FIXED-INCOME: ANALYSIS

OF RISK
CFA Level 1 – Study session 15
Christine Verpeaux, CFA
Contents
 Reading 46: Understanding fixed-income risk and
return
 Reading 47: Fundamentals of credit analysis
Understanding Fixed-Income Risk
and Return
Reading 46

2/3/2021
LOS
a. Calculate and interpret the sources of return from investing in a fixed-rate
bond
b. Define, calculate, and interpret Macaulay, modified, and effective durations
c. Explain why effective duration is the most appropriate measure of interest
rate risk for bonds with embedded options
d. Define key rate duration and describe the use of key rate durations in
measuring the sensitivity of bonds to changes in the shape of the benchmark
yield curve
e. Explain how a bond’s maturity, coupon, and yield affect its interest rate risk
f. Calculate the duration of a portfolio and explain the limitations of portfolio
duration
g. Calculate and interpret the money duration of a bond and price value of a
basis point (PVBP)
LOS
h. Calculate and interpret approximate convexity and distinguish between
approximate and effective convexity
i. Estimate the percentage price change of a bond for a specified change in
yield, given the bond’s approximate duration and convexity
j. Describe how the term structure of yield volatility affects the interest rate risk
of a bond
k. Describe the relationships among a bond’s holding period return, its duration,
and the investment horizon
l. Explain how changes in credit spread and liquidity affect yield-to-maturity of
a bond and how duration and convexity can be used to estimate the price
effect of the changes
Sources of return
 Yield measures should consider the three sources of
return to follow:
1. Coupon interest payments

2. Capital gain (capital loss) when the security matures,

is called, or is sold

3. Income from reinvesting of interim cash flows

(interest and/or principal payments prior to stated
maturity)
Sources of return
 An investor purchases a 6% coupon bond with 10
years to maturity at a price of $92.89.

 The yield to maturity for this bond is 7%

 Determine the dollar return that must be generated

from reinvestment income in order to generate an
ex-post return of 7% and the percentage of the
reinvestment income relative to the total dollar return
needed to generate a 7% yield.
Sources of return
 Initial investment = 92.89% of nominal
 Future value at 7% (bond equivalent) =
92.89% (1 + 7% / 2)20 = 184.83%
 Total dollar return = 184.83% - 92.89% = 91.94%
 Sources of return:
 Coupon interest = 20 x 3% = 60%
 Capital gain = 100% - 92.89% = 7.11%
 Total without reinvestment income = 67.11%
 Reinvestment income = 91.94% - 67.11% = 24.83% of nominal
 Reinvestment income relative to the total dollar return =
24.83 / 91.94 = 27%
 Reinvestment income needs to generate 27% of total return.
Duration
 Duration is the most widely used measure of bond price
volatility.

 A bond’s price volatility is a function of:

 Coupon
 Maturity
 Initial yield

 There are a number of different bond duration measures:

 Macaulay duration
 Modified duration
 Effective duration
Macauley duration
 Macauley duration is a weighted average of ti, the
time of release of cash flow CFi:
𝑛
 𝑀𝑎𝑐𝑎𝑢𝑙𝑒𝑦 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑖=1 𝑤𝑖 𝑡𝑖
 Each weight is equal to the market value of cash
flow CFi in % of the total:
𝐶𝐹𝑖 𝐷𝐹(𝑡𝑖 )
 𝑤𝑖 =
𝐵0
 CFi is the amount of the ith cash flow
 ti is the time of the release of cash flow CFi
 B0 is the current market value of the bond.
Modified duration
𝑀𝑎𝑐𝑎𝑢𝑙𝑒𝑦 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛
 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
1+𝑦

 Interpretation of modified duration: percentage

change in B, the price of the bond, for a change of
1% in the bond yield.

2/3/2021
Effective duration
𝐵+ −𝐵−
 𝐸𝐷 =
2𝐵0 ∆𝑦
 B+ is the estimated price if yield decreases by Δy
 B- is the estimated price if yield increases by Δy
 B0 is the initial price of the bond
 Δy is the required change in decimal form

2/3/2021
Example
 Consider a 15-year option-free bond with an annual
coupon of 7%, trading at par.

