Notes for Level I CFA® Program

R55 Fundamentals of Credit Analysis

7.1. High YieldWatch Video Play


These are non-investment grade, junk bonds that are rated below Baa3/BBB by most agencies.

Why do bonds issued by some companies get junk status?

Instructor’s Note: Remember the points from the four Cs in credit analysis that an investment-grade bond must have. This list is just the opposite of that.

  • Highly leveraged capital structure.
  • Limited or negative free cash flow (no capacity).
  • Weak or limited operating history.
  • Highly cyclical business.
  • Poor management (poor character).
  • Risky financial policies.
  • Declining industry.
  • Lack of competitive advantages.

If the bond is at a risk of default, then the analysis must be more detailed than for an investment-grade bond. The factors a credit analyst must focus on for a high-yield bond are as follows:

  • Liquidity and cash flow.
  • Detailed financial projections.
  • Debt structure.
  • Issuer’s corporate structure.
  • Equity-like approach to high-yield analysis.

Let us look at each of the points in detail now:

Liquidity

  • Investment grade companies have cash on their balance sheets or committed sources of capital to roll over maturing debt.
  • High-yield companies may not have access to debt/equity markets or other sources of capital.
  • Sources of liquidity (listed below are sources ordered from strongest to weakest) for a high-yield company must be analyzed:
    • Cash on the balance sheet – most reliable.
    • Working capital.
    • Operating cash flow.
    • Bank credit facilities.
    • Equity issuance – not reliable if market conditions are bad.
    • Asset sales – least reliable.

Cause of concern/warning sign:

  • Debt coming due in the next 6 to 12 months with low sources of liquidity.

Detailed financial projections

  • Forecast future earnings and cash flow under different stress scenarios to see if credit profile is improving, stable or declining.
  • Must take into account ongoing capital expenditures.

Debt structure

  • High-yield companies issue debt with varying levels of seniority (second lien, senior unsecured, subordinated, preferred stock). It is important to understand the debt structure – how much debt is senior and subordinated? Within senior debt, how much is secured and unsecured?
  • Leverage (calculated as Debt/EBITDA ratio) at each level of debt must be calculated to determine the recovery rate if default occurs. Leverage can either be calculated as gross or net leverage. Gross leverage includes cash. In net leverage, cash is subtracted from debt and calculated as (Debt-cash)/EBITDA.
  • Lower the ranking à lower the credit rating àlower the expected recovery rate.

Corporate structure

  • High-yield investors must analyze an issuer’s corporate structure and distribution of debt between the parent and its subsidiaries. Is the corporate structure complex?
  • How does the cash flow between the parent (holding company) and its subsidiaries – subsidiary to parent or parent to subsidiary?
  • Is the issuer a holding company? Do the holding company’s subsidiaries have outstanding debt? How are the leverage ratios for each debt-issuing entity?

Covenant analysis

The covenants for high-yield issuer may include:

  • Change of control put: If the issuer gets acquired, then this clause requires the issuer to buy back the debt from investors either at par or small premium to par. The objective is to protect them from a downgrade after acquisition or a weaker acquirer.
  • Restricted payments: Defines how much cash can be paid to shareholders over time.
  • Limitations on liens and additional indebtedness: Defines how much secured debt an issuer can have. Objective is to protect unsecured bondholders in the event of default by not having too many secured layers above them.
  • Restricted versus unrestricted subsidiaries: Subsidiaries are classified as restricted and unrestricted. Certain subsidiaries with significant assets may be classified as restricted to help service parent-level debt.

Equity-like approach to high-yield analysis

  • Risk and return profile of high-yield bonds falls somewhere in between high-quality investment grade bonds and stocks.
  • So, analyzing high-yield bonds like equities is useful.
  • Credit analysts may analyze high-yield bonds by calculating enterprise value = equity market capitalization + total debt – cash.
  • Then, they may compare EV/EBITDA and Debt/EBITDA of different issuers as part of their analysis.