Fixed Income · Reading 66
Credit Analysis for Corporate Issuers
CFA Level I · Fixed Income · Reading 66 · about 25 min
What you'll learn
- LOS 66.a Describe the qualitative (business model, competition, business risk, governance) and quantitative factors used to assess a corporate borrower's creditworthiness.
- LOS 66.b Calculate and interpret EBITDA, FFO, RCF and the profitability, coverage and leverage ratios used in credit analysis.
- LOS 66.c Describe seniority rankings, secured versus unsecured debt, the priority of claims in bankruptcy, and how they affect issue ratings (notching).
Module 66.1
Credit Analysis for Corporate Issuers
This reading applies credit analysis to corporate issuers: the qualitative and quantitative factors, the financial ratios analysts use, and how seniority and collateral affect recovery and ratings. A candidate must be able to compute and interpret profitability, coverage and leverage ratios, rank debt by priority of claims, work out recoveries in a liquidation, and explain notching and structural subordination.
LOS 66.a — Qualitative and quantitative factors in corporate credit analysis
Qualitative factors
| Factor | Signs of high credit quality |
|---|---|
| Business model | Stable, predictable cash flows; for long-dated debt, consider whether the model must change to stay competitive (change adds business risk) |
| Industry competition | Less intense competition, now and over the life of the debt |
| Business risk | Low risk of unexpected deviations from expected revenues and margins (from issuer, industry or external sources) |
| Corporate governance | Fair and legal treatment of debtholders, judged through covenants and accounting policies |
Covenants. Unsecured investment-grade issuers typically have mainly affirmative covenants (comply with laws, maintain assets, pay taxes), so analysts must judge the risk that management adds debt that dilutes existing lenders. High-yield issuers usually also have negative covenants restricting dividends and new debt. For them, analysts look for past evidence of favoring shareholders over lenders, such as a debt-financed buyback that led to a downgrade.
Accounting policies. Fraud is the obvious concern. Other warning signs about management's character include aggressive revenue recognition, heavy off-balance-sheet financing, a strong preference for capitalizing rather than expensing, and frequent changes of auditor or CFO.
Quantitative factors
Analysts forecast financial statements and cash flows to see what drives the probability of default and loss given default over the economic cycle. Investors in unsecured investment-grade debt worry mostly about the probability of default rising. Investors in secured high-yield debt also focus on loss given default, because default is more likely for high-yield issuers. Inputs can be top-down (macro cycle, industry size, market share, event risk), bottom-up (issuer revenue, costs, assets, liabilities, cash flows), or a hybrid of both.
All else equal, credit quality is higher with strong operating profits and recurring revenues, low leverage, high coverage of debt service by income, and high liquidity for short-term obligations.
In a bottom-up analysis these features come from the three financial statements: revenue and operating profit from the income statement, leverage and liquidity from the balance sheet, and the cash available to service debt from the cash flow statement. The profitability, coverage and leverage ratios in LOS 66.b measure the first three features.
LOS 66.b — Financial ratios used in credit analysis
Ratios let analysts judge a company's creditworthiness, follow trends over time and compare the company with industry averages and peers. The main groups are profitability, coverage and leverage.
Building blocks
Key concept
| Measure | Definition |
|---|---|
| EBITDA | Operating income + depreciation and amortization. Drawback: ignores capital expenditures and working capital needs |
| Cash flow from operating activities (CFO) | Net income + noncash charges − increase in working capital (from the cash flow statement) |
| Funds from operations (FFO) | Net income from continuing operations + depreciation + amortization + deferred taxes + other noncash items (like CFO but excludes working capital changes) |
| Free cash flow (FCF) | CFO − fixed asset expenditures + net interest expense; the discretionary cash that could go to providers of financing once all the company's obligations are met |
| Retained cash flow (RCF) | Operating cash flow (CFO, FFO or another chosen measure) − dividends |
Key ratios
Key concept
| Type | Ratio | Higher credit quality shown by |
|---|---|---|
| Profitability | EBIT margin = EBIT / revenue | Higher |
| Coverage | EBIT to interest expense | Higher |
| Leverage | Debt to EBITDA | Lower |
| Leverage | RCF to net debt = RCF / (debt − cash and marketable securities) | Higher |
Example. A company reports (USD millions) revenue 4,000; EBIT 600; D&A 200; interest expense 75; total debt 2,400; cash 400; CFO 700; dividends 150.
