of a new issue bond, the underwriter typically has to have the issue fully distributed and off its own balance sheet to begin making markets and providing liquidity for the issue. In the bank market, the agent and, to a lesser extent, others involved in distributing the bank loan are expected and, in some cases, required to hold on to part of the loan. Investors in this market sometimes become uneasy if the agent bank does not hold any of the loan. Several other features are typical in the loan market and differ from what is usually seen in the leveraged bond market. These are covered in greater detail in later chapters, but it is worthwhile to briefly highlight them here. Loans usually have floating-rate coupons, meaning that they are priced as a spread off some index, typically LIBOR. The coupon moves up and down over time. Sometimes a minimum floor is put on LIBOR. Sometimes company issuers or investors pay a fee to “swap” their loan into a fixed-rate coupon for part or all of the life of the loan. Additionally, loans sometimes have a grid that lowers or increases the spread that the issuer has to pay, depending on how strong a certain ratio or other metric may be. This is described in a bit more detail in Chapter 13, “Structural Issues: Coupons.” Loans sometimes have principal amortization during the life of the security (a fancy word for required debt 30 paydown). This is exceptionally rare in bonds. However, these amortizing loans are significantly less common in the high-yield market than in the investment-grade market. Many lower-rated loans generally have little or no amortization. Loans often have a required cash flow sweep. This means that a defined portion of excess cash flow from operations may be required to pay down bank debt each year. This feature is fairly unusual to see in bonds. Term loans may often be divided into a term loan A and a term loan B. There are no hard rules about the differences between term As and term Bs, but typically term loan A tranches are designed to be held by traditional commercial banks, and term loan B tranches by institutional investors like mutual funds or CLOs. Term loan A tranches will typically have some better terms, perhaps a slightly shorter maturity or more amortization. Term loan B tranches rarely have meaningful amortization. There can also sometimes be tranches beyond B: there could be C, D, or E tranches, too. Bank loans are typically callable at any time, and usually at a very low premium. Bondholders usually want some call protection to reap benefits from credit improvements and due to their lower ranking. Any bank loan repayments, even open market repurchases, typically need to be made pro rata across all tranches of bank debt. This is not true with bonds. However, bank debt has exceptions. Sometimes there are “first out” tranches of debt that are required to be paid out ahead of other tranches of bank debt, especially from proceeds from an event, such as a public stock offering or asset sale. Bank loans are usually senior or at least pari passu (equal ranking) with bonds. They typically have security or subsidiary guarantees. Bank loans typically have affirmative and financial covenants that require that certain reporting and financial metrics be maintained. These are often called maintenance covenants; bonds typically do not have these. It is also much more common, and generally considered easier, to get amendments and waivers from loan holders than from bondholders. For example, if the issuer of a loan begins to experience an operational rough patch and cannot meet its maintenance covenants, it goes to its loan group and, usually for a fee, asks for a change or temporary waiver on the covenant test. When a company is troubled and violating some of the covenants in its loan agreement, banks often continue to give waivers and work with the company. This is due to a number of reasons: Banks typically rank senior and are more comfortable that they will be taken care of in any restructuring than more subordinated lenders. The concept of lender liability often dissuades lenders from forcing a company to default on a technical matter. The amendment and waiver fees are a way of getting repaid some cash from a troubled or potentially troubled loan. If an analyst is on the public side, getting bank documents can sometimes be a challenge. Some companies make their bank agreements public, and some do not. Even companies with public stock do not always make their bank agreements public. Also note that sometimes bank agreements are filed not as a separate document but as an appendix to a quarterly or annual report or some other filing. Sometimes the agreement is filed on special gated websites where you have to get permission from the company to gain access. If you do have a bank document, remember to check for any filings of amendments or waivers that may have changed the terms of the agreement from its original terms. 