 Compute the bond’s effective duration with a 50bp

increase and decrease in yield.
Example
 N = 15; PMT = 7.00; I/Y = 7.5%; CPT→ PV
PV = 95.586

 N = 15; PMT = 7.00; I/Y= 6.5%; CPT→ PV

PV = 104.701

 Effective duration =
(104.701 – 95.586) / (2 x 100 x 0.005) = 9.115
Using effective duration to calculate a
price change
 Approximate change in price = (-) (effective duration) x
Δy x initial price

 Approximate new price = initial price (1 – effective

duration x Δy)

 Example:
 Consider the 15-year, 7% bond from the previous example
 Estimate the price change if yield falls or rises by 150bp
Using effective duration to calculate a
price change
 Approximate change in price if yield increases by
150bp =
(-) (9.115) x 0.015 x $100 = -$13.6725

 Estimated new price = $100 - $13.6725 = $86.3275

 Approximate change in price if yield drops by 150bp =

(-) (9.115) x (-0.015) x $100 = $13.6725

 Estimated new price = $100 + $13.6725 = $113.6725

Using effective duration to calculate a
price change
 Estimated new prices with the full valuation method:
N = 15; PMT = 7; I/Y = 8.5; CPT→ PV: 87.5436
(compared to 86.3275)

N = 15; PMT= 7; I/Y =5.5; CPT→ PV: 115.0564

(compared to 113.6725)
Using effective duration to calculate a
price change
 The estimated price changes differ from the actual price
changes, regardless of whether prices go up or down.

 This is a well known characteristic of duration:

 With small changes in yield (less than 50bp), the estimated
and actual price changes are very close
 For large swings in yield (50bp or more), duration tends to
underestimate the increase in price that occurs with a
decrease in yield and overestimate the decrease in price
that comes with an increase in yield
Money duration and price value of a
basis point
 The money duration or dollar duration is the absolute change in the
value of a bond in response to a 1% change in yield.

 Some analysts use a measure of price sensitivity called the PVBP,

the price value of a basis point, also known as the dollar value of a
01 or DV01.

 This is the absolute value of the price change of a bond in response

to a 1bp change in yield.

 Mathematically:
 PVBP = I new price if yield changes by 1bp – initial price I
 PVBP = initial price x modified duration x 0.0001
Example
 Consider a 10-year bond 10% semi-annual pay
bond, currently selling at par.

 Compute its PVBP.

N = 10; PMT = 5.00; P/Y = 2; I/Y = 9.99; CPT→ PV
PV = 100.062
PVBP = 100.06 – 100 = 0.062
Bond features that affect interest rate
risk
 Impact of maturity : the longer the maturity, the… the interest rate
risk.

 The impact of coupon rate : the higher the coupon rate, the… the
interest rate risk.

 The impact of the yield level : the higher the yield level, the… the
interest rate risk and the… the reinvestment risk.

 The impact of embedded option :

 Price of callable bond = price of option-free bond – price of
embedded call option
 The higher the value of the call, the… the reinvestment risk, and the…
the interest rate risk
Duration of a portfolio
 Two approaches to estimating the duration of a portfolio:
1. Cash flow duration: consists to calculate the weighted average
duration of the cash flows
2. Take a weighted average of the durations of the individual bonds in
the portfolio

 The first approach is not often used in practice. The yield used for
calculating portfolio duration is the cash flow yield, the IRR of the
bond portfolio.

 The second approach is typically used in practice. Using the

durations of individual portfolio bonds makes it possible to
calculate the duration for a portfolio that contains bonds with
embedded options.
Yield curve risk
𝑛
 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑖=1 𝑤𝑖 𝐷𝑖

 One limitation of this approach is that for portfolio

duration to make sense, the yield to maturity of every
bond in the portfolio must change by the same amount.

 This approach is consistent only with the assumption of a

parallel shift in the yield curve.