- EBIT margin
- EBIT/interest
- Debt/EBITDA
- RCF/net debt
Reading the results. Suppose a peer reports an EBIT margin of 11.0%, EBIT/interest of 9.0×, debt/EBITDA of 2.2× and RCF/net debt of 36%. The company is more profitable than the peer but more heavily indebted: its coverage is slightly weaker, its debt/EBITDA is higher and its RCF/net debt is lower. Mixed results like these are common, so the analyst weighs profitability against leverage instead of relying on any single ratio.
A multi-year average ratio can be taken as the simple average of the yearly ratios. Dividing total debt by total EBITDA over the same years gives a slightly different figure.
LOS 66.c — Seniority, secured vs unsecured debt, priority of claims and ratings
A bond's place in the priority of claims is its seniority ranking. Secured debt is backed by collateral and ranks ahead of unsecured debt, which is a general claim on the issuer's assets and cash flows.
Key concept
| Rank (highest first) | Category |
|---|---|
| 1 | First lien / first mortgage |
| 2 | Senior secured (second lien) |
| 3 | Junior secured |
| 4 | Senior unsecured |
| 5 | Senior subordinated |
| 6 | Subordinated |
| 7 | Junior subordinated |
Debt in the same category ranks pari passu (equal priority). Any part of a secured claim not covered by its collateral ranks pari passu with senior unsecured claims.
Example. A company is liquidated. Its senior secured lenders are owed $200 million and their collateral sells for $150 million. Senior unsecured bondholders are owed $300 million and subordinated noteholders $100 million. After the collateral is sold, $270 million of other assets remain.
- The secured lenders take the $150 million from their collateral. Their $50 million shortfall joins the senior unsecured claims.
- The senior unsecured pool is million, and it shares the $270 million pro rata: of each claim.
- Nothing is left for the subordinated notes or the shareholders (under strict priority).
The secured lenders recover million (94.3%), the senior unsecured bondholders 77.1%, and the subordinated noteholders nothing. Recovery rates fall, and credit risk rises, with each step down in seniority. In practice, strict priority is often not applied. Junior creditors and even shareholders may receive something before seniors are paid in full, because a negotiated settlement shortens a costly bankruptcy during which asset values tend to erode.
Issuer vs issue ratings. The issuer credit rating, called the corporate family rating (CFR), reflects the borrower's overall creditworthiness and is typically based on its senior unsecured debt. Issue credit ratings apply to specific bonds (individual debt obligations). Issue credit ratings are also called corporate credit ratings (CCRs). Setting an issue rating above or below the issuer rating is notching. Seniority and covenants (including collateral) drive it.
| Issue feature | Likely notching |
|---|---|
| Secured, strong protective covenants (e.g., limits on additional debt) | Upward (e.g., one notch above the CFR) |
| Subordinated, weak protection | Downward |
Structural subordination. In a holding company group, a subsidiary's covenants may block cash transfers to the parent until the subsidiary's own debt is serviced. The subsidiary's bonds then have the first claim on the subsidiary's cash flows. The parent's bonds are therefore effectively subordinated to them with respect to those cash flows, even though they are not formally junior. Rating agencies consider structural subordination when notching.
Notching is more common for lower-rated issuers. When the probability of default is high, differences in expected recovery between issues matter more. For highly rated issuers they matter little, so the issues may not be notched at all.
Common exam traps
- EBITDA adds D&A to operating income (EBIT). Dividing debt by EBIT overstates leverage. In the example, debt/EBIT gives 4.0× instead of a debt/EBITDA of 3.0×.
- FFO starts from net income from continuing operations. It does not start from CFO and does not subtract capex or dividends.
- Debt/EBITDA is the one key ratio for which a lower value means stronger credit. Higher earnings, all else equal, lower it and raise the other three.
- RCF/net debt uses net debt. Dividing RCF by total debt, without subtracting cash and marketable securities, understates the ratio. In the example, dividing by total debt gives 22.9% instead of 27.5%.
- Second lien is still secured debt and ranks above all unsecured debt; subordinated debt ranks below senior unsecured.
- Bonds of the same seniority rank pari passu whatever their maturity or coupon, so a 3-year and a 20-year senior unsecured bond of one issuer have the same priority of claims in bankruptcy.
- Notching can be upward or downward.