31 Trading loans takes more documentation than bonds. There are two different ways to trade bank loans—by assignment (more common) or through participation. With assignment, the purchaser of the bank debt ends up owning the piece of bank debt and has voting rights and so on. Assignments typically need to get approval from the agent bank and the company. The other way of trading bank debt is through participation. Here a buyer gets a legal claim to the economics of owning the bank debt, but the debt actually remains held by the seller. Voting rights and such are retained by the seller. When analyzing bank debt, do not fall into the trap of just assuming that if the bank debt is secured, it is secured ahead of other debt obligations or is secured by all assets. Also do not assume that bank debt always has priority over other debt instruments. As described in Chapters 13 through 16, be sure to read the terms of a bank agreement to fully understand ranking, guarantees, and security. Because bank loans are not publicly registered, securities and traditionally bank lenders get more regular updates on financial results than the public. Bank investors usually can choose to be public or private. Typically, if an investor chooses to be private, he gets more information about the company. However, he is restricted from talking about it with investors or potential investors who are not private. He also is restricted from being able to trade bonds or public stock in the company. Questions 1. Which type of loan can typically be repaid and then reborrowed? A. Revolving loan B. Term loan C. Bank loan D. Secured loan 2. Most bank loans rank __________ relative to bonds. A. pari passu B. junior C. equal D. senior 3. Which method of trading bank debt transfers the voting rights to the new owner? A. Cash trading B. Assignment C. Participation D. Lender terms 4. Which traits listed below are not typical of loans? A. Floating rate coupons and LIBOR floors B. Immediately callable and low or no call premiums C. Administrative agent fully distributes the loans and no debt amortization D. Security, subsidiary guarantees, and maintenance covenants 32 8. A Primer on Prices, Yields, and Spreads What’s in this chapter: How prices are used in high-yield debt How yields and spreads are used Differences between typical bank loan coupons and bond coupons When and how duration and total return are used The concept of prices and yields in deferred pay bonds This chapter covers how prices, yields, and spreads are used in the leveraged finance market. Prices, trades, and value are often discussed in the market using these terms, especially when relative value between two or more investments is being discussed. However, yields and spreads are also measures of expected absolute and relative returns on these debt instruments. The Basics When someone wants to know the “price” at which to buy or sell a bond or loan, the price is actually given as a percentage of the principal or face value, which is a proxy for the debt’s dollar price. However, just as often, bonds and loans are quoted by giving the yield that the bonds are offering at a given price and sometimes by giving the spread. It is worth reviewing these measures used to discuss the price of debt instruments. Even though people in the market often put a dollar or other currency sign in front of a bond price, this is wrong. The bond price is quoted as a percentage of face value. For example, suppose the price is 90 and you are buying a bond that at maturity will pay off $1,000 (face value, par value). You would pay $900 for that bond, not $90 (1,000 × 0.90, or 90%). Similarly, if you bought €2,000,000 of the same bond, you would not pay €90, but €1,800,000. Bonds have different coupon terms and mature at different dates. Therefore, comparing two bonds by price doesn’t really tell an analyst which bond represents better value. Typically either yield or spread is used to compare two different fixed-income securities. Yield is effectively a rate of return if the debt is held to a certain time and then retired at a certain price. Spread is that rate of return compared to a benchmark. (The benchmark is most commonly a government bond or a proxy for it with a similar maturity.) LIBOR and U.S. treasuries are two of the most common benchmarks from which to spread loans and bonds. These benchmark yields are viewed as riskless. The idea is that the spread represents the compensation for the risk that you do not get paid back when buying a corporate bond or loan. It is important to note that the spread is calculated from a benchmark of similar maturity. So if a bond is trading to a seven-year maturity, you should use a seven- year treasury bond as a benchmark. Note loans are more often spread off of LIBOR and bonds off a government bond of similar currency, such as U.S. treasuries. When you compare bonds of different maturities, especially when they are meaningfully different, comparing spreads is usually more meaningful than comparing yields. This is true because of the concept of the time value of money. The yield curve is partially based on the concept that longer maturities (or the longer you must wait to get paid back) should get paid higher yields, to compensate for inflation and such. So by looking at the spread rather than the yield, you get a better sense of the value of bonds of different maturities. A Few Points on Yields The yield-to-maturity (YTM) and yield-to-worst (YTW) are simply measures of rates of return. The 33 actual calculations are fairly time-consuming. But many programs can calculate these yields rapidly, such as systems from Bloomberg and Interactive Data Corp. Also, systems can be built using programs such as Microsoft Excel. The YTM takes a bond’s cash flows from its interest payment and maturity and its price and determines the return, or yield, using rate of return and reinvestment