 We will illustrate yield curve risk with a practice

example…
Portfolios
Assumption: the spot curve is horizontal and all spot rates are equal to 10%
Macauley
Issue Yield Portfolio 1 Portfolio 2 Portfolio 3
Duration
2 10% 2 1,000.00 -1,000.00 562.50
5 10% 5 1,000.00 4,200.00 1,700.00
10 10% 10 1,000.00 -200.00 737.50
Market value (thousand $)
3,000.00 3,000.00 3,000.00
Duration 5.15 5.15 5.15
Key rate durations
Assumption: the spot curve is horizontal and all spot rates are equal to
10%

Change in the
value of the
portfolio for a Portfolio 1 Portfolio 2 Portfolio 3
100bp change in
the key rate

2
18,181.82 -18,181.82 10,227.27

5
45,454.55 190,909.09 77,272.73

10
90,909.09 -18,181.82 67,045.45

Portfolio
154,545.45 154,545.45 154,545.45
Scenarios

Scenario 1 Scenario 2 Scenario 3

2 +50 -25 +25
5 +50 0 -25
10 +50 +25 +25

 Scenario 1: parallel shift of 50 (+50 on 2, 5 and 10)

 Scenario 2: curve steepening of 50

(-25 basis points on 2; +25 basis points on 10)

 Scenario 3: curve twist

(-25 basis points on 5 ; +25 basis points on 2 and 10)
Change in the market values of
portfolios
Portfolio 1 Portfolio 2 Portfolio 3

Scenario 1 -77,272.73 -77,272.73 -77,272.73

Scenario 2 -18,181.82 0.00 -14,204.55

Scenario 3 -15,909.09 56,818.18 0.00

 Portfolio 1: sensitive to the various moves of the yield curve.

 Portfolio 2: hedged against a steepening/flattening as the key rate

duration on 2 is equal to the key rate duration on 10.

 Portfolio 3: hedged against a twist as the key rate duration on 2 and 10 is

equal to the key rate duration on 5.
Actual versus estimated price curve
Actual versus estimated price curve
 The curved line represents the actual price.

 It lies above the straight line which represents the

estimated price using the effective duration measure.

 The error in the estimate is due to the curvature of the

actual price curve.

 This is referred to as the convexity of the price curve.

Convexity adjustment
 Duration is a good approximation of price changes
for an option-free bond, but it’s only good for
relatively small changes in interest rates.

 As rate changes increase, the curvature of the bond

price/yield curve becomes more critical, implying
that the error due to linear estimate will widen.
Convexity adjustment
 Since we know that the price curve is not linear but
convex, we need to estimate the error due to the
convexity of the curve.

 An approximation of convexity is given by the following

equation:
𝐵+ +𝐵− −2𝐵0
 𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑐𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 =
2𝐵0 ∆𝑦

 In the developments to follow, we will refer to this value

as “convexity”.
2/3/2021
Example
 Consider a 15-year option free non-callable bond with
an annual coupon of 7% trading at par.

 If interest rates rise by 50bp, the estimated price of the

bond is 95.586.

 If interest rates fall by 50bp, the estimated price of the

bond is 104.701.

 Calculate the convexity of this bond.

Example
 Convexity = (104.701 + 95.586 – 200) / (200
(0.005)2) = 57.4

 Convexity should be used in combination with

duration to provide a more accurate estimate of
price changes.
Estimating the convexity effect
 To obtain an estimate of the % change in price due to
convexity, or the amount of price change that is not accounted
for by duration, we make the following calculation:
 Convexity effect = convexity x (Δy)2

 In our example:
 Convexity effect = 57.4 (0.015)2 = 1.2915%

 Take care!
 Use the decimal representation of the change (0.015 for
150bp).
Important properties of convexity
 Convexity corrects the error embedded in the duration,
so it should have much smaller effect than duration.

 For an option-free bond, the convexity effect is positive,

no matter which direction interest rates move.

 It is always added to the duration estimate of the new

price to modify the volatility error due to duration.

 This decreases the drop in price (due to an increase in

yields) and adds to the rise in price due to a fall.
Using convexity to improve price
change estimates
 By combining duration and convexity, we can obtain
a more accurate estimate of the change in the price
of a bond, especially for large changes.

