Credit analysis is instrumental in understanding the risk of a bond investment. Credit rating agencies such as DBRS, S&P, Moody’s, and Fitch assign ratings to bonds and issuers based on their own proprietary analysis. Although credit ratings are a solid indicator of creditworthiness, solely relying on them to make bond investment decisions can be risky. Therefore, fundamental credit analysis is critical to help investors better understand the credit risk associated with investing in a bond.
Four C’s Analysis
Traditional credit analysis, known as “four C’s analysis”, contains four key components: capacity, collateral, covenants, and character.
Capacity is an issuer’s ability to repay its obligations when due. Capacity analysis includes three levels of assessment: industry structure, industry fundamentals and company fundamentals.
Industry structure can be described by Porter’s five forces: rivalry among existing competitors, threat of substitute products, threat of new entrants, bargaining power of buyers and bargaining power of suppliers.
Industry fundamentals, the next level of assessment, includes: industry cyclicality (i.e. cyclical industries are riskier due to higher earnings and cash flow volatility) and industry growth potential (credit risk is higher for a slow growing or declining industry).
The last level of capacity analysis is company fundamentals, including competitive position, operating history and ratio analysis. Competitive position analysis measures market share, operational efficiency and cost structure compared to peers in the industry. Operating history analysis examines the performance of the company over different phases of the business cycle, trends in margins and revenues, and current management’s tenure.
Ratio analysis is an important part of capacity analysis. Two key ratio subsets are leverage ratios and coverage ratios. Ratio analysis is commonly used to assess the viability of an issuer, to find trends over time, and to benchmark an issuer to industry peers.
- Leverage ratios - measure the amount of debt a company carries in relation to its total value. Within an industry, companies with more relative debt on the balance sheet generally have greater credit risk. The two commonly used leverage ratios are Debt-to-Capital and Debt-to-EBITDA.
- Debt-to-Capital (Total Debt ÷ Total Capital) - calculates the proportion of debt in the capital structure, with a high ratio implying potentially higher credit risk (Total Capital is the sum of Total Debt and Total Shareholders’ Equity).
- Debt-to-EBITDA (Total Debt ÷ EBITDA) - calculates the total debt relative to EBITDA, with a higher ratio implying potentially higher credit risk. This ratio is volatile for firms in cyclical industries or with high operating leverage because of their high variability of EBITDA.
- Coverage ratios - measure an issuer’s ability to generate cash flows to fund its interest payments. The two most commonly used are EBITDA-to-Interest Expense and EBIT-to-Interest Expense.
- EBITDA-to-Interest Expense (EBITDA ÷ Interest Expense) - calculates EBITDA relative to interest expense and is designed to approximate the number of times a company should be able to service its interest expense with cash flows earned from operations. A higher ratio indicates lower credit risk. Generally, a company’s ability to meet interest expenses becomes questionable when the ratio migrates below 1.5x.
- EBIT-to-Interest Expense (EBIT ÷ Interest Expense) - calculates EBIT relative to interest expense. This ratio is similar to the EBITDA-to-Interest Expense ratio but is more conservative as depreciation and amortization are removed.
Collateral is an investor’s “Plan B”. It answers the question “if an issuer defaults, what value will the underlying assets have?” by analyzing the market value of an issuer’s assets. This is especially important for issuers with poor creditworthiness because sufficient collateral gives investors comfort they will get repaid even if the issuer defaults.
Covenants are the terms and conditions issuers have agreed to as part of a bond issue. Covenants help protect investors while providing issuers some flexibility to operate the business. There are two types of covenants. The first, positive (affirmative) covenants mandate the issuer to take certain actions such as paying interest and maintaining certain financial ratios. The , negative (restrictive) covenants, restrict the issuer from doing certain things such as increasing dividends and repurchasing shares. Covenant analysis should examine whether the covenants protect the bond investors without overly restricting issuer’s operating activities.
Character refers to management’s commitment to fulfill its debt obligations. Character analysis should include management’s track record, soundness of strategy, accounting and tax policies, and historical treatment of bond investors.