calculations. When the bonds are at par (100% of face value), the YTM and the coupon on the bond are the same. When the price is higher, the yield goes down and is below the coupon. The inverse is true when the price goes lower. When a bond is callable, meaning that the company can buy back the bonds at a set price at its option, the YTW comes into play. If the bonds are trading at a price above the call price, the yield-to-call (YTC) is lower than the YTM. Whichever yield is lower is usually the one that is used, to be conservative. This is the YTW, and we will use it throughout the rest of this book. Bond calculators run the yield to each possible call date and to maturity and pick out the most conservative. A Few Points on Spreads Considering all the different yields, such as yield-to-maturity, yield-to-worst, and yield to the next call, how do you look at the spread? Typically you just use the corresponding spread to the corresponding yield. So if the lowest yield corresponds to a call date that is five years out, you would use a treasury bond with a five-year maturity to run the spread. As explained in Chapter 2, “Common Leveraged Finance Terms,” the spread-to-worst (STW) is simply the yield-to-worst minus the yield on some benchmark of a similar maturity. Let’s use the ten-year bond as an example. Suppose the yield-to-worst meant that the bond was “trading to” a call date that was only seven years out. You would run the spread off the seven-year U.S. treasury rather than the ten-year (or a rate interpolated from the treasury curve that equated to seven years). If the bond was issued in British sterling (pounds), the spread typically would be calculated from the British government equivalent. Bank Loan Coupons To reiterate from the preceding chapter, bank loans typically have floating coupons and usually are spread over LIBOR. For example, a bond would typically have a set interest rate, such as 10%, and a typical bank rate would be set at +500bp over LIBOR. This means that if LIBOR is 2%, the holders of the bank debt get paid 7% interest (2% + 5%, or 500bp). But if on the next interest rate reset date LIBOR is at 3%, holders of the bank debt would get paid 8%. Occasionally bonds are set up as floating-rate notes too, but not often. For floating-rate notes and loans, instead of an STW, a calculation called the discount margin generally is used. It assumes that the reference rate (LIBOR in our example) will follow a certain pattern over the life of the loan. Also, some loans and floating-rate bonds have a “floor” set for LIBOR. For example, using a bond or loan with a floating-rate spread of +500 bp, as we just did, if a 3% floor is set in the terms of the bonds or loan, even if LIBOR is at 2%, the rate on the loan or bond would have to be a minimum of 8% (3% floor +500 bp). Duration Another concept worth mentioning that involves prices, coupons, and maturity is duration. Duration is a measure of the estimated change in price if the yield changes. So if a bond’s duration is four, it is assumed that if the yield changes 100bp, the price moves about four points. In general bond texts, this measure is used to compare the difference in sensitivity or volatility between two 34 bonds to the change in interest rates. This can also be used to see how the prices of two bonds issued by the same company might respond differently to a news event that would materially change the yield. Typically, the longer the maturity and the lower the coupon, the higher the duration (or the more sensitive price movements are to changes in yield). Total Returns The information about yields, spreads, and prices is fairly universal with bonds. However, as mentioned, certain features are more relevant to leveraged finance companies than others. In leveraged finance, analysts also often need to look at total return in the case of a major news event or a bankruptcy. The easiest way to address this is as if you are running a typical yield-to-worst calculation. However, the end price you get is not the par value of the bond or loan, but whatever the payout is due to an event or what the recovery is in bankruptcy. Similarly, the date you are getting this principal payoff may not be at the maturity date of the bonds or the call date, but some other date that you will estimate in your analysis. For example, assume that the high-yield company Zeta is bought by investment-grade company Alpha. If Alpha has a much lower cost of borrowing, it might not even wait for the bonds to be callable. Alpha may decide to try to offer a price to buy the bonds early, with an offer called a tender. An analyst would want to calculate the yield or total return for that tender date and price. In a bankruptcy analysis you might want to see what the return is if you buy the bonds at a certain price today and the bankruptcy does not settle for two years. Then you would estimate the different types of values you might get at the end of the bankruptcy. Similarly, in a stressed situation you might want to assume that a bond pays interest for one year and then goes through a one-year bankruptcy. In these cases you typically run an internal rate of return starting with the price paid for the bond (including accrued interest) of the stream of payments to see the total return. Deferred Payment Bonds: Prices and Yields One type of bond that has been prevalent during certain cycles of the high-yield