 Percentage price change ≈ duration effect +

convexity effect = - duration x Δy + convexity (Δy)2
Example
 In our example:
 Percentage price change for -150 bp = -9.115 x (-0.015) +
57.4 (-0.015)2 = 0.1367 + 0.0129 = 0.1496 = 14.96%

 Approximate new price = 114.96%

(compared to 115.06% with full valuation)

 Percentage price change for +150bp = -9.115 x 0.015 + 57.4

(-0.015)2 = -0.1367 + 0.0129 = 0.1238 = 12.38%

 Approximate new price = 87.62%

(compared to 87.54% with full valuation)
Example
 Consider a bond priced 95.00, with an effective
duration of 10.5 and a convexity of 97.3

 Using both of these measures, estimate the price

change for this bond, given market yields are
expected to decline by 200bp.
Example
 Percentage price change = -10.5 x (-0.02) + 97.3 (-
0.02)2 = 0.1367 + 0.0129 = 24.89%

 Price change = 24.89% x 95.00 = 23.65

 New price = 95 + 23.65 ≈ 118.65

 Or calculate directly the new price:
 New price = old price (1 – duration x Δy + convexity x
(Δy)²) = 95 (1 – 10.5 x (-0.02) + 97.3 (-0.02)²) = 95 x
1.24892 ≈ 118.65
The importance of yield volatility
 To illustrate the importance of yield volatility, let us recall
the formula for the duration effect:
 ΔB = - effective duration (Δy)

 A bond with higher yield volatility will tend to

experience larger Δy’s.

 Therefore, if two bonds A and B have the same duration,

but A has higher yield volatility, A will tend to
experience larger changes in price, higher price volatility
and greater rate exposure.
The importance of yield volatility
 Consider the following bonds:
 Bond A: a 5% semiannual pay 20-year U.S. Treasury bond priced to
yield 5%
 Bond B: a 15% semiannual pay 20-year corporate bond rated Caa
and priced to yield 15%

 The duration of bond A is 12.55 and the duration of bond B is 6.30

 The bond rated Caa will likely have greater yield volatility than the
Treasury bond.

 Therefore, the price volatility of bond B can be higher, even though

its duration is lower.
The term structure of yield volatility
 In calculating duration and convexity, we implicitely
assumed that the yield curve shifted in a parallel
manner.

 In practice, this is often not the case. For example,

changes in monetary policy may have more of an effect
on short-term interest rates than on longer-term rates.

 It could be the case that a shorter-term bond has more

price volatility than a longer-term bond with a greater
duration because of a greater yield volatility.
Investment horizon and holding period
return for a bond
 We will illustrate the relationship among a bond’s
duration, investment horizon and holding period return
with some examples…

 Consider an 8.5% 8-year bond, priced at 89.52% to

yield 10.5%. The Macauley duration of the bond is 6.

 Let us calculate the bond’s horizon yield for horizons 3

years, 6 years, and 10 years, assuming the yield to
maturity falls to 9.5% before the first coupon date.
Investment horizon and holding period
return for a bond
 Should the bond be sold 3 years from now, the
horizon return would be:
3 coupons compounded at 9.5%,
respectively in year 1, 2 and 3 = 28%

 Price of an 8.5% 5-year bond,

discounted at 9.5% = 96.16%

 Holdingperiod return =
((28% + 96.16%) / 89.52%) 1/3 -1 = 11.52%
Investment horizon and holding period
return for a bond
 Should the bond be sold 6 years from now, the
horizon return would be:
6 coupons compounded at 9.5%,
respectively in year 1, 2, 3, 4, 5 and 6 = 64.76%

 Price of an 8.5% 2-year bond,

discounted at 9.5% = 98.25%

 Holdingperiod return =
((64.76%% + 98.25%) / 89.52%)1/6 -1 = 10.505%
Investment horizon and holding period
return for a bond
 Should the bond be sold 8 years from now, the horizon return
would be:
 8 coupons compounded at 9.5%,
respectively in year 1, 2, 3, 4, 5, 6, 7 and 8 = 95.46%%
 Maturity value = 100%
 Holding period return =
((95.46%% + 100%) / 89.52%)1/8 -1 = 10.253%

 Conclusion: for an investment horizon equal to the bond’s

duration, the holding period return is equal to the yield to
maturity; for a shorter horizon, the price effect dominates and
the holding period return is greater than the yield to maturity;
for a longer horizon, the reinvestment income dominates and
the holding period return is less than the yield to maturity.
Investment horizon and holding period
return for a bond
 The difference between a bond’s Macauley duration
and the bondholder’s investment horizon is referred
to as a duration gap.

