Fixed Income II
Reading 47. Fundamentals of Credit Analysis
Learning Outcome Statements
j. explain special considerations when evaluating the credit of high yield, sovereign, and municipal debt issuers and issues.
CFA Curriculum, 2020, Volume 5
Subject 6. Special Considerations of High-Yield, Sovereign, and Municipal Analysis
High-yield bonds are issued by organizations that do not qualify for investment-grade ratings. These issuers must pay a higher interest rate to compensate investors for the increased risks. In analyzing the creditworthiness of high-yield corporate bonds, an analyst should pay close attention to the following:
- Liquidity: how liquid is the issuer? What is its ability to generate cash as needed?
- Projections of future earnings and cash flow
- Debt structure analysis (debt seniority)
- Corporate structure: what are the relationships among all of the subsidiaries? Are the subsidiaries potentially contributing to or draining resources from the creditors?
- Covenants: change of control put, payment restrictions, limitations on liens and additional indebtedness, restricted versus unrestricted subsidiaries, etc.
- Equity-like approach to high yield analysis
Traditionally, high-yield bonds have provided a greater return than high-grade bonds, but lower than equities. Similarly, high-yield bond risk has been higher than that of investment grade bonds, but less than equities. High-yield bonds have historically been more highly correlated with equity securities than with investment-grade bonds. Thus, some analysts believe that an equity analysis approach will provide a better framework for high-yield bond analysis than a traditional credit approach.
An equity-like approach to high-yield analysis can be helpful. Calculating and comparing enterprise value with EBITDA and debt/EBITDA can show a level of equity "cushion" or support beneath an issuer's debt.
Two key issues for sovereign analysis:
- A government's ability to pay.
- A government's willingness to pay.
Both quantitative and qualitative analyses are employed in assessing sovereign risk with ratings performed in both local currency and foreign currency. It is important to evaluate the ratings in both currencies since historically the default rate on foreign currency debt has been greater than the default rate on local (or domestic) currency debt; there is different risk in the two ratings. Generally, if an issuer is planning to default, it is more likely to do so with a foreign currency issue. Thus, the ratings need to be performed for both types of issues.
A framework is presented in the reading. It highlights five broad areas:
- Institutional effectiveness and political risks
- Economic structure and growth prospects
- External liquidity and international investment position
- Fiscal performance, flexibility, and debt burden
- Monetary flexibility
There are two basic types of municipal bonds:
General obligation (GO) bonds depend on the general creditworthiness of a municipality to repay the debt. The credit analysis has some similarities to sovereign analysis. In general, a municipal analyst should look at employment, industry, and real estate valuation trends needed to generate taxes and fees.
Revenue bonds support specific projects. The credit analysis is identical to that of a corporate bond analysis. The focus is to assess whether or not the underlying cash flows from the project will be sufficient to meet the obligations.
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Recap from previous chapters...
Two types of muni bonds:
1. Tax-backed bonds
- GO (e.g. double-barreled)
- Appropriation-backed (e.g. moral)
2. Revenue bonds (higher coupon rate)
- considered 2nd safest type of muni
""if it quacks like a duck""?????? wtf... what's the point of that lol