Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives

CHAPTER 10

Framework for the Credit Analysis of Corporate Debt

In this chapter, we provide a framework for the analysis of corpo■ rate debt, explaining how credit assessments are more than just the traditional review of financial ratios and leverage metrics.

APPROACHES TO CREDIT ANALYSIS

At one time, when interest rates were stable and investors purchased debt instruments with the purpose of holding them to maturity, the major focus of credit analysis for corporate debt was almost exclusively on the likelihood that the corporation would not make the scheduled interest and principal payments. The analysis primarily involved the calculation of a series of ratios (e.g., fixed charge coverage, leverage, and cash flow to total debt) that were associated with debt instruments. This one-dimensional approach ignored fluctuations in the market value of the debt instruments because changes in interest rates were minimal, and fluctuations attributable to credit changes of the obligor were mitigated by the fact that the investor had no intention of selling the instrument prior to its maturity date.

During the past three decades, the approach to the analysis of corporate debt instruments changed due to the fact that the motivation for acquiring debt instruments changed dramatically. Specifically, an increasing number of institutional investors actively trade them with the purpose of generating an attractive returns attributable to changes in interest rates, or in absolute or relative credit ...