 A positive duration gap exposes the investor to

interest rate risk from increasing interest rates.

 A negative duration gap exposes the investor to

reinvestment risk from decreasing interest rates.
Price effect of changes in credit
spread and liquidity
 Let us illustrate the price effect of changes in credit
spread and liquidity with an example:
 Consider a bond valued at $180,000 that has a duration
of 8 and a convexity of 22.
 The bond’s spread to the benchmark curve increases by 25
basis points due to a credit downgrade and the liquidity
spread increases by 5 basis points
 Approximate relative change in the bond’s market value:
 -8 x 0.0030 + 0.5 x 22 x 0.0030² = -2.39%
 Approximate absolute price in the bond’s market value:
 -2.39% x $180,000 = -$4,302
Fundamentals of Credit Analysis
Reading 47

2/3/2021
LOS
a) Describe credit risk and credit-related risks affecting corporate
bonds
b) Describe default probability and loss severity as components of
credit risk
c) Describe seniority rankings of corporate debt and explain the
potential violation of the priority of claims in a bankruptcy
proceeding
d) Distinguish between corporate issuer credit ratings and issue credit
ratings and describe the rating agency practice of “notching”
e) Explain risks in relying on ratings from credit rating agencies
f) Explain the four Cs (Capacity, Collateral, Covenants, and
Character) of traditional credit analysis
g) Calculate and interpret financial ratios used in credit analysis
LOS
h) Evaluate the credit quality of a corporate bond
issuer and a bond of that issuer, given key financial
ratios of the issuer and the industry
i) Describe factors that influence the level and
volatility of yield spreads
j) Explain special considerations when evaluating the
credit of high yield, sovereign, and municipal debt
issuers and issues
Credit-related risk affecting corporate
bonds
 Credit risk is the risk associated with losses stemming
from the failure of a borrower to make timely and full
payments of interest or principal.
 Credit risk has two components: default risk and loss
severity.
 Default risk: probability that a borrower (bond issuer)
fails to pay interest or repay principal when due.
 Loss severity: or loss given default: value a bond investor
will lose if the issuer defaults (monetary amount or
percentage of a bond's value).
 Expected loss: default risk multiplied by the loss severity
(monetary value or percentage of a bond's value).
Credit-related risk affecting corporate
bonds
 Recovery rate: percentage of a bond's value an investor will
receive if the issuer defaults.
 Loss severity as a percentage = 1- the recovery rate.
 Bonds with credit risk trade at higher yields than bonds
thought to be free of credit risk.
 The difference in yield between a credit-risky bond and a
credit-risk-free bond of similar maturity is called its yield
spread.
 Example:
 If a 5-year corporate bond is trading at a spread of 250 basis
points to Treasuries and the yield on 5-year Treasury notes is
4.0%, the yield on the corporate bond would be 4.0% + 2.5%
= 6.5%
Credit-related risk affecting corporate
bonds
 Credit migration risk or downgrade risk: possibility
that spreads will increase because the issuer has
become less creditworthy.

 Market liquidity risk: risk of receiving less than

market value when selling a bond (reflected in the
size of the bid-ask spreads).
Seniority ranking of corporate debt
 Each category of debt from the same issuer is ranked
according to a priority of claims in the event of a default.
 A bond's priority of claims to the issuer's assets and cash flows
is referred to as its seniority ranking.
 The general seniority rankings for debt repayment priority
are the following:
 First lien or first mortgage: a specific asset is pledged
 Senior secured debt
 Junior secured debt
 Senior unsecured debt
 Senior subordinated debt
 Subordinated debt
 Junior subordinated debt
Seniority ranking of corporate debt

 Recovery rates are highest for debt with the highest

priority of claims and decrease with each lower rank
of seniority.

 The lower the seniority ranking of a bond, the higher

its credit risk. Investors require a higher yield to
accept a lower seniority ranking.