market is the issuance of deferred-pay securities. This typically includes discount notes and pay-in-kind (PIK) notes. You must understand how bonds work to understand the differences in the concepts of face value and accreted value and how the bonds are quoted in the market. Because some of these concepts can take time to get used to, we go over them in Chapters 13, “Structural Issues: Coupons,” and 23, “Distressed Credits, Bankruptcy, and Distressed Exchanges.” Zero coupon bonds are usually issued below par and then pay par at maturity. The value of this note increases each day it moves closer to maturity; this is called accretion. It is important to note that the note’s value and its claim in bankruptcy are based on the accreted value, not the face value that would be due at maturity. For example, if a five-year note was issued at a discount price of 61.4%, the yield to maturity would be 10%. Assume that the amount that this bond is due at maturity is $500 million. The price of a bond when it was issued would be 61.4 (quoted in a percentage of face value), the same as its accreted value. The amount of debt on the company’s balance sheet would be $307 million ($500 million × 0.614). After year one from issuance, the note should have accreted to 67.68% of face value. If on that date you still wanted to buy the bond with a yield of 10% (the yield that it was issued at), you would pay the accreted value price of 67.68. If you believed the bond’s risk required a higher yield, you would pay a price below accreted value. 35 On the company balance sheet, the $500 million face amount obligation that was on the balance sheet a year ago at $307 million has now accreted to $338.5 million ($500 million × 0.6768). The increase in the accreted value is booked as interest expense on the income statement. In the high-yield market, the zero coupon note structure is a bit different. A typical structure is for a discount note to be issued at a discount and take five years to accrete to par. At that time the bond usually begins paying cash interest for the remainder of its life, typically another five years. There are also PIK notes. Instead of being issued at a discount, these bonds are issued at or close to face value. However, the company can pay the interest on these notes by issuing additional bonds valued at par, instead of cash. This causes the debt on the balance sheet to increase in a pattern similar to a zero coupon note. Typically, these bonds PIK for three or five years and then are required to start paying cash interest. After each PIK payment, the next interest payment is calculated from the new amount of bonds outstanding, the original amount, and the PIK amount. More recently a slight change to the PIK structure has evolved, known as toggle bonds. The company issuing the notes has an option for the PIK period, typically three or five years to either PIK the notes or pay in cash. Frequently it can do both. Here are three points to keep in mind about PIK and toggle notes: Unless the company has announced that it will pay in cash, the notes do not trade with accrued interest. (But typically the price increases commensurate with the implied interest accrual and then drops on the payment date.) Once the interest is paid in additional bonds, the next interest payment is made on the original bonds plus those issued for the PIK payment. If the bonds are trading at a significant discount or premium to par value, those who trade the bonds typically adjust the yield or price on the bond because the PIK interest payment has a value less than or greater than par. A Pragmatic Point on Terminology In practice, usually the higher quality the credit is, the lower the yield on the debt instruments. The bonds and loans that trade at relatively low yields are more likely to be quoted using a spread. The bonds and loans that are trading at higher yields tend to be quoted in price and/or yield. When bonds and loans are trading at yields closer to the benchmark, they are often said to be trading “tighter.” If they are trading at yields further from the benchmark, they are said to be “wider.” Also, if two bonds of similar quality are trading at different yields, the one with the lower yield may be referred to as “trading rich.” The other might be said to be “trading cheap.” Questions 1. If you pay $900,000 for $1,000,000 face amount of a bond, how would that price be quoted in the high-yield market? A. 900 B. $900,000 C. 90 D. $1,000,000 2. If a ten-year bond has seven years until it matures, which maturity of a treasury bond should you use to 36 calculate the spread? A. Ten-year B. Seven-year C. Three-year D. Five-year 3. If a bond is trading at par, the coupon is equal to which figure? A. The spread-to-worst B. The call price C. The yield-to-maturity D. The spread-to-maturity 4. True or false: If a bond is noncallable, meaning that it does not have a call price, the YTW doesn’t matter. 