- The rating typically based on senior unsecured debt is the issuer rating (CFR), not an issue rating.
Bottom line
- The qualitative factors in corporate credit analysis are the business model, industry competition, business risk and corporate governance, the last judged through covenants and accounting policies.
- All else equal, credit quality is higher with strong operating profits and recurring revenues, low leverage, high coverage of debt service by income and high liquidity for short-term obligations.
- EBITDA is operating income plus depreciation and amortization, FFO starts from net income from continuing operations and adds back noncash items, and RCF is the chosen operating cash flow measure minus dividends.
- Higher EBIT margin, EBIT/interest expense and RCF/net debt indicate higher credit quality, while for debt/EBITDA a lower value indicates higher credit quality; net debt is debt minus cash and marketable securities.
- The priority of claims runs first lien, senior secured (second lien), junior secured, senior unsecured, senior subordinated, subordinated, junior subordinated; debt in the same category ranks pari passu, and any secured claim not covered by collateral ranks with senior unsecured claims.
- Recovery rates fall and credit risk rises with each step down in seniority, although in practice strict priority is often not applied because a negotiated settlement shortens a costly bankruptcy.
- The issuer credit rating (corporate family rating) is typically based on senior unsecured debt, and issue ratings are notched above or below it according to seniority and covenants, with notching more common for lower-rated issuers.
- Under structural subordination, a subsidiary's own bonds have the first claim on its cash flows, so the parent's bonds are effectively subordinated to them for those cash flows even though they are not formally junior.
Quick check
All else equal, which of the following would indicate higher credit quality for a corporate issuer?
Show answer and explanation
Correct answer: B
Other things equal, companies have higher credit quality when they have strong operating profits and recurring revenues, low leverage, high coverage of debt service by income, and high liquidity to meet short-term debt payments. Higher liquidity means more cash and liquid assets to meet obligations that fall due soon.
Why the other options are wrong
- A. Higher leverage means greater reliance on debt in the capital structure, which points to lower credit quality.
- C. Lower coverage means income covers interest and principal payments less comfortably, which points to lower credit quality.
Key takeaway Signs of stronger corporate credit: strong, recurring profits; low leverage; high coverage; high liquidity.
Practice Questions
Tamworth Mills is being liquidated. It has three classes of debt outstanding: senior subordinated notes, first mortgage bonds and senior unsecured notes. Which list ranks them from highest to lowest priority of claims?
Show answer and explanation
Correct answer: A
Secured debt ranks ahead of unsecured debt, and a first mortgage, which pledges a specific property, sits at the top of the secured classes. Senior unsecured debt is the highest class of unsecured debt. Senior subordinated debt ranks below it, because all subordinated classes rank behind other unsecured debt. Recovery rates fall with each step down this ranking.
Why the other options are wrong
- B. This places unsecured debt ahead of secured debt. First mortgage bondholders have a claim on the pledged property and rank first.
- C. The word "senior" in senior subordinated notes gives them priority only over other subordinated classes. They still rank behind senior unsecured notes.
Key takeaway General ranking: first lien or first mortgage, senior secured (second lien), junior secured, senior unsecured, senior subordinated, subordinated, junior subordinated.
How does an issuer credit rating most likely differ from an issue credit rating?
Show answer and explanation
Correct answer: A
The issuer credit rating (the corporate family rating) reflects the borrower's overall creditworthiness and is typically based on its senior unsecured debt. Issue credit ratings apply to specific bonds and may be notched above or below the issuer rating depending on seniority and covenants.
Why the other options are wrong
- B. Notching can go either way: a secured issue with strong covenants may be rated above the issuer, a subordinated issue below it.
- C. The issuer rating (CFR) is the one typically based on senior unsecured debt. An issue rating reflects the seniority and covenants of one specific bond.
Key takeaway The CFR rates the issuer and is anchored on senior unsecured debt; an issue credit rating rates one specific bond and can be notched up or down.
This reading has 13 questions in the full bank. Practice all of them.
Key Takeaways
- Signs of stronger corporate credit: strong, recurring profits; low leverage; high coverage; high liquidity.
- General ranking: first lien or first mortgage, senior secured (second lien), junior secured, senior unsecured, senior subordinated, subordinated, junior subordinated.
- The CFR rates the issuer and is anchored on senior unsecured debt; an issue credit rating rates one specific bond and can be notched up or down.