 All debt within the same category is said to rank

pari passu, or have same priority of claims.
Corporate issuer/issue credit rating
 Credit rating agencies assign ratings to categories of bonds with
similar credit risk.

 Rating agencies rate both the issuer (i.e., the company issuing the
bonds) and the debt issues, or the bonds themselves.

 Issuer credit ratings are called corporate family ratings (CFR), while
issue-specific ratings are called corporate credit ratings (CCR).

 Issuer ratings are based on the overall creditworthiness of the

company.

 The issuers are rated on their senior unsecured debt.

Corporate issuer/issue credit rating
 A borrower can have multiple debt issues that vary by credit rating.

 Issue credit ratings depend on the seniority of a bond issue and its
covenants.

 Notching is the practice by rating agencies of assigning different

ratings to bonds of the same issuer.

 Notching is based on several factors, including seniority of the

bonds and its impact on potential loss severity.

 An example of a factor that rating agencies consider when notching

an issue credit rating is structural subordination.
Corporate issuer/issue credit rating
 Example:
 In a holding company structure, both the parent company
and the subsidiaries may have outstanding debt.
 A subsidiary's debt covenants may restrict the transfer of
cash or assets "upstream" to the parent company before
the subsidiary's debt is serviced.
 In such a case, even though the parent company's bonds
are not junior to the subsidiary's bonds, the subsidiary's
bonds have a higher priority of claim to the subsidiary's
cash flows.
 Thus the parent company's bonds are effectively
subordinated to the subsidiary's bonds.
Risks of relying on ratings from credit
rating agencies
1. Credit ratings are dynamic. Credit ratings change over time.
Rating agencies may update their default risk assessments during
the life of a bond. Higher credit ratings tend to be more stable
than lower credit ratings.

2. Rating agencies are not perfect. Ratings mistakes occur from time
to time. For example, subprime mortgage securities were assigned
much higher ratings than they deserved.

3. Event risk is difficult to assess. Events that are difficult to anticipate

are not captured in credit ratings.

4. Credit ratings lag market pricing. Market prices and credit

spreads change much faster than credit ratings.
Components of traditional credit
analysis
 A common way to categorize the key components of credit
analysis is by the four Cs of credit analysis: capacity,
collateral, covenants, and character.
 Capacity: refers to a corporate borrower's ability repay its
debt obligations on time.
 Collateral: more important for less creditworthy companies.
 Covenants: terms and conditions the borrowers have agreed
to as part of a bond issue to protect lenders (affirmative
covenants, negative covenants).
 Character: refers to management's integrity and its
commitment to repay the loan (management's business
qualifications and operating record).
Financial ratios used in credit analysis

 Profits and cash flows are needed to service debt.

 Here we examine four profit and cash flow metrics

commonly used in ratio analysis by credit analysts…
Financial ratios used in credit analysis
1. Earnings before interest, taxes, depreciation, and
amortization (EBITDA)

2. Funds from operations (FFO) (similar to cash flow from

operations (CFO) except that FFO excludes changes in
working capital)

3. Free cash flow before dividends (net income + depreciation

- increase in working capital - capital expenditures).

4. Free cash flow after dividends (free cash flow before

dividends – dividends)
Financial ratios used in credit analysis
 The three most common measures of leverage used by
credit analysts are the debt-to-capital ratio, the debt-to-
EBITDA ratio, and the FFO-to-debt ratio.
1. Debt/capital. Capital is the sum of total debt and
shareholders' equity. Represents the percentage of the
capital structure financed by debt.

2. Debt/EBITDA. This ratio is more volatile for firms in

cyclical industries or with high operating leverage
because of their high variability of EBITDA.

3. FFO/debt.
Financial ratios used in credit analysis
 Coverage ratios measure the borrower's ability to
generate cash flows to meet interest payments.

 The two most commonly used are EBITDA-to-interest and

EBIT-to-interest.
1. EBITDA/interest expense. A higher ratio indicates lower
credit risk. This ratio is used more often than the EBIT-to-
interest expense ratio.