5. If a bond has a face amount of $2,000,000 and was issued at an accreted value of 60, the price of the bond is ____, and the amount on the balance sheet for the bond is _______________ at the time of issuance. A. 60, $2,000,000 B. 60, $1,200,000 C. 100, $2,000,000 D. 60, $600,000 37 9. A Primer on Key Points of Financial Statement Analysis What’s in this chapter: What sections of the financial statement commentary to prioritize How to derive key figures from company financial statements Deriving EBITDA and deciding what to include in adjusted EBITDA Free cash flow and interest expense, capital expenditures, and changes in working capital What you should focus on from the balance sheet This chapter shows you how to derive key data used in our analysis from a company’s financial statements. It also discusses other uses of these documents. A company’s financial statements include more than just key numbers. Material amounts of descriptive information lend considerable insight to the analysis. Whenever possible, read through all the information— especially the footnotes to the financial statements. When your time is limited, try to focus on these sections: A description of the business (if you’re looking at a new company) Management’s discussion of recent results Recent events (which often include events that happened after the reporting period) The section describing liquidity The footnotes regarding the debt structure Although accounting standards differ slightly around the globe, they are becoming more and more similar with the use of international accounting standards. The examples in this book use the U.S. generally accepted accounting principles (GAAP). Most companies make quarterly financial results available. Some European companies report only semiannually. Sometimes a company puts out an earnings release as a press release that may contain different or additional information than what is included in its formal financial filings. For companies that file with the U.S. Securities and Exchange Commission, the press release will be in a form 8-K, quarterly financials will be in a form 10-Q, and the annual financials will be in a form 10-K. The key parts of the financial statement used in credit analysis are the income statement, balance sheet, and consolidated statement of cash flows. You hope to derive numerous subsets, details, and nuances from a more detailed reading of the documents. But initially you want to derive four key items from these statements: Key measures of cash flow, most commonly using adjusted EBITDA and free cash flow The amount of debt obligations The cost to service the debt obligations Other potential sources of liquidity to help service debt EBITDA The most widely used figure as a measure of cash flow from operations is EBITDA: earnings before interest, taxes, depreciation, and amortization. (Some people use OIBDA: operating income before depreciation and amortization.) EBITDA is not a GAAP figure but is derived using GAAP numbers. It is looked upon as a measure of cash from operations available to service interest expense and other obligations, which is why interest and taxes are 38 added back. The depreciation and amortization are added back because they are noncash charges. EBITDA is also often viewed as the key unleveraged cash flow figure by which people value companies—or at least it’s a reasonable proxy. EBITDA is often faulted in textbooks for a number of reasons. Typical reasoning is that depreciation is a proxy for capital spending, so it is unrealistic to add it back—and that there are truer measures of cash flow. For this reason, some prefer EBIT (excluding depreciation and amortization). However, the bottom line is that the relatively easy-to-derive EBITDA figure is the one that is most widely used when looking at leveraged finance credit analysis, so it cannot be ignored. For almost all these other measures of cash flow, we will construct them starting with EBITDA. EBITDA can usually be derived from the income statement. The income statement shown in Table 9-1 is a typical example. You can start with the net income on line 12 and add back taxes, interest expense, depreciation, and amortization from lines 11, 9, 5, and 6, respectively. From this you derive a simple EBITDA. T able 9-1. Inco me Statement Sample in $000,000s Sometimes, however, depreciation and amortization are not broken out on the income statement. Sometimes they are included in certain expense lines, as shown in Table 9-2. When this is the case, you must go to the statement of cash flows. As you can see in Table 9-3, the first section focuses on cash related to operating activities, as opposed to investing or financing. This section derives a figure called net cash provided by operating activities. Within the line items in this section, the depreciation and amortization are shown on line 2 and can be added back. This statement contains numerous other helpful items, several of which we will come back to later. For credit analysis, this statement is one of the most useful financial pages on any 39 company. T able 9-2. Inco me Statement Sample 2 in $000,000s T able 9-3. Statement o f C ash F lo w s in $000,000s 40 More commonly used now instead of EBITDA is adjusted EBITDA. This typically adds back other types of noncash items. The most universal add-back is noncash or stock compensation, as shown on line 3 in Table 9-3. Sometimes you also add back other noncash items, such as noncash charges or write-downs of asset values. When you use adjusted EBITDA on a spreadsheet or report, it is strongly recommended that you footnote the adjusted EBITDA and include in the footnote exactly which items are being added to EBITDA to avoid any confusion. This chapter mentions OIBDA as an alternative to EBITDA. OIBDA is operating income before depreciation and amortization. This implies that operating income is measured before taxes