Credit analysis is an essential consideration for any fixed income investment
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.
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.
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.