2. EBIT/interest expense. This ratio is the more

conservative measure because depreciation and
amortization are subtracted from earnings.
Example: Credit ratings based on
ratios
 A credit rating agency publishes the following
benchmark ratios for bond issues of multimedia
companies in each of the investment grade ratings,
based on 3-year averages over the period 20X1 to
20X3:
Example: Credit ratings based on
ratios
Credit Ratings AAA AA A BBB

Operating margin 24.50% 16.50% 10.00% 7.50%

Debt/EBITDA 1.3x 1.8x 2.2x 2.5x

EBITDA/interest 25.0x 20.0x 17.5x 15.0x

FCF/debt 30.00% 24.00% 20.00% 17.00%
Debt/capital 25.00% 30.00% 35.00% 40.00%
Example: Credit ratings based on
ratios
 The following table includes the financial ratios for
Saxor and Coyote, two U. S. multimedia companies:
Example: Credit ratings based on
ratios
3-Year Averages Saxor Coyote
Operating margin 16.80% 11.50%
Debt/EBITDA 1.6x 2.3x
EBITDA/interest 24.7x 19.5x
FCF/debt 24.20% 23.20%
Debt/capital 26.50% 37.50%
Example: Credit ratings based on
ratios
 Based on the ratio averages, it is most likely that
Saxor's issuer rating is AA and Coyote's issuer rating
is A.
Factors that influence the level and
volatility of yield spreads
 Yield spreads on corporate bonds are affected primarily by five interrelated
factors:
 Credit cycle: Credit spreads narrow as the credit cycle improves. Credit
spreads widen as the credit cycle deteriorates.
 Economic conditions: Credit spreads narrow as the economy strengthens and
investors expect firms' credit metrics to improve. Conversely, credit spreads
widen as the economy weakens.
 Financial market performance: Credit spreads narrow in strong-performing
markets overall, including the equity market.
 Broker-dealer capital: Yield spreads are narrower when broker-dealers
provide sufficient capital but can widen when market-making capital
becomes scarce.
 General market demand and supply: Credit spreads narrow in times of high
demand for bonds and widen in times of low demand for bonds.
Return impact of spread changes (x)
 Example:
 An 8-year semiannual-pay corporate bond with a 5.75%
coupon is priced at $108.32.

 This bond's duration and reported convexity are 6.4 and

50.

 The bond's credit spread narrows by 75 basis points due to

a credit rating upgrade.

 Estimate the return impact with and without the convexity

adjustment.
Return impact of spread changes (x)

 Return impact with no convexity adjustment:

≈ - modified duration x Δs = -6.4 (-0.0075) = 4.80%

 Return impact with convexity adjustment:

≈ - modified duration x Δs + ½ convexity x (Δs)² ≈ -
6.4 x -0.0075 + ½ x 50 x (-0.0075)² ≈ 0.0480 +
0.0014 = 4.94%
Evaluating the credit of high yield
issues
 High yield or non-investment grade corporate bonds
are rated below Baa3/BBB by credit rating
agencies.

 These bonds are also called junk bonds because of

their higher perceived credit risk.

 Special considerations for high yield bonds include

their liquidity, financial projections, debt structure,
corporate structure, and covenants.
Liquidity
 Liquidity or availability of cash is critical for high yield issuers. High
yield issuers have limited access to additional borrowings, and
available funds tend to be more expensive. Bad company-specific
news and difficult financial market conditions can quickly dry up the
liquidity of debt markets.
 Many high yield issuers are privately owned and cannot access
public equity markets for needed funds.
 Analysts focus on six sources of liquidity (in order of reliability):
 Balance sheet cash
 Working capital
 Operating cash flow (CFO)
 Bank credit
 Equity issues
 Sales of assets
Financial projections
 Projecting future earnings and cash flows, including
stress scenarios and accounting for changes in
capital expenditures and working capital, are
important for revealing potential vulnerabilities to
meet debt payments.
Debt structure
 Example: Debt structure and leverage
 Two European high yield issuers in the same industry
have the following financial information:
Example: Debt structure and leverage
In € million A B
Cash 100,00 50,00
Interest expense 40,00 20,00
EBITDA 85,00 42,50
Secured bank debt 500,00 125,00
Senior unsecured debt 200,00 50,00
Convertible bonds 50,00 200,00
Example: Debt structure and leverage
Secured debt leverage: 500.0 / 85.0 = 5.9x 125.0 / 42.5 = 2.9x
secured debt/EBITDA