and interest expense are deducted, although some definitions simply define OIBDA as adding back these two items. OIBDA is similar to EBITDA. But because it uses operating income instead of earnings as its starting point, it typically excludes any income from discontinued operation, gains, or losses from subsidiaries and other nonoperating items. For these reasons you could argue that OIBDA is a significantly better figure to use, and in many cases it is. However, realistically EBITDA is still the standard. Then people may adjust the EBITDA to get a more realistic operating figure. Before talking about measures of free cash flow, we should discuss capital expenditures, cash and noncash interest expense, and cash and noncash taxes and changes in working capital in a bit more detail. Capital Expenditures Capital expenditures are the amount that a firm invests in longer-term assets. Because these are not regular operating expenses for accounting purposes, but are considered longer-term investments, they do not appear on the income statement. Instead, they appear on the statement of cash flows under investing activities. Then the investment is recorded on the balance sheet as an asset, and the income statement includes a “depreciation” expense spread out over the “useful life” of the asset for accounting purposes. As discussed earlier, depreciation is not a cash item but represents the decline in value of a capital investment, or sort of a proxy for how much would need to be spent each year to replace the asset over its useful life. However, in reality this does not always match up, especially when things such as rapidly evolving technology impact a company. So typically as an analyst, you use adjusted EBITDA and then net out capital expenditures. Sometimes this is called unleveraged free cash flow, but we prefer a more detailed free cash flow measure. In the statement of cash flows, capital expenditures is shown, but its label may vary. Sometimes it is called capital expenditures, and other times it is something like purchases of fixed assets, as shown on line 12 of Table 9-3. 41 Here is a simple example. A manufacturing company decides to invest $100 million in a new plant for a new product. That is recorded as a use of cash in the investment section of the statement of cash flows and as a new asset on the balance sheet. Using a simple straight line method, if the plant is supposed to last ten years, the company would record $10 million of depreciation expense per year for each of the next ten years on its income statement. The asset on the balance sheet would be reduced each year by that amount. However, the plant may actually last much longer, or it may become obsolete sooner, or technology could cause the cost of the plant to come down, so ten years from now the plant may cost less to replace. However, importantly, the company is not spending that $10 million a year of depreciation that appears on the income statement and therefore can use it for other items. Although companies do not show it in their statement of cash flows, an analyst often wants to determine how much capital expenditure is necessary to maintain the business and how much is discretionary. This helps determine the true cash needs to keep the business running if liquidity is tight. Those types of insights can sometimes be gleaned from text in management’s earnings releases or comments from management. Sometimes you have to estimate it by looking at the historical patterns. Interest Expenses Not all the interest expense that is recorded on the balance sheet is always an actual cash item. The income statement records a total interest expense figure, as shown on line 7 on the income statements shown earlier. However, several debt structures (such as the deferred pay structure mentioned in the preceding chapter) and other factors may result in a difference between the cash interest expense paid and the amount recorded on the income statement. So you want to see what the true cash interest is. You can start with the total cash interest from the income statement and then look at the statement of cash flows to see what noncash interest expenses need to be adjusted. You can see on line 4 of the statement of cash flows the noncash interest expense. So an analyst could record both the cash and noncash interest expense. Note that on this statement, the noncash cash interest in column A line 4 is much larger than the next two years in columns B and C. This implies that perhaps a deferred-pay bond was outstanding in year 1 that was either retired or perhaps began paying cash interest afterwards. Taxes You also have to be careful to properly account for taxes versus actual cash taxes. Because of interest expense and depreciation and amortization, most high-yield companies are not cash taxpayers. Or if they are, the cash taxes are not very significant. Taxes may be recorded on the income statement, but because of items such as net loss tax carry-forwards, they may not actually be a cash item. Similarly, as laid out in the income statements in this example, the “tax benefits” are not actually cash gains. So again you should use the items from the income statement and adjust them for items in the statement of cash flows to determine if they are truly cash or noncash items. In the earlier examples, the tax adjustments occur on line 5 in the statement of cash flows. Changes in Working Capital Working capital is defined using two figures from the balance sheet—current assets (line 7) and current liabilities (line 17). However, the changes in working capital can often be a meaningful source or use of cash that is not shown on the income statement but that can be derived from the statement of cash flows. On the statement of cash flows, the changes in the components of working capital can be seen on lines 7 through 10. Working capital items are balance sheet items related to operations. 