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.

As the first step the financial risk of a company has to be assessed. As the next step the business risk has to be defined and its effect on the financial risk has to be explained because various business strategies will result in different finanical profiles. The third component is event risk which is partly influenced by management, but also external factors which are out of the control of management. The trend in a company’s financial risk profile is determined to a large extent by the underlying business. The analysis of business risk deals with the stability, quality and predictability
of a company’s business throughout the entire economic cycle, for example, cash flows and earnings of car manufacturers depend to a large extent on the economy and investors will require higher risk premia in weak economic periods which results in the spread widening for bonds issued by car manufacturers. In this case a comparable analysis of an issuer’s market position versus its peers and the ability to manage weak economic periods in the past should be incorporated in the dynamic part of the credit analysis.