Introduction to Credit Management

Credit investors also face other event risks which are out of control for management and we will discuss this topic later. The subjective assessment of a credit analyst can provide valuable information about future changes of an issuer’s credit quality and hence the performance of bonds.

As the next step the capital structure and covenants have to be analyzed which is particularly important for high-yield issues. Sometimes bonds of issuers with a negative credit trend have coupon step-up language which means that bondholders will receive, for example, 25 bp in the case of 1 notch downgrade by one rating agency. This way a company can show committment to its current rating and bondholders have some protection in the case of a downgrade.

In a final step a relative value analysis has to be conducted in order to make a final investment decision based on the fundamental analysis results. Analysts and portfolio managers are used to express their views relative to a chosen average, for example, statements like bond X should trade 15–20 bp wide to bond Y are quite common. At this point spread volatility and the liquidity of single bonds have to be considered in the final decisionmaking process.

The main anchors of credit analysis are cash flows, asset value, profitability, management assessment and covenants. Every company has to be able to generate positive cash flows in the long run. Companies with permanently negative cash flows will face liquidity constraints at some point in future. Another focus lies on balance sheet strength. The value of assets is very important for bondholders because they can be pledged against liabilities. For particularly high leveraged companies a situation might evolve where asset sales are the last option for deleveraging. The management assessment is another important factor for credit analysis particularly for assigning probabilities to various event risks. Finally, covenants have the main purpose of limiting event risk in terms of a company undertaking bondholder-unfriendly actions.  Another focus lies on the equity-market performance and the implied volatility of a company’s stock. We can identify periods where equity and corporate bonds move in the same direction and times where they decouple; in distressed cases the decoupling will be permanent because equity will have no value and the remaining value will reside with debt.