42 To explain this, we’ll go over a simple example of how this might work for one line item. Accounts payable is money that the company owes to others. This may be suppliers of raw materials or delivery companies. When that figure on the balance sheet goes down, this means that the company used cash to pay others. This would appear as a use of cash on the statement of cash flows, as it was in year 1 (column A, line 9). To calculate the changes in working capital during a given time period, you would add up the line items from the statement of cash flows from lines 7 through 10, remembering that the numbers in parentheses are negative. Changes in working capital should always be calculated, and material changes or large items in changes in working capital should always be questioned. In some free cash flow calculations you will want to use changes in working capital. However, an analyst also must try to understand when this is inappropriate to use. Most businesses go through periods where changes in working capital are a use and some where it is a source. These cycles can be due to seasonality in a business, changes in customers, new-product timings, or any number of factors. So one of the important considerations when using changes in working capital is to make sure you are looking at it over a long-enough period of time to be meaningful. Looking at it for just one quarter or even half a year can be misleading. Even looking at changes in working capital over a one-year period can be misleading for some businesses, depending on what changes or delivery cycles they go through. Counterbalancing these caveats previously listed, when a company is in a tight liquidity position, changes in working capital can be a vital item that can force the company to default or supply critical liquidity for a period of time. Keep in mind that not all financial statements are laid out the same. The amount of detail and the breakout of various line items can vary greatly from company to company. This can be particularly true in the statement of cash flows, especially for the changes in working capital. Free Cash Flow Free cash flow is a derived figure that uses information from both the income statement and the statement of cash flows. It is a good measure of cash liquidity generated from operations. This figure is useful in credit analysis for bondholders to see what is available to pay down debt obligations each year. It is generally preferred to use a free cash flow figure that nets out interest expense, cash taxes, and capital expenditures and adjusts for changes in working capital as well (see Table 9-4). Capital expenditures are an “investment” item on the statement of cash flows, but a large component of it can be an ongoing and vital business expense and often a large use of cash. T able 9-4. F ree C ash F lo w in $000,000s 43 The importance of both capital expenditures and working capital can vary by industry. Certain industries, such as manufacturing and retailing, can be big capital spenders and see significant changes in working capital. However, other industries, such as broadcasting, are not big users of either. Later chapters use these items as key factors in analyzing liquidity ratios. The Balance Sheet The next key items to look at are the balance sheet items—notably, cash and debt. As shown in Table 9-5, line 2 has the figure for cash on hand. Line 3 has an item for marketable securities. This often includes other highly liquid stocks or bonds or other items that can be monetized. These items are usually accounted for along with cash as a form of liquidity. T able 9-5. Sample B alance Sheet in $000s 44 Sometimes you see a line item for “restricted cash.” Typically this is not counted in cash for liquidity. But you should read the footnotes to the financial statements to find out what this cash is, because sometimes it is reserved to meet debt obligations. On to the liability side of the balance sheet. The first item to go to is the current portion of debt, which is line 16 on the balance sheet. This is the debt that is due within one year. You want to see if this is manageable relative to the company’s liquidity and free cash flow. Then you want to note the total debt number on line 18. In other cases several lines may have more details about each of the debt items, perhaps breaking out bank debt and bonds. Another item on the balance sheet to consider in the same section as the debt items are capital leases, on line 19, which are like a debt obligation. Typically it is conservative to count debt due within one year, long-term debt, and capitalized leases all as part of total debt. To look at net debt, you would subtract cash and equivalents from the total debt figure. These items give you the basics of debt, but you must look up other items to get a fuller picture of the debt. Earlier it was rec

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