Corporate Debt
Instruments and Credit Analysis
Chapter 20
All Pages
Corporate Debt Instruments
Corporate Debt
Securities
Secured Bonds
Corporate Bonds
Medium-Term
Notes (MTNs)
Unsecured Bonds
(Debenture Bonds)
Credit-Enhanced
Bond
Mortgage Debt
secured by real property
or personal property
Collateral Trust
Bonds
secured by
financial assets
Commercial Paper
Directly-Placed
guaranteed by a
Third Party
guaranteed by a
Bank Letter of Credit
Dealer Placed
Moody's S&P
Fitch
Brief Definition
Investment Grade: High Credit Worthiness
Aaa
AAA
AAA
Gilt edge, prime, maximum safety
Aa1
AA+
AA+
Aa2
AA
AA
Very high grade, high quality
Aa3
AA–
AA–
A1
A+
A+
A2
A
A
Upper medium grade
A3
A–
A–
Baa1
BBB+
BBB+
Baa2
BBB
BBB
Lower medium grade
Baa3
BBB2
BBB2
Distinctly Speculative: Low Creditworthiness
Ba1
BB+
BB+
Ba2
BB
BB
Low grade, speculative
Ba3
BB–
BB–
B1
B+
B+
B2
B
B
Highly speculative
B3
B–
B–2
Predominantly Speculative: Substantial Risk or in Default
CCC+
Caa
CCC
CCC
Substantial risk, in poor standing
CCC–
Ca
CC
CC
May be in default, extremely speculative
C
C
C
Even more speculative than those above
CI
CI = Income bonds; no interest is being paid
DDD
Default
DD
D
D
Credit analysis for corporate bonds
Trading Strategy
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Strategy – find bonds whose credit rating is too low
(yield spread to Treasury is too high)
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Can also play corporate bond spreads overall
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Buy Corp Bond with view that the market corrects to agree
with your position
Make profits from the tightening credit spread
Example: Buy IBM bonds & Sell Dell bonds
Spread trades involve going long the underpriced
security and/or short the overpriced security
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Shorting can be done through Credit Default Swaps (CDS)
Areas analyzed by bond credit analysts
Page 445
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I - Bond covenants
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II - Collateral analysis
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Protections to Bond Holders
What assets are available should issuer fail
III - Ability to make payments (financial situation)
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Cash Flow generation
Part I - Covenant analysis
pg. 445-447
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Credit analysis involves close scrutiny of the
indenture for each bond issue
Covenants can be strong or weak and involve
loopholes
Meant to protect lenders (Bond Investors)
Two types
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Affirmative (what they WILL do)
Negative (or Restrictive – what they CAN’T do)
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Example – Limit ability to issue more debt
Part II - Collateral analysis
pg. 446
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Secured versus unsecured debt
Absolute priority rule puts secured first
Often unsecured creditors are made whole
first in reorganization
Secured debtholders have stronger
bargaining position in chapter 11 reorg

Sometimes Secured Debt holders end up holding
debt in the newly re-emerging entity
Part III - Assessing issuers ability to pay
pg. 446-456
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Business risk
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Governance risk
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Financial risk
Business risk analysis
Pg. 447-450
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Risk associated with operating cash flows
Revenue (adjusted for accruals)-cash expensestaxes
What could effect this?
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Macro-economic risk
 Overall economic slowdown
Industry risk – very important
 Industry Growth Rates (relative to GDP)
 Cyclical or not
 Industry structure (different from most?)
Competitors/competitive position
 R&D
 Barriers to entry
 Price takers or makers – ability to pass along costs?
Governance risk
Pg. 450-453
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Ownership structure
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Board strength
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Independent boards (bigger is better)
Audit committee strength
Financial disclosure policies
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Managers and shareholders aligned
Aggressive versus conservative accounting
policies
Shareholders rights
Financial risk
Pg. 453-456
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Look at ratios (versus industry)
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Interest coverage ratio or pretax interest coverage
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Leverage Ratio
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EBITDA/interest expense
High is good (indicates lower credit risk)
LT Debt/ market capitalization
LT Debt/EBITDA (Text Example w/ Lear Corp)
Cash Flow
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Very important for high risk borrowers (below invest. grade)
Operating cash, free cash*, discretionary cash
* Most Commonly used
Financial Risk Continued
Net assets and working capital – pg. 455-456
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Ratio of Net Assets to Total Debt
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Working Capital (Current Assets minus Current Liab)
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Liquidation Value of assets should be considered
Liquidity of the assets is important (page 456 top)
Primary measure of company’s financial flexibility
Current ratio (current assets/current liabilities)
Acid test (takes out inventories from current assets)
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Receivables quality is important
High liquidity is better than low