1. Credit Analysis:
When analyzing the fixed income opportunities use the 5 Cs of credit analyst which are
a) Character - how honest are the management and owners? Having they screwed over lenders and creditors in the past? All these sorts of questions need to be answered before contemplating becoming a creditor of the company
b) Capital - how much the borrower has put up in capital into the business. If for example an LBO firm seeks debt financing, it is worth while looking at how much equity the LBO firm is willing to put up from its side and how much capital there is in the business to date. The more equity capital the project has, the safer it is for the creditor to provide financing.
c) Capacity - ability of the business to meet its credit obligations. If there is a cushion to protect companies if the operating performance declines or if the revenues and profits are resilient due to the non-cyclical nature of the business, then the company is more credit worthy.
d) Collateral - if default occurs, the creditors should look at what assets they can use to cover whats is due to them. Banks typically pledge company assets but in the case of fixed income investors they would look at what assets can be recovered after the more senior creditors recover their money and the liquidity of those assets. For example a business with a factory and some real estate issues a bond but also has a bank loan which is guaranteed by a mortgage over the real estate. (the bank would have a senior claim over the real estate of the company in this case)
In this case if the business collapses, the bank can take over the real estate, liquidate it and recover its money but the fixed income investor may be stuck with an illiquid and abandoned brownfield site that would be sold for cents on the dollar materializing in a large loss to the fixed income investor.
e) Covenants - these could be negative (restrictive) or positive (affirmative)
Affirmative covenants are things that the issuer must do like maintain insurance or certain liquidity ratio.
Negative coventants restrict the issuer from doing something that is not in the interest of the creditor like paying large dividends or increasing leverage beyond a certain level.
2. Concepts
It is often worthwhile to understand key investing concepts. Here is a summary:
a) Credit risk has two components default risk and loss severity (also referred to loss given default)
Some fixed income investors use the formula:
credit spread = annual credit loss risk = (probability of default) x (1- recovery rate)
b) Spread Duration - a concept useful to comparing credit risk of bonds especially with a floating rate element. Spread duration measures the price change due to a change in the credit spread.
change in the bond price = change in the bond price due to a change in the risk free rate + change in the bond price due to a change in the spread.
Typically a standard fixed interest bond will have a modified duration equal to the spread duration. This is however not the case for floating rate bonds which have very little duration but could have substantial spread duration.
Spread duration is most useful for investment grade bonds.
Spread risk generally refers to the change in the bond price relative to a risk free bond due to spread widening (Credit Migration). Credit Migration refers to the decline in credit quality of the issuer leading to lower credit ratings and an increased spread.
c) Empirical Duration - is based on regression of actual bond prices and interest raEmpte changes
Effective durations are based on the present value of future expected cash flows should bond yields change either up or down.
Empirical duration tends to be lower than effective duration for investment grade bonds where as for high yield bonds the difference is negligible.
Investment grade investors primarily experience interest rate risk while credit and spread risk is secondary. For high yield bonds investors on the other hand
d) Liquidity Risk - ability to buy or sell quickly in the market at near fair market value.
When analyzing the fixed income opportunities use the 5 Cs of credit analyst which are
a) Character - how honest are the management and owners? Having they screwed over lenders and creditors in the past? All these sorts of questions need to be answered before contemplating becoming a creditor of the company
b) Capital - how much the borrower has put up in capital into the business. If for example an LBO firm seeks debt financing, it is worth while looking at how much equity the LBO firm is willing to put up from its side and how much capital there is in the business to date. The more equity capital the project has, the safer it is for the creditor to provide financing.
c) Capacity - ability of the business to meet its credit obligations. If there is a cushion to protect companies if the operating performance declines or if the revenues and profits are resilient due to the non-cyclical nature of the business, then the company is more credit worthy.
d) Collateral - if default occurs, the creditors should look at what assets they can use to cover whats is due to them. Banks typically pledge company assets but in the case of fixed income investors they would look at what assets can be recovered after the more senior creditors recover their money and the liquidity of those assets. For example a business with a factory and some real estate issues a bond but also has a bank loan which is guaranteed by a mortgage over the real estate. (the bank would have a senior claim over the real estate of the company in this case)
In this case if the business collapses, the bank can take over the real estate, liquidate it and recover its money but the fixed income investor may be stuck with an illiquid and abandoned brownfield site that would be sold for cents on the dollar materializing in a large loss to the fixed income investor.
e) Covenants - these could be negative (restrictive) or positive (affirmative)
Affirmative covenants are things that the issuer must do like maintain insurance or certain liquidity ratio.
Negative coventants restrict the issuer from doing something that is not in the interest of the creditor like paying large dividends or increasing leverage beyond a certain level.
2. Concepts
It is often worthwhile to understand key investing concepts. Here is a summary:
a) Credit risk has two components default risk and loss severity (also referred to loss given default)
Some fixed income investors use the formula:
credit spread = annual credit loss risk = (probability of default) x (1- recovery rate)
b) Spread Duration - a concept useful to comparing credit risk of bonds especially with a floating rate element. Spread duration measures the price change due to a change in the credit spread.
change in the bond price = change in the bond price due to a change in the risk free rate + change in the bond price due to a change in the spread.
Typically a standard fixed interest bond will have a modified duration equal to the spread duration. This is however not the case for floating rate bonds which have very little duration but could have substantial spread duration.
Spread duration is most useful for investment grade bonds.
Spread risk generally refers to the change in the bond price relative to a risk free bond due to spread widening (Credit Migration). Credit Migration refers to the decline in credit quality of the issuer leading to lower credit ratings and an increased spread.
c) Empirical Duration - is based on regression of actual bond prices and interest raEmpte changes
Effective durations are based on the present value of future expected cash flows should bond yields change either up or down.
Empirical duration tends to be lower than effective duration for investment grade bonds where as for high yield bonds the difference is negligible.
Investment grade investors primarily experience interest rate risk while credit and spread risk is secondary. For high yield bonds investors on the other hand
d) Liquidity Risk - ability to buy or sell quickly in the market at near fair market value.
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