Senior leverage: (500.0 + 200.0) / 85.0 = (125.0 + 50.0) / 42.5 =

(secured + senior unsecured 8.2x 4.1x
debt)/EBITDA

Total debt leverage: (500.0 + 200.0 + 50.0) / (125.0 + 50.0 + 200.0) /

total debt/EBITDA 85.0 = 8.8 42.5= 8.8x

Net leverage: (750.0 - 100.0) / 85.0 = (375.0 - 50.0) / 42.5 = 7.6x

7.6x
Example: Debt structure and leverage
 Company B has a lower secured debt leverage ratio
than Company A, while total and net leverage ratios are
about the same.

 Company B is more creditworthy for unsecured debt

holders because it is less top heavy and may have
additional capacity to borrow from banks, which
suggests a lower probability of default. If it does
default, Company B may have a higher percentage of
assets available to unsecured debt holders than
Company A, especially if holders of convertible bonds
have exercised their options.
Covenants
 Important covenants for high yield debt include:
 Change of control put. This covenant gives debt holders the right to require
the issuer to buy back debt in the event of an acquisition. For investment
grade bonds, a change of control put typically applies only if an acquisition
of the borrower results in a rating downgrade to below investment grade.
 Restricted payments. The covenant protects lenders by limiting the amount of
cash that may be paid to equity holders.
 Limitations on liens. The covenant limits the amount of secured debt that a
borrower can carry.
 Restricted versus unrestricted subsidiaries. Issuers can classify subsidiaries as
restricted or unrestricted. Unrestricted subsidiaries' cash flows and assets can
be used to service the debt of the parent holding company.
Sovereign debt
 Sovereign debt is issued by national governments. Sovereign
credit analysis must assess both the government's ability to
service debt and its willingness to do so.
 The assessment of willingness is important because
bondholders usually have no legal recourse if a national
government refuses to pay its debts.
 Credit rating agencies assign each national government two
ratings: (1) a local currency debt rating and (2) a foreign
currency debt rating. Foreign currency debt typically has a
higher default rate and a lower credit rating because the
government must purchase foreign currency in the open
market to make interest and principal payments, which
exposes it to the risk of significant local currency depreciation.
Sovereign debt
 A basic framework for evaluating and assigning a credit rating to
sovereign debt includes five key areas:
 Institutional effectiveness includes successful policymaking, absence of
corruption, and commitment to honor debts.
 Economic prospects include growth trends, demographics, income per
capita, and size of government relative to the private economy.
 International investment position includes the country's foreign reserves,
its external debt, and the status of its currency in international markets.
 Fiscal flexibility includes the government's willingness and ability to
increase revenue or cut expenditures to ensure debt service, as well as
trends in debt as a percentage of GDP.
 Monetary flexibility includes the ability to use monetary policy for
domestic economic objectives (this might be lacking with exchange rate
targeting or membership in a monetary union) and the credibility and
effectiveness of monetary policy.
Municipal debt
 Municipal bonds are issued by state and local governments or their
agencies. Municipal bonds usually have lower default rates than
corporate bonds with same credit ratings.

 Most municipal bonds can be classified as general obligation bonds

or revenue bonds.

 General obligation (GO) bonds are unsecured bonds backed by

the full faith and credit of the issuing governmental entity, which is
to say they are supported by its taxing power.

 Municipal governments' ability to service their general obligation

debt depends ultimately on the local economy (i.e., the tax base).
Municipal debt
 Revenue bonds finance specific projects. Revenue bonds often have
higher credit risk than GO bonds because the project is the sole
source of funds to service the debt.

 Analysis of revenue bonds combines analysis of the project, using

techniques similar to those for analyzing corporate bonds, with
analysis of the financing of the project.

 A key metric for revenue bonds is the debt service coverage ratio
(DSCR), which is the ratio of the project's net revenue to the
required interest and principal payments on the bonds.

 Many revenue bonds include a covenant requiring a minimum debt

service coverage ratio to